COMMERCIAL REAL ESTATE: The effects of Proposal A on the real estate industry
The passage of Michigan’s Proposal A over six years ago affected the way the state collects many types of taxes. The changes ranged from the way we collected taxes on and for cigarettes, personal income, schools, property transfer fees, and sales tax to how taxes are collected for real property. How this tax shift affected our schools is still being hotly debated and there are many issues related to that subject that will likely carry on for a while.
The issues concerning the real estate community as they relate to Proposal A are significant. It was the outcry of Michiganders that their property taxes were too high which began the ball rolling for a tax change in the first place. Proposal A’s tax change for the homeowner became the basis for everyone’s glee because now the homeowner would be taxed at a rate much lower than all the other property (i.e., commercial and investment property held for income).
Basically all other property, which is not occupied by the homeowner, is considered non-homestead property and is taxed at a much higher rate. The higher taxation rate of non-owner occupied property, which also includes second homes or cottages, opened the infamous debate and subsequent lawsuit that originated in our own area against the State of Michigan.
Prior to Proposal A both types of property were taxed according to their state equalized value (SEV), which was adjusted annually according to area market conditions. After Proposal A, the SEV continued as the avenue for tracking increases in appreciated values. Whatever the SEV had been for a particular property at the time Proposal A passed, it became the property’s taxable value. This is the value at which all townships use to assess real property and special assessments.
As a result of Proposal A, the state mandated that both homestead and non-homestead property’s taxable value could increase no more than five percent or the rate of inflation, whichever was less. Both types of properties enjoy the benefit of those caps on their values until the property is sold. At the time of sale this cap comes off and the property is taxed at a new value determined by the ever-changing SEV.
This overview may seem elementary to knowledgeable real estate investors since Proposal A has now been in effect for over six years. However, we’re just beginning to see the ramifications of all these property tax changes and where they might lead us. For example, the longer a property is held by the original owner, since Proposal A passed, the greater the difference between the property’s SEV and its taxable rate (this assumes the property is appreciating each year).
This may spell relief for the original owner, but when the property sells, the buyer better be aware and plan for possible substantial property tax increases. If the buyer has not properly calculated this dramatic property tax increase into his financial Performa for purchasing commercial or investment property, it could have devastating consequences for achieving a proper return or even any kind of cash flow at all. The tax increase from one owner to the next could be substantial, depending upon the last time the property had been sold.
I’m aware of one transaction recently that the property tax change incorporated a 700 percent increase for the purchaser. The disturbing news is this situation could get even worse as properties are held for longer periods of time.
Additionally, the incentive for the current owner to fight new assessed values, as reflected in the property’s current SEV, is lost because the property owner understands that for as long as he/she owns the property, taxes are capped and can only increase by five percent or the rate of inflation. Why would a property owner fight the current SEV? It won’t affect him or her, only the next owner. The current owner only cares about the taxable value.
As a result of Proposal A, buyers have additional concerns when it comes to property taxes. The property tax increases for a buyer purchasing investment property held for lease where there’s an assignment of a triple net lease can cause major conflicts. Who should absorb the substantial tax increases incorporated in the triple net lease arrangement–the existing tenant (who pays the taxes under a triple net lease provision) or the new purchaser?
The passage of Proposal A has not only been a concern for the purchaser, but there are issues for the seller as well. When a piece of property is sold, the state and county charge what’s known as a transfer tax to all sellers of real property, including both residential and commercial real estate.
Prior to Proposal A, the combined transfer tax for a property was $1.10 per thousand dollars of the selling price. The post-Proposal A fee is $8.20 per thousand dollars of the selling price.
So a property being sold at $300,000 pre-Proposal A would have paid a transfer fee of $330. The transfer fee for the same property now costs $2,580. That represents over a 780 percent increase.
There are a few other issues concerning the effects of Proposal A on real estate; however time and space doesn’t allow for an in-depth discussion.
Consult your real estate professional for a greater insight into the hidden costs to watch out for when buying or selling real estate.
William Sage has been in the real estate industry for over 22 years and is the owner/broker of Sage Real Estate Services, a Traverse City firm specializing in negotiations for the sale, acquisition, lease, option and exchange of commercial real estate. BN