The Role of Property Tax in American Government (Part 2)

By Todd D. Jones, MAI, CRE, FRICS and Michael J. Mard, CPA/ABV, CPCU
Note to reader: This article is second in a series of columns addressing The Role of Property Tax in American Government culminating in the generally accepted methodology of the real estate appraisal, business valuation and accounting industries reconciled and properly applied to a property tax case study. The series of columns will address trends in government, statutory limitations available to tax payers, industry standards applicable and a sample case study.

Remedies for Overassessment

Residential Property Challenges

While understandably burdensome, especially in recessionary economic environments, most individual homeowner’s property tax burden is insufficient to merit a cost-effective challenge with professional representation. As such, most homeowners lose challenges, or simply grumble and pay the tax. In many cases, property taxes and insurance premiums are bundled with the mortgage escrow; in these situations, the issue is frequently overlooked.

Commercial Property Challenges

Property tax is usually one of the largest operating line item for income-producing real estate. For many companies, property taxes exceed their federal income tax liability. Prudent owners and operators scrutinize not just the amount of the tax, but its underlying basis annually. In some jurisdictions, property tax implications may derail as much as 70% of all commercial property transactions. Due to the practice complexities, professional representation is generally recommended.

The Exemption/ Abatement Trap

It is all too common that once a company negotiates a long-term property tax abatement in the process of erecting a new facility, and creating new jobs within a taxing jurisdiction, attention to the assessment level wanes, because it is not an imminent threat to profitability. Unfortunately, ten years later, the abatement terminates and the assessment level has an established, and unmanaged, history. At this point, the assessment has momentum and becomes difficult to stem.

PILOTs (Payments in Lieu of Property Taxes)

According to the federal Department of the Interior’s website, “Payments in Lieu of Taxes” (PILOT) are federal payments to local governments that help offset losses in property taxes due to non-taxable federal lands within their boundaries. The key law is Public Law 94-565, dated October 20, 1976. This law was rewritten and amended by Public Law 97-258 on September 13, 1982 and codified at Chapter 69, Title 31 of the United States Code. The law recognizes that the inability of local governments to collect property taxes on federally-owned land can create a financial impact.

PILOT payments help local governments carry out such vital services as firefighting and police protection, construction of public schools and roads, and search-and-rescue operations. The payments are made annually for tax-exempt federal lands administered by the BLM, the National Park Service, the U.S. Fish and Wildlife Service (all agencies of the Interior Department), the U.S. Forest Service (part of the U.S. Department of Agriculture), and for federal water projects and some military installations. PILOT payments are one of the ways that the Federal government can fulfill its role of being a good neighbor to local communities.

The Department of the Interior’s (DOI) Office of the Secretary has administrative authority over the PILOT program. In addition to other responsibilities, DOI calculates payments according to the formulas established by law and distributes the available funds. Applicable DOI regulations pertaining to the PILOT program were published as a final rule in the Federal Register on December 7, 2004.

The formula used to compute the payments is contained in the PILOT Act and is based on population, receipt sharing payments, and the amount of federal land within an affected county. PILOT payments are in addition to other federal revenues (such as oil and gas leasing, livestock grazing, and timber harvesting) that the federal government transfers to the states. The DOI has distributed more than $6.3 billion dollars in PILOT payments to states (except Rhode Island), as well as the District of Columbia, Puerto Rico, Guam, and the Virgin Islands since these payments began in 1977.(2)

Litigation

Taxpayers or local government entities frustrated with the administrative process generally have the right to litigate the dispute. Sometimes an impending deadline might motivate a lawsuit to protect the taxpayer’s rights when deadlines would otherwise foreclose the administrative action, so that the parties can continue to negotiate or mediate the matter. Like all transactions taxpayers and their representatives should make litigation decisions based on the likely benefit.

Legislation

Interested parties regularly lobby for modifications to state laws. The American Bar Association publishes a Property Tax Deskbook (3) that provides state-by-state overviews of property tax laws and other information useful to practitioners.

Moral Hazards

It is noteworthy to mention that the political and economic aspects of property taxation introduce significant moral hazards. In economic theory, a moral hazard is a situation where a party will have a tendency to take on risk, because the cost that could result from taking that risk will not be felt by the party taking the risk. In reality, property owners, their elected representatives, government employees, and elected officials all have personal financial interests in the outcome of disputes regarding a hypothetical market value. This is why the arena is so contentious. Risk shifting is commonplace.

Valuation Methodology Overview

In most states, the standard of value for property taxation is fair market value; the basis for the taxation is drawn from the property’s value. Ad valorem is Latin for “from the value” but is generally understood to mean “in proportion to value.” Standards are statutorily specified by each state and must be followed by the local assessment authorities as assessed values are placed on real and personal property. Some states then apply assessment ratios, frequently by class of property, to the value standard to result in the taxable assessed value.

Market value is, by definition, a hypothetical value; and as such, agreement and understanding of a specific definition and its implications is a frequent point of contention among valuers. According to the Appraisal Institute, market value is described as:

The major focus of most real property appraisal assignments. Both economic and legal definitions of market value have been developed and refined.(4)

The most widely accepted components of market value are incorporated in the following definition:

The most probable price that the specified property interest should sell for in a competitive market after a reasonable exposure time, as of a specified date, in cash, or in terms equivalent to cash, under all conditions requisite to a fair sale, with the buyer and seller each acting prudently, knowledgeably, for self-interest, and assuming that neither is under duress.(5)

Market value is described in the Uniform Standards of Professional Appraisal Practice (USPAP) as follows:

A type of value, stated as an opinion, that presumes the transfer of a property (i.e., a right of ownership or a bundle of such rights), as of a certain date, under specific conditions set forth in the definition of the term identified by the appraiser as applicable in an appraisal. Appraisers are cautioned to identify the exact definition of market value, and its authority, applicable in each appraisal completed for the purpose of market value. (6)

USPAP also requires that certain items be included in every appraisal report. Among these items, the following are directly related to the definition of market value:

  • Identification of the specific property rights to be appraised.
  • Statement of the effective date of the value opinion.
  • Specification as to whether cash, terms equivalent to cash, or other precisely described financing terms are assumed as the basis of the appraisal.
  • If the appraisal is conditioned upon financing or other terms, specification as to whether the financing or terms are at, below, or above market interest rates and/or contain unusual conditions or incentives. The terms of above- or below-market interest rates and/or other special incentives must be clearly set forth; their contribution to, or negative influence on, value must be described and estimated; and the market data supporting the opinion of value must be described and explained.

The following definition of market value is used by agencies that regulate federally insured financial institutions in the United States:

The most probable price that a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimulus.

Implicit in this definition is the consummation of a sale as of a specified date and the passing of title from seller to buyer under conditions whereby:

  • Buyer and seller are typically motivated;
  • Both parties are well informed or well advised, and acting in what they consider their best interests;
  • A reasonable time is allowed for exposure in the open market;
  • Payment is made in terms of cash in U.S. dollars or in terms of financial arrangements comparable thereto; and
  • The price represents the normal consideration for the property sold unaffected by special or creative financing or sales concessions granted by anyone associated with the sale.(7)

The International Valuation Standards Council defines market value for the purpose of international standards as follows:

The estimated amount for which a property should exchange on the date of valuation between a willing buyer and a willing seller in an arm’s-length transaction after proper marketing wherein the parties had each acted knowledgeably, prudently, and without compulsion. (8)

The Uniform Standards for Federal Land Acquisitions define market value as:

Market value is the amount in cash, or on terms reasonably equivalent to cash, for which in all probability the property would have sold on the effective date of the appraisal, after a reasonable exposure time on the open competitive market, from a willing and reasonably knowledgeable seller to a willing and reasonably knowledgeable buyer, with neither acting under any compulsion to buy or sell, giving due consideration to all available economic uses of the property at the time of the appraisal.

With so many variations on the definition, the likelihood of confusion, even among professionals, is understandable. (9)

Standards of Value

Fair Market Value

Fair Market Value is a term that is, in concept, similar to market value in general usage; used mainly in condemnation, litigation, income tax, and property tax situations. When an appraisal assignment involves developing an opinion of fair market value, the appropriate, requisite, and precise definition of the term depends on the use of the appraisal and the applicable jurisdiction. For example, the Internal Revenue Service defines fair market value as follows:

The price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts. The fair market value of a particular item of property includible in the decedent’s gross estate is not to be determined by a forced sale price. Nor is the fair market value of an item of property to be determined by the sale price of the item in a market other than that in which such item is most commonly sold to the public, taking into account the location of the item wherever appropriate. (10)

The California Code of Civil Procedure (Section 1263.320(a)) defines fair market value as follows:

The highest price on the date of valuation that would be agreed to by a seller, being willing to sell but under no particular or urgent necessity for so doing, nor obliged to sell, and a buyer, being ready, willing, and able to buy but under no particular necessity for so doing, each dealing with the other with full knowledge of all the uses and purposes for which the property is reasonably adaptable and available.(11)

Fair Value

Adding to the complexity, fair value actually has two definitions per the Financial Accounting Standards Board (FASB)(12). Definition 1 is:

The amount at which an asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale.

The second official definition is:

the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

Importantly for accurate property tax assessments, intangible assets are defined as:

Assets (not including financial assets) that lack physical substance. (The term intangible assets is used to refer to intangible assets other than goodwill.)(13)

Premise of Value

Even further complicating the matter is the premise on which the value definition is founded. The Financial Accounting Standards Board’s Accounting Standards Codification 805 states that financial assets may be valued “in use” or “in exchange” under specified conditions.

  • Value In Exchange
    Attribution of value to goods or services based on what can be obtained for them in exchange for other goods and services. (14)
  • Value In Use
    The value of a property assuming a specific use, which may or may not be the property’s highest and best use on the effective date of the appraisal. Value in use may or may not be equal to market value but is different conceptually. (15)

Property assessed under a value-in-use premise will punish superior performance, because above-average profitability is taxable. Property taxed under a value-in-exchange premise theoretically renders a similar assessment for all property within the same strata thus approaching just value.

For example, consider two otherwise identical income-producing properties, which are taxed based on the income approach, with the following income statements:

PropertyAB
Gross Revenue$100,000$150,000
Less:Vacancy($10,000)($10,000)
Net Revenue$90,000$140,000
Less: Expenses($50,000)($50,000)
NOI/EBITDA$40,000$90,000
Mult: Tax Rate0.02000.0200
Gross Tax$800$1,800

The more profitable business operation will pay more under a value-in-use premise; thus, punishing the entrepreneur and disincentivizing economic development for that jurisdiction. Under a value-in-exchange premise, both owners would pay an equal amount, i.e., Just Value.

Fee Simple

Absolute ownership unencumbered by any other interest or estate, subject only to the limitations imposed by the governmental powers of taxation, eminent domain, police power, and escheat.(16)

In jurisdictions in which a fee simple interest in property is the standard, market-derived valuation metrics are proper for application in developing assessments.

Leased Fee

A freehold (ownership interest) where the possessory interest has been granted to another party by creation of a contractual landlord-tenant relationship (i.e. a lease).(17)

In jurisdictions in which a leased fee interest in property is the standard, property specific valuation metrics are proper for application in developing assessments. Otherwise, property assessed as a leased fee interest will punish superior performance, because above-average profitability is taxable. Property taxed as a fee simple interest theoretically renders a similar assessment for all property within the same strata, thus approaching just value.

Real Property Valuation Issues

In appraising real estate for market value, the professional appraiser has three traditional approaches from which to select: Income Approach (generally income capitalization), Asset Based Approach (also known as the cost approach), and Market Approach (sales comparison). Although all three-valuation procedures should be considered, the inherent strengths of each approach and the nature of the subject property must be evaluated to determine which will provide supportable estimates of market value. The appraiser then selects one or more of the appropriate approaches in arriving at a final value estimate.

Income Approach

The income capitalization approach analyzes a property’s ability to generate financial returns as an investment. The appraisal estimates a property’s operating cash flow, projecting both revenue and expenses. Inherent to the income approach, specifically the capitalized earnings method, is the capitalization of the resulting net operating income. Through an income capitalization procedure, the value of each component is calculated. The total of the mortgage component and the equity component equals the value of the property. The model emulates a typical investor’s analysis of return on and return of capital. The value derived from the direct capitalization analysis may then be compared to a conventional discounted cash flow analysis as a final check. Importantly, there are derivations to this method including those utilizing net free cash flow. The income approach is often selected as the preferred valuation method for operating properties because it most closely reflects the investment rationale of knowledgeable buyers.

Market Approach

The market or sales comparison approach estimates the value of a property by comparing it to similar properties sold on the open market. To obtain a supportable estimate of value, the sales price of a comparable property must be adjusted to reflect any dissimilarity between it and the property being appraised. The sales comparison approach is most useful in the case of simple forms of real estate, such as vacant land and single-family homes, where the properties are homogeneous and the adjustments are few and relatively simple to compute. In the case of complex investments such as shopping centers, office buildings, restaurants, and lodging facilities, where the adjustments are numerous and more difficult to quantify, the sales comparison approach loses much of its reliability. For instance, hotel investors typically do not employ the sales comparison approach in reaching their final purchase decisions. Although the sales comparison approach may provide a range of values that supports the final estimate, reliance on this approach beyond the establishment of broad parameters is rarely justified by the quality of the sales data.

Asset Based Approach

The asset based or cost approach estimates market value by computing the current cost of replacing the property and subtracting any depreciation resulting from physical deterioration, functional obsolescence, and external (or economic) obsolescence. The value of the land, as if vacant and available, is then added to the depreciated value of the improvements to produce a total value estimate. The cost approach is most reliable for estimating the value of new properties; however, as the improvements deteriorate and market conditions change, the resultant loss in value becomes increasingly difficult to quantify accurately.

Uniformity

Equal treatment, as mandated by the United Sates Constitution, has required most state legislatures to enact “uniform” assessment laws. Similar property should be similarly assessed. According to Black’s Law Dictionary, uniformity in taxation implies equality in the burden of taxation, which cannot exist without uniformity in the mode of assessment, as well as in the rate of taxation. Further, the uniformity must be coextensive with the territory to which it applies. And, it must be extended to all property subject to taxation, so that all property may be taxed alike and equally.(18)

Centrally Assessed Property

Most states relegate certain property types to central assessment, where valuations are developed at the state level, due to its multijurisdictional nature. Typically, railroads, railroad cars, microwave towers, telecommunications towers, telephone cooperatives, gas utilities, electric utilities, electric cooperatives, natural gas pipelines, oil pipelines, and airlines are centrally assessed.

Intangible Assets

Intangible assets are assets (not including financial assets) that lack physical substance. While accountants and business valuers are well acquainted with intangible property, its very existence (when integrated into real or personal property) is resisted by assessors; probably because intangible assets are not assessable and therefore are nontaxable in most jurisdictions. The Uniform Standards of Professional Appraisal Practice requires that appraisers separately identify, and, if possible, value, separate real, personal, and intangible components in assignments where such property exists. USPAP Standard 1-4(g) states:

When personal property, trade fixtures, or intangible items are included in the appraisal, the appraiser must analyze the effect on value of such non-real property items.

Reconciliation

The final step in the valuation process is the reconciliation and correlation of the value indications derived from one or more of the three approaches. Factors that are considered in assessing the reliability of each approach include the purpose of the appraisal, the nature of the subject property, and the reliability of the data used. In the reconciliation, the applicability and supportability of each approach, each component asset and its rate of return are considered and the range of value indications is examined. The most significant weight is given to the approach that produces the most reliable solution and most closely reflects the criteria used by typical investors.

Tax Billing

In most jurisdictions, assessment challenges are resolved before tax bills are mailed to property owners. In major urban jurisdictions however, assessment challenges can take years to resolve.

When the assessor mails the notice of proposed assessments to taxpayers, the assessor also notifies the tax collector and the relevant taxing authorities that may levy taxes on the property. Depending on where a property is located geographically the owner may receive one or several bills (e.g., county, city, school district, etc.) from a tax collector. In most jurisdictions, tax bills are mailed several months after the proposed assessment notice. The tax bill may arrive with the proposed tax notice in some jurisdictions.

Collecting

As the title implies, the tax collector is responsible for collecting taxes, mostly property taxes, on behalf of the taxing authorities. In many jurisdictions, the tax collector is an independent agency, but in some jurisdictions the tax assessing and tax collecting functions are combined into a single office or agency. Failure to pay property taxes timely typically results in a lien against the property that may eventually result in foreclosure.

The Current Fiscal Dilemma

Today, state and local governments across the US are facing serious operating inefficiencies and deficits, as well as substantial pension obligations. These problems are compounded by expected declines in tax revenue as the Baby Boomer population begins to retire.

The dilemma is summarized in an article titled “States Expand Lucrative Pensions To More Jobs,” in USA Today, reported on December 9, 2011:

Special retirement benefits once reserved for police, firefighters and others with dangerous jobs are now being given to tens of thousands of state workers employed as park rangers, foresters, dispatchers, coroners, even highway laborers, museum guards and lifeguards.

The trend will add heavily to the $70 billion that state taxpayers owe state retirement funds each year and is costing states such as Florida and Maryland $15 million to $30 million annually, a USA TODAY analysis shows.

Thirty-one states have passed laws since 2000 that expand the range of workers who can retire when they turn 50 or 55 or after working 20 or 25 years, then collect special pensions that will pay some an extra $1 million or more in retirement. The pensions are enhanced because they are usually based on a higher percentage of a worker’s salary than pensions for ordinary state workers.

There’s been a massive increase in the scope of who qualifies for (early) retirement benefits,” said William Eggers, public-sector research director at Deloitte consultants. “They’re supposed to be for people who are getting shot at and running into buildings that are on fire.”

Early retirement is usually far more costly to taxpayers because retirees collect a pension for additional years and are not paying into the state pension system as full-time workers.

“You could easily end up spending more on public-safety workers while they’re retired than when they’re working,” said North Carolina State University retirement expert Robert Clark, author of A History of Public Sector Pensions in the United States. “If these folks are starting work in their 20s, they are eligible to retire in their late 40s, early 50s and get a pension and health insurance for the rest of their life.”

The growth of early retirement has helped fuel massive deficits in some of the nation’s largest public pension plans, including the main California and Florida retirement systems.

The deficits led 36 states in recent years to take cost-control steps such as requiring workers to pay more toward their pension or delaying when they can retire, said Ron Snell, a pension expert at the National Conference of State Legislatures. “This is unprecedented,” he said.

Accounting giants Deloitte, PricewaterhouseCoopers, and Ernst & Young, as well as the Pew Research Center have all documented the problem and realized similar conclusions.

In an ongoing report titled “Bankrupt Cities, Municipalities List and Map,” Governing.com reports:

Many local governments across the U.S. face steep budget deficits as they struggle to pay off debts accumulated over a number of years. As a last resort, some filed for bankruptcy.

Governing is tracking the issue, and will update this page as more municipalities seek bankruptcy protection. (20)

In 2013 Detroit became the largest municipality in U.S. history to file for bankruptcy. The state had already appointed an emergency financial manager for the city, saddled with debts totaling an estimated $18 billion.

Overall, though, bankrupt municipalities remain extremely rare. A Governing analysis estimated only one of every 1,668 eligible general-purpose local governments (0.06 percent) filed for bankruptcy protection over the past five years. Excluding filings later dismissed, only one of every 2,710 eligible localities filed since 2008.

The majority of filings have not been submitted by bankrupt cities, but rather lesser-known utility authorities and other narrowly-defined special districts throughout the country. In Omaha, Neb., a dozen sanitary districts have filed for bankruptcy. The report indicates that 38 cities have filed for bankruptcy protection, including Detroit, MI, San Bernardino, CA, Mammoth Lakes, CA (Dismissed), Stockton, CA, Jefferson County, AL, Harrisburg, PA (Dismissed), Central Falls, RI, and Boise County, ID (Dismissed). Understandably, significant political pressure will come to bear on elected officials and employees (including appraisers) working for government agencies to find revenue to meet these pressing demands.

Citations

  1. The authors thank Joryn Jenkins, Esq. for her legal insights and contributions to this article.
  2. http://www.doi.gov/pilt/index.cfm
  3. http://apps.americanbar.org/abastore/index.cfm</a
  4. Appraisal Institute, The Dictionary of Real Estate Appraisal, 5th ed. (Chicago: Appraisal Institute, 2010).
  5. Ibid.
  6. USPAP, 2012-2013 ed.
  7. 12 C.F.R. Part 34.42(g); 55 Federal Register 34696, August 24, 1990, as amended at 57 Federal Register 12202, April 9, 1992; 59 Federal Register 29499, June 7, 1994.
  8. International Valuation Standards, 8th ed., 2007.
  9. For further discussion of this important term, see The Appraisal of Real Estate, 14th ed. (Chicago: Appraisal Institute, 2013).
  10. IRS Regulation §20.2031-1(b).
  11. Appraisal Institute, The Dictionary of Real Estate Appraisal, 5th ed. (Chicago: Appraisal Institute, 2010).
  12. Financial Accounting Standards Board, Accounting Standards Codification, Master Glossary
  13. Ibid
  14. Appraisal Institute, The Dictionary of Real Estate Appraisal, 5th ed. (Chicago: Appraisal Institute, 2010).
  15. Ibid.
  16. Ibid.
  17. Ibid.
  18. Exchange Bank v. Hines, 3 Ohio St. 15. And see Edye v. Bobertson, 112 U. S. 580, 5 Sup. Ct. 247, 28 L Ed. 798. Adams v. Mississippi State Bank, 75 Miss. 701, 23 South. 395; People v. Auditor General, 7 Mich. 90.
  19. Op. cit.
  20. http://www.governing.com (article link)

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