Tax Prorations at Closing
What are “Tax Prorations”, and how do they work?
Whenever a change in property ownership occurs within a calendar year, the question always comes up, “who is responsible for paying the property tax bill for that year”? The answer is: It Depends…
The Typical Scenario
It most real estate purchases, a realtor or attorney will prepare a contract which specifies how the property tax bill will be handled for that year. The standard practice is for the tax bill to be prorated based on the date of closing, i.e. each party is responsible for the portion of the tax bill corresponding with their portion of ownership for the calendar year. For example, a transaction closes on July 1 of 2016, with a tax bill of $2,000. The buyer and seller would each be responsible for $1,000, which would be in proportion to their ownership interest for the year. (Each owned the property for 50% of the year, therefore each is responsible for 50% of the tax bill)
The small wrinkle – Taxes are paid in arrears
The wrinkle we encounter most often is due to the way our property tax bills are created. (For more on how the county determines what your tax liability is, and how those bills come out, see our previous blog here) In short, a tax bill is based on the assessed value of a property on December 31st of the previous year. However, that bill is not prepared and sent to property owners until late October or early November. That means that for purchases which occur before tax bills come out, we must base the tax proration upon an estimate of what this year’s tax bill will be. In most cases, the best estimate of what the tax bill will be is the prior year’s tax bill.
4% vs 6%
The tax code provides for two main tax rates on property within the state, 4% for owner occupied primary residences, and 6% for all other property, including investment property, second homes, and commercial property. In most cases, we find the seller occupied the property as their personal residence, and likewise the buyer intends to occupy the property as their personal residence. This means that both parties are paying the 4% tax rate on their assessed property values. However, some transactions involve a buyer and seller with differing tax rates. In that situation, most contracts will provide that the tax bill will be prorated based upon the tax bill in the hands of the seller. That means that if the seller would pay a 4% tax rate, the tax bill will be prorated on the 4% rate. If the seller would pay a 6% tax rate, the tax bill will be prorated on the 6% rate. Again, the reasoning behind this is that the tax bill is based on the assessed value of the property on December 31 of the prior year, while the seller owned the property. That means that the county cannot change raise the tax rate on the property until the next calendar year, which is good news for a 6% buyer. Likewise, we have good news for a 4% buyer. Should the property they purchase be assessed at the 6% level during the year they make their purchase, most counties will retroactively lower the tax rate to 4% for that calendar year. The counties are not legally required to make this adjustment, and cannot be forced to do so. However, this is the common practice in almost every county in our state.
Everything is negotiable
Now, here’s the biggest thing buyers and sellers don’t realize, everything is negotiable. You can write into a contract whatever terms regarding tax prorations you would like. If you’re a 6% seller, with a 4% buyer, you probably want the buyer to agree to prorate the tax bill at 4%. Likewise, if you are a 4% buyer with a 6% seller, you want to make sure they seller agrees to adjust the proration amount in the event the actual tax bill is more than the prorated amount. It’s completely up to the two parties to determine how they would like to handle the tax prorations.
The Bottom Line
The good news is that if you have a good team of professionals, this is most likely something you will never have to worry about. Nevertheless, if you have any questions, or would like to speak further with a Real Estate Attorney, email us at email@example.com or give us a call at 864-232-3541, we’d be glad to help!