"Unfortunately for investors, a property's taxable value
is 'uncapped,' and the taxable value is increased
the year following a transfer of ownership."

The real estate news from the Motor City continues to differ from that in most of the country's other major metropolitan areas. The Detroit metro area may even be in a unique position, though not an enviable one.

Until very recently, real estate across much of the country enjoyed news ranging from the good to the fantastic. In fact, so strong a resurgence occurred in some markets that the only question was whether down markets have been replaced by speculative bubbles.

While the positive developments of this year's first quarter proved less robust than the huge gains of the past two years, many markets continue to hold their own, even after the Fed's 14th straight interest rate hike in February 2006.

Faltering economy
Unfortunately, this is not the story in the Detroit area. The unpleasant news starts with the local economy. The federal government recently reported that the Detroit ranked No. 2 in unemployment among the 49 metropolitan areas with populations of one million or more. Many of the area's most renowned and important corporate citizens have either filed for bankruptcy or had their bonds rated below investment grade.

As a result, much of the Detroit area faces a continuing supply and demand imbalance causing stubbornly high vacancy rates in both the commercial and industrial sectors.

For example, the vacancy rate in Detroit's commercial office market, while down from its recent peak, remained over 15 percent at the end of 2005, while the national rate was 12 percent. During 2005, Detroit's industrial sector vacancy rate declined about 2 percent, to 11.4 percent. In contrast, national vacancy rates were estimated at close to 9 percent. Even if these sectors have hit bottom, by no means a certainty at this time, no one is expecting a quick or vigorous recovery in the Detroit area.

Amid the gloom, however, a few bright spots dot Detroit's landscape: the recent completion of some major corporate headquarters in downtown Detroit and significant residential developments in some suburban areas.

Tax problems
Adding to the problems, Michigan's unique property tax system continues to inhibit new investment. It began in 1994 when Michigan voters enacted an amendment known as Proposal A.

Prior to this proposal, property taxes were based on a property's assessed value, which was set at half the property's market value. Today, under Proposal A, assessors continue to be required to set assessed values at half of each property's market value.

However, taxes are now based on taxable value. Generally, taxable le value is the same as assessed value in the year after a property's ownership changes. Similarly, in the year after new construction is completed there is usually little difference between a property's taxable value and assessed value.

However, the assessed values and taxable values can diverge over time because assessed value should always represent half of market value, and taxable value increases are generally capped at the lesser of 5 percent or the rate of inflation, unless a transfer of ownership occurred or new construction is completed.

For this reason, on average the taxable value of Detroit property today is about 20 percent twenty percent less than assessed value. The 20 percent spread, of course, represents just an average and for many properties the gap between taxable and assessed value is greater.

Unfortunately for investors, a property's taxable value is "uncapped," and the taxable value is increased the year following a transfer of ownership.

Thus, Proposal A benefits current property owners who do not intend to sell and disadvantages new purchasers and newly constructed property. The following example illustrates the problem. Let's say that in 1995 two commercial buildings, identical in every respect, were built side-by-side in downtown Detroit.

Each building carried a $10 million market value. Under Proposal A, their assessed value each came to $5 million in 1995. By 2005, each building's market value rose to $15 million and the assessed value of each increased to $7.5 million. However, the 2005 taxable value was $6 million due to the caps on taxable value increases.

In 2005, one of the buildings sold for $15 million. The taxable value of the sold building will be "uncapped," resulting in a taxable value increase from $6 million to $7.5 million (a 25 percent increase). In contrast, the taxable value of the building that did not sell will increase only 3.3 percent, to about $6.2 million. Thus, the new owner pays a tax bill that is about 20 percent higher than the neighbor with an identical building.

Adding insult to injury, recently the Michigan Court of Appeals held that the taxable value is uncapped even where an entity that does not itself own real estate transfers its interest in an entity that does own real estate. For example, under this decision, if an entity has a subsidiary, the subsidiary owns real estate, and more than 50 percent of the parent is sold, an uncapping will result. It is expected that the Michigan Supreme Court will be asked to review this decision.

Obviously, the real estate market in Detroit has a number of very unusual aspects. Accordingly, investors should obtain the advice of experienced Michigan property tax counsel if they are considering a purchase of real estate or the construction of property in the Detroit area.

Given the state of the Detroit area real estate market, owners and managers are furiously looking for opportunities to minimize their operating expenses. Property tax reductions provide one fertile area.

Taxpayers who filed appeals on their excessively valued property have achieved property tax reductions that fully warranted the time and effort expended in the appeals process.

Savvy property owners will carefully scrutinize the taxable values on every property they own and challenge any values that appear to be out of line.

Stewart Mandell and Michael Shapiro are partners in the Detroit-based law firm of Honigman Miller Schwartz and Cohn LLP. The firm is the Michigan member of American Property Tax Counsel (APTC), the national affiliation of property tax attorneys. Stewart Mandell can be reached at slmandell@honigman.com and Michael Shapiro can be reached at mshapiro@honigman.com