You Underwrote the Seller's Tax Bill. Yours Is Going to Be Different

Buyers underwrite from the seller's operating statements, and property taxes appear as a line on those statements. It is an easy number to carry forward into your own projection.

In many jurisdictions it is the wrong number. A sale triggers reassessment, and the new assessment is based on what you paid rather than what the seller was paying. On a property held for decades, the increase can be large enough to change the economics of the purchase.

Why does the bill change?

Property tax is generally based on an assessed value multiplied by a local rate. In many places, assessed value is adjusted only modestly while ownership stays the same, but resets on a change of ownership.

An owner who bought in 1996 may be assessed on a value far below today's market. When you buy at market price, the assessment can jump to that price.

How large can the difference be?

Consider a property assessed at 1.1 million dollars with taxes of about 13,000 dollars a year, sold to you for 3.2 million. If the assessment resets to the purchase price at a similar rate, the bill could rise toward 38,000 dollars.

That 25,000 dollar annual increase comes straight out of net operating income. At a 6 percent capitalisation rate, it is worth over 400,000 dollars of value.

Which places do this?

Practice varies widely. Some states reassess on sale, some reassess periodically regardless of ownership, and some limit annual increases for existing owners while resetting on transfer.

California is the best known example of a system with limited annual increases and reassessment on change of ownership, but many jurisdictions have their own variations, including some that reassess on sale and others that phase increases in.

Because the rules are local, the only reliable approach is to ask the county or municipal assessor for the property you are buying.

Does a 1031 exchange prevent reassessment?

Generally no. A 1031 exchange is a federal income tax provision. Property tax is a state and local matter, and a transfer that qualifies as a like kind exchange is still a change of ownership for property tax purposes in most places.

Investors sometimes assume the deferral extends to property taxes. It does not.

Are there exclusions?

Some jurisdictions provide exclusions from reassessment for particular transfers, such as certain transfers between family members, transfers into revocable trusts, or transfers where beneficial ownership does not actually change.

Entity transfers are a specific area. In some places, transferring interests in an entity that owns property can trigger reassessment once a threshold of ownership changes, and in others it does not. Structuring decisions made for income tax reasons can therefore have property tax consequences.

What else can change at purchase?

Transfer taxes. Charged on the sale itself, sometimes at significant rates.

Special assessments and districts. Local improvement districts may add charges tied to the property.

Exemptions lost. An exemption the seller enjoyed, such as an agricultural or owner occupancy classification, may not carry over.

Appeal rights. Where an assessment is higher than market value, appeal may be available, usually within a short window after the notice.

How should you underwrite it?

• ›Ask the assessor what the property would be assessed at following a sale at your price
• ›Apply the current rate and any special assessments
• ›Model the increase from the first year it applies, which may not be the year you buy
• ›Check whether phased increases apply
• ›Ask about appeal deadlines in case the assessment overshoots

Then feed that figure into your projection rather than the seller's historic number.

How does this affect fractional interests?

A Delaware Statutory Trust holding property in a reassessing jurisdiction faces the same issue, and the sponsor should have underwritten it. Asking whether the projection uses the post acquisition tax bill is a reasonable question, because a projection built on the seller's taxes overstates income.

What to do first

For every replacement property you consider, telephone the county assessor during diligence and ask what the taxes will be after a sale at your price. It takes one call, and on a long held property it is frequently the largest single difference between the seller's operating statement and yours.

Nothing here is tax, legal or investment advice. Property tax rules are local and change. Confirm with the relevant assessor and your CPA.