Real estate acquisitions and improvements harbor traps for the unwary taxpayer.
|Estimating the costs of purchasing or improving real proper ties may seem a simple exercise. However, tax traps await owners who are unaware of the dangers to avoid or otherwise veer off the trail. Prudent investors will be alert to the hidden tax snakes inherent in real estate decisions. Missteps taken at the time of purchase can lead to substantially higher property taxes later. To avoid these snakebites, the prudent investor will carefully research a property's existing tax treatment before closing, consider whether to execute an allocation engagement and ensure that the transaction is properly documented.|
In some states, statutory caps limit valuation increases that would otherwise rise to reflect the market. For example, California's Proposition 13 limits increases in assessed value to 2 percent per year even if the property's market value is increasing at a faster rate, so long as ownership remains unchanged. Property owners should know that acquisitions and improvements can dramatically impact tax values that were previously limited by statutory caps.
In most states, acquisitions trigger reassessments at the next applicable valuation date. In researching existing tax values prior to purchase, prospective buyers often research the taxing authority's online tax records. Online research may fail to distinguish between capped or taxable value versus fair market value, however. If the acquisition removes the prior cap and the buyer estimates taxes based on the capped value rather than the fair market value, the new property owner could be in for a very rude awakening come tax time.
Acquisitions can also change deadlines for filing tax appeals in some jurisdictions. For example, the normal filing deadline for appeals in South Carolina is January 15, but most county assessors will mail new assessment notices during the year following an acquisition. In those circumstances, the filing deadline is 90 days after the date of the reassessment notice.
Failure to take simple but essential steps in documenting a purchase can have substantial tax ramifications. For example, South Carolina law potentially exempts as much as 25 percent of a commercial property's purchase price from later ad valorem taxation, but only if the purchaser files for the exemption on or before January 30 following the closing. Failure to file can cost purchasers tens of thousands of tax dollars or more. Yet many purchasers are unaware of this exemption until after they receive the new tax bill, when it is generally too late to file for the exemption.
Closing documents can increase future property tax bills. Many assessors calculate taxable value based on the consideration recited in a deed. Purchasers typically acquire income producing properties based on existing or potential cash flow.It is the combination of the real property, tangible personal property and intangible personal property which generates that cash flow.
The deed consideration should reflect only the value of the real property and improvements, not the total transaction value. Similarly, title insurance should reflect the real property's value and exclude value attributable to tangible or intangible personal property. A well-thought-out allocation agreement potentially simplifies later record keeping and yields significant savings on income, property and transfer taxes, sometimes worth millions of dollars.
For example, operating hotels are generally sold as going concerns. That distinct from the underlying real estate. The hotel's intangible personal property, such as its brand, reservation system or on-line presence, may substantially increase cash flow but is generally exempt from ad valorem taxation.Using the transaction's value, rather than the value of the real estate and improvements, in the deed not only increases documentary stamps but could lead to unwarranted higher ad valorem taxes.
Pre-purchase cost segregation studies are often useful in documenting these separate values, but many purchasers and their lenders are reluctant to engage in this component analysis. For example, large hotel loans typically proceed from a lender 's corporate loan department,not the real estate department, and with good reason. Loan officers can be reluctant to explain to their superiors or to regulators why title insurance values might be lower than the face amount of the note, when the loan is really underwritten on the value of the cash flow and not the individual components contributing to that cash flow. That reluctance could manifest itself in reduced loans being made available for borrowers.
Similarly, loans secured by retail real estate occupied by national credit tenants previously garnered less scrutiny from lenders and regulators in assessing loan risk. That laissez faire attitude may be changing as e-commerce erodes sales at brick-and-mortar stores, which continue to close in large numbers.
In some jurisdictions, changes in the property's condition such as a vacancy by a major retail tenant do not trigger a reassessment, and may not be factored into tax bills. The key inquiry in those situations is whether the change in condition occurred after the applicable valuation date.
Property improvements also create taxation pitfalls. In states that cap taxable property values, the caps may come off when improvements are made. In other words, the cost of improvements could include not only construction expenses but also a substantially greater tax burden.
The effect of improvements on property taxes varies by jurisdiction. Florida has adopted a bright-line test that examines whether the completed improvement increases value by at least 25 percent. California law protects properties from reassessment so long as any work is normal maintenance or repair, or the improvement does not convert the property to a state "substantially equivalent to new." Whether new construction or improvements fall into this category is "a factual determination that must be made on a case by-case basis," the California statute states. South Carolina law contains no such guidance.
Timing also matters. Most jurisdictions prohibit taxing improvements until after the improvements are completed, as defined by applicable statute. If the applicable valuation date is Dec. 31, 2018, an owner might consider delaying completion until after Jan. 1,2019, to delay a major tax increase. Regardless, careful analysis and plannirig can help property owners address the hidden cost of increased taxes.With careful planning, the prudent property owner can avoid being bitten by the lurking snake of increased property taxes and walk the property tax trail with confidence.