FEATURE ARTICLE, JUNE 2008

TAXATION INFLATION?
The irony of real estate taxes in a changing economy.
George Relias

Global Recession! Bear Market! Sub-Prime Lending Crisis! Record Energy Costs! Headlines like these are becoming an everyday occurrence. In this era of increasing costs, property owners and managers are under pressure to ensure their assets continue to meet and beat their performance goals. How will real estate taxes react to this changing economic climate?

Real estate taxes are a function of assessed values and tax rates. Examining each component yields clues as to how real estate taxes will respond in the changing economy. Usually, assessed values are closely related to real estate market values. As market values increase, so too, should assessed values. Conversely, as market values decrease, assessed values should theoretically decrease. Unfortunately, nothing is that simple.

In recent years, assessing officials looked to sales as the primary indicator of market value. However, their valuation models often ignored “non-arms-length” transactions such as foreclosures, tax sales and 1031 exchanges. With reports of nationwide foreclosures and tax delinquencies on the rise, sales that indicate downward moves in market values often are excluded from the assessor’s valuation models. The prospect of lower sales being sidelined for various reasons could slow the assessors’ downward correction of values. This is exacerbated by property owners that choose to hold their properties until the real estate market rebounds instead of taking a loss.

It is natural for the real estate market to lag other economic indicators. The real estate market does not share the same liquidity as the securities or equity markets, and cannot adjust to shifting economic conditions or changing market perceptions quickly enough. This natural lag intensifies the perception that real estate taxes are too high relative to the value of the underlying real estate assets. Negative economic data and excessive media attention to slumping housing market statistics create a palpable perception that values are declining. However, the empirical sales data and substantive real estate evidence such as decreased rental rates may be more elusive when sought to support a clear decline in real time real estate values.

Assessing jurisdictions typically establish a “lien date” of January 1st as the date in which all properties will be valued for that assessing period. In 2007, it is widely believed that overall real estate values declined steadily throughout the year. However, if January 1st is the valuation date, and taxes are paid in the next calendar year, taxpayers could be paying tax on property values based on sales or financial data from 12, 24 or even 36 months prior. This lag could be dramatic in certain parts of the country.

The assessors’ reliance on sales, combined with the lag in the real estate market and the substantial delay in the tax billing process, causes real estate taxes to adjust slowly to declining real estate values.

Tax levies, on the other hand, may increase with turmoil in the economy. In general, tax rates are directly related to the budgetary needs of the agencies that rely on the tax revenue. School districts, and fire and police departments are the most common examples of those agencies relying on tax dollars to fund their operations. As the economy falters, more pressure on social services will be inevitable. For example, a tax levy increase for local community colleges to provide increased job training to unemployed workers is conceivable. Unionized police and fire often have employment contracts that adjust for inflation or have fixed annual increase. These contracts also place upward pressure on budgets and, by extension, the tax rates.

Even if the budgetary needs of the agencies stay the same, tax rates will likely increase if assessed values decrease. Simply stated, the tax levy will be spread over a smaller assessed value pool. Therefore, higher tax rates are needed to compensate for lower real estate values in order to generate the same dollar amount in taxes to fund the agencies’ budgets.

Since taxing bodies use current or future budgets to establish their revenue needs, tax rates do not experience the same lag as the real estate valuation market. Consequently, it is likely tax rates will increase faster than assessed values decrease.

In order to mitigate the negative effects of a slow valuation adjustment and rising tax rates, property owners must be vigilant in monitoring their assessed values. Waiting for the assessor to register the decline in overall sales is too passive. Owners must aggressively engage the assessing authorities as soon as possible when increased vacancies or poor performing financials threaten the value of their properties. Assessors, in general, will reduce values on specific properties when they have information that supports a decline in value. It is incumbent upon property owners to make the assessor aware of their property’s specific situation.

Through this doom and gloom there is a silver lining. Even the most cynical economist knows that markets are cyclical. Real estate values will be on the rise. The Dow Jones again will experience a bull market, and the velocity of real estate transactions will again increase as lenders and borrowers adjust to new lending requirements. When real estate values rise, assessed values will likely lag and property owners will enjoy a period of low real estate taxes relative to the value of their real estate.

George Relias is an attorney with Chicago-based Enterprise Law Group. Relias is a licensed real estate broker, as well as a member of the Chicago Bar Association, Illinois State Bar Association and American Bar Association.

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