Will property taxes ruin your investment? | Hahn Loeser & Parks LLP
Property buyers often fail to factor in the tax increase associated with their potential sale price when running cash flow pro formas. In Ohio, the sale price is considered fair market value for property tax purposes. Prudent buyers should estimate and pro-rate taxes assuming the sale price is the basis for the value of their investment. Otherwise, a “standard” pro rata clause in the purchase agreement will force the buyer to pay the increased tax themselves, even for the part of the year the property belonged to the seller.
As real estate values continue to climb at historic rates, property taxes can be a hidden trap when it comes to crunching numbers for a seemingly safe real estate investment. Prudent investors should analyze their potential real estate transactions based on cash flow, which is the cash generated from the remaining property after all expenses have been paid, including property taxes. But, in many states, such as Ohio and Illinois, property taxes are paid in arrears. This means that taxes for the current year are not due and paid until the following year, and the amount due is often affected by the purchase price of your future contract. This alone causes a great deal of confusion when it comes to accurately analyzing a real estate investment, including assessing the possibility of a new increased tax burden for the property.
Many do not realize that in many cases property taxes are set based on the purchase price of an arm’s length transaction. So if your potential property is currently assessed at $2 million by the auditor for property tax purposes and you are considering offering a purchase price of $8 million, you can expect that a large increase in the property’s property taxes becomes effective for the current year, but due and payable the following year. Many investors, even the most savvy ones, may forget to account for this increase in relying on the current tax bill for their cash flow calculations, or grossly underestimate the potential increase in tax burden. This can lead to overpayments on investments and (swallow!) negative cash flow.
So what can be done to ensure that you have solid calculations for your potential investment? First, always check with the county auditor to determine the current market value set by the auditor for tax purposes. This is public information easily accessible online. Second, if your proposed purchase price is higher than the auditor’s market value, you can usually expect your property taxes to increase based on the sale. In order to determine the new tax burden, many counties have online calculators that can be used to estimate the new property tax amounts. However, if no tax calculator is available, you can simply divide the current tax bill by the current market value established by the auditor and get the current tax percentage. Then apply the current tax percentage to your proposed purchase price, and voila! – you have your new estimated tax bill.
Another issue that investors should be aware of when crunching numbers and determining the best purchase price for a property investment is whether there are any tax deductions on the property. A tax abatement is an exception to property taxes, which means that none are due. The tax allowances can be for the total value of the property, or for a part. However, it is important to note that tax allowances are generally valid for a fixed period. Therefore, you will want to know when the tax relief was granted and how long it will be in effect. Next, you’ll need to calculate the new tax burden based on your proposed purchase price and determine when those taxes will eventually start accumulating.
Finally, when buying a new property, consider requiring favorable terms in the purchase agreement regarding the structure of the transaction and/or the pro rata tax paid by the seller at closing. Again, since taxes are paid in arrears in Ohio, buyers typically get a per diem credit from the seller at closing for the part of the year the seller owned the property. This pro-rata is usual because the tax bill for the year the seller owned the property will be paid in full by the buyer when it finally becomes due the following year. So if the tax burden increases based on the sale price, but the seller’s pro-rated credit is based on the lowest existing tax burden, you’re not getting a fair credit for the period the seller owned. of the property. There are also ways to creatively structure a deal to try to avoid a large tax increase. However, these strategies aren’t guaranteed to work, so the new tax burden should still factor into your bottom line. It is important to resolve these property tax issues before or at closing, as many standard purchase agreements make the pro rata final at closing. Even though there is language permitting a post-closing recalculation of the tax pro rata, the merger doctrine, which states that all matters under the purchase agreement merge into the deed at closing, may preclude such a pro rata if specific language is not included in the act of preserving the show.
Property taxes can get complicated, but the help is there! Don’t hesitate to contact an experienced real estate attorney to guide you through the tax issues and pitfalls before committing to that new investment property!