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Thursday, January 25, 2007

BIG NEWS REGARDING HB4050, THE PREDATORY LENDING DATABASE:

it may have just been effectively repealed!

As we detailed in a previous article, a new law establishing a “predatory lending database” was signed into law last year by Gov. Blagojevich and went into effect on September 1, 2006. Known as “HB4050,” the law was designated as a “pilot program” and applied to only 10 zip codes, designated by the Department of Financial and Professional Regulation, located within the Southwest corner of Cook County.

The idea was that high foreclosure rates in economically unstable neighborhoods was largely the result of predatory lending. Among other things, HB4050 sought to curb predatory lending by putting onerous reporting and documentation burdens on lenders. It also interposed counseling requirements that were designed to educate borrowers but that would also substantially slow the lending process.

The law was viewed by lenders, brokers, and almost anyone else with a stake in the system, as being overly burdensome and fraught with pitfalls and traps for the unweary. Enactment of the law was preceded by predictions that it would create more problems than it would solve for residents of the affected zip codes. For example, many predicted lenders would simply pull out of affected areas.

Whether or not those predictions came to fruition remains to be seen, but HB4050 appears to have been effectively repealed via an administrative maneuver. Following is the text of a letter from the Department of Financial and Professional Regulation, which oversees implementation of HB4050, which was published January 19, 2007:

The Secretary of the Department of Financial and Professional Regulation (the “Secretary”) is making this designation of the “Pilot Program Area” as directed in 765 ILCS 77 (HB4050 from the 94th General Assembly). In making this designation, the Secretary received and reviewed information that suggests that the prior designation may be detrimental to the Pilot Program’s purpose, namely, to curb predatory lending practices in areas with high rates of foreclosure on residential home mortgages. Based on this review, the Secretary hereby withdraws the designation made on January 27, 2006, and designates the Pilot Program Area as no zip codes or areas whatsoever.
Emphasis added. The letter is signed by Dean Martinez, Secretary of the Department of Financial and Professional Regulation.

In coming weeks and months we will be watching with interest to see if any new area is designated as a Pilot Program Area or whether this effectively marks the end of HB4050. If this marks the end, the explanation will be very interesting. Did lenders pull out as predicted? Did residents complain? Whatever the reason, it had to be enough to convince Governor Blagojevich that implementation of HB4050 was politically untenable, if in fact this is the end of HB4050. It will be equally interesting to see how the above affects legal challenges to HB4050 that are currently pending in Federal court.

We will keep you posted.

Prepared by: Douglas Oliver © 2006. Staff Attorney
Freedman, Anselmo, Lindberg & Rappe, LLC.
Thomas Anselmo, Real Estate Practice Partner

Wednesday, December 20, 2006

HB4050: LEGISLATIVE REDLINING? THIS IS ONE LAW THAT IS HEADED FOR THE ILLINOIS SUPREME COURT.

If you are involved in real estate or mortgage lending, it is hard to imagine that you haven’t heard of HB 4050 by now, as it has been a controversial law to say the least. Officially known as the “Illinois Predatory Lending Database Act,” commonly referred to as HB4050, the law was signed by Governor Blagojevich last year and took effect January 1, 2006. The Act confers upon the Department of Professional Regulation, Banking Division (“Banking Division”) the responsibility of implementing the Act. This officially took place on September 1, 2006, and thus the Act has now been in operation for three months. By its terms, the Act is a four-year “pilot program.”

Briefly, here is what the law requires. First, it requires the Banking Division to create a “Predatory Lending Database.” All mortgage brokers and loan originators licensed by the Banking Division must enter mortgage loan application information into the Database whenever the property is located in one of ten designated Cook County zip codes (all on the Southwest side of the County).

In addition, and more importantly, the Act requires that borrowers whose FICO scores fall below 620 must receive financial counseling from a HUD-approved counselor before entering into a mortgage transaction. Likewise if the borrower’s FICO score is between 621 and 650, and any of the following apply:
a. the mortgage loan in question is interest only;
b. the mortgage loan is adjustable within three years or less;
c. the mortgage loan carries a prepayment penalty;
d. the mortgage loan is negatively amortized;
e. closing costs exceed five percent of the purchase price;
f. the borrower has financed the same property within the past twelve months;
g. the borrower is putting down less than five percent to close.

Some lenders and some types of property are exempt. For example, federally licensed lenders, who have an “N.A.” at the end of their name, are exempt. Transactions relative to commercial and investment properties that are not owner-occupied are also exempt, for example.

If a loan proceeds to closing for which the Act required counseling, the title company or closing agent must report additional information to the Database.

The Cook County Recorder of Deeds will record no mortgage on a property located within the ten zip codes unless the mortgage is accompanied by a certificate of compliance with the Act or a certificate of exemption from the Act.

Further, in the event of a foreclosure of an affected mortgage, the lis pendens must be recorded with a statement that the lis pendens was served upon the mortgagee, or it is of no effect.

The Act states that failure to comply with its terms is a violation of the Illinois Consumer Fraud Act.

Lenders, real estate brokers, mortgage brokers and others have raised howls of opposition to the this law and have collectively published volumes of objections. Statements by supporters have been harder to find, but strong support for the Act is proven by its passage of both houses of the Illinois Legislature.

Supporters assert that foreclosures in the affected areas are twice the state-wide average, that many of these foreclosures result from predatory lending practices, and often the borrower never understood the risky and expensive features of the loan in the first place. Obviously, the Act’s reporting requirement is intended to facilitate quantifying and measuring this premise. Proponents might be expected to further argue that it is the affected communities as a whole that suffer from predatory lending practices, and not just the individual borrowers.

From the chorus of industry objections to this law, some common themes have emerged. Many predict the Act will have negative effects on a practical level: First, will affected lenders and brokers abandon the ten zip codes in significant numbers? If so, that will reduce the number of options available to affected borrowers and raise their costs, it is argued. Second, will there be enough counselors to do the job? It is estimated that there are hundreds of thousands of residential properties located in th affected zip codes. Third, will all affected closings be dry? Many title companies have stated that they will not disburse until they have received certificates of compliance with the Act, and those certificates come from the Banking Division.

Finally, many argue that all of the above create barriers that, collectively, will slow home sales in the affected areas, making it harder for affected residents to sell or obtain the highest possible price for their property. The effect could be to solidify blight.

From a legal perspective, serious issues loom regarding the viability of the Act. First, the Act is arguably “special legislation,” which is prohibited by the Illinois Constitution. Article 4, Section 13 states in part “[t]he General Assembly shall pass no special or local law.” In People ex rel. Vermilion County Consv. Dist. v. Lenover, 43 Ill.2d 209 (1969), the Illinois Supreme Court, interpreting Article 4, Section 13, held that a law must operate uniformly throughout the state in all localities and on all persons in like circumstances and conditions.

The state constitutional ban on special legislation flows from the principle of equal protection under the law. Therefore, the Act may violate the equal protection clauses of both the Illinois and United States Constitutions for the same reasons it may constitute impermissible special legislation.

Second, some community activists, noting the racial makeup of the affected zip codes, have deemed the Act an example of “legislative redlining.” Redlining, of course, is the illegal practice of marking off certain areas on a map and, as a matter of policy, doing no business within those areas or doing business only on unfavorable terms. In response, State Senator Jaqueline Collins, who is Chair of the Senate Financial Institutions Committee and a sponsor of the Act, has reportedly stated that any lender who refuses to do business in the affected zip codes will be guilty of redlining and should be prosecuted. At least two law suits attempting to block the Act have already been filed. Others are sure to follow soon.

In the end, HB 4050 seems to be intended to protect potential borrowers not just from predatory lenders but also from themselves. Whether that legislative justification can withstand equal protection scrutiny will probably determine whether HB 4050 lives or dies. Given the strong legislative support that made the Act law and the vociferous opposition to it, it is almost certain that the courts will resolve the debate.

Prepared by: Douglas Oliver © 2006. Staff Attorney
Freedman, Anselmo, Lindberg & Rappe, LLC.
Thomas Anselmo, Real Estate Practice Partner

Monday, October 30, 2006

A SCARY STORY ABOUT RESIDENTIAL REAL PROPERTY DISCLOSURES

It is common knowledge that, with few exceptions, the seller of residential real property is required by law to provide the buyer with a list of 22 possible “material defects,” indicating with a “yes” or a “no” whether the seller has knowledge of the defect. Many of these are familiar at this point: knowledge of flooding, leaking, septic issues, underground storage tanks, etc. But what about specters, banshees, apparitions or poltergeists??? Wouldn’t the known presence of otherworldly entities constitute a material defect? One New York appellate court thinks so, and one terrified and unhappy buyer was permitted to rescind a purchase contract because of it.

Before looking at this very interesting case from New York, though, this would be an excellent opportunity for a quick overview of the Illinois Residential Real Property Disclosure Act, which has been on the books since 1994. Some aspects of the Act can seem a bit counterintuitive.

The Act applies to any transfer or exchange of residential real property, including not only sales but also options to purchase, ground leases and installment land sales contracts. However, sellers are exempt from making the disclosures under certain circumstances. For example, if the transfer is pursuant to a court order, such as in probate, the seller is exempt. Likewise, if a homeowner is deeding the property to a mortgage lender to avoid foreclosure. If the transfer is to someone who is already a co-owners, or if it is from one spouse to another, there is no disclosure requirement. There are other, similar exceptions. But one other exception that is worth noting comes up regularly in residential real property transactions: the seller of newly constructed property is exempt from disclosure. So builders of new homes, condominiums and coop properties are exempt.

What the Act requires is that the seller provide the buyer with the familiar form that lists 22 possible defects, in the nature of those described above, with a “yes,” “no” and “n/a” column to the left. The Act specifically requires the seller to complete all 22 items that are applicable. The seller must check “yes” for any listed defect of which he or she has actual “knowledge.” The word “knowledge” is placed in quotes because a seller can know of a past defect but can still check “no” if he or she reasonably believes the defect has been remedied or if he or she has been so informed by a licensed engineer, land surveyor, structural pest control operator, or contractor, where the matter is within the scope of said expert’s occupation.

One important aspect of the Act is that it requires that the disclosure be made by use of the form we all know. Even if the seller otherwise disclosed the defect and the buyer admits that he or she had actual knowledge thereof prior to sale, the seller remains liable for damages under the act if he or she failed to use the form.

The Act requires that the seller deliver the signed disclosure to the buyer prior to contract formation, but the disclosure of a material defect does not prevent the parties from entering into a contract or from closing on that contract. However, if the disclosure comes after the parties have entered into a sales contract, the buyer has 3 business days to terminate, in which case any earnest money or down payment must be returned.

If a seller violates the Act by either failing to provide the disclosures or by making disclosures that are untruthful, the seller is liable for any damages that the buyer can prove resulted directly from the seller’s violation of the Act. In the law, these are termed “actual damages.” In addition, the buyer can recover court costs and attorney fees. What this might normally entail is the seller being liable to pay the buyer’s bill for remediating whatever defect went undisclosed.

A buyer must file any suit under the act within one year of possession, occupancy or recording of deed, whichever is earlier. However, the passing of one year does not relieve the seller of all possible liability for his or her failure to disclose known defects. This is because the Act does not limit other legal remedies the buyer may have, such as breach of contract or fraud, which have much longer statutes of limitation.

This is one other aspect of the Act that can operate a bit counter-intuitively. As stated, the Act does not impair other legal remedies a buyer may have against a seller arising out of the transaction. Therefore, if a buyer can prove that some un-listed material defect existed, that the seller knew about it but concealed it, and that the defect, if disclosed, might have caused the buyer to back away, then the buyer may have a cause of action for fraudulent conveyance, even though the seller provided the form disclosure. For example, mischievous spectral entities are not on the Act’s list of know defects. Yet, their playful misdeeds have undone at least one real estate transaction.

In the New York case of Stambovsky v. Ackley, a buyer sued a seller and the seller’s broker when the buyer “to his horror, discovered that the house he had recently contracted to purchase was widely reputed to be possessed by poltergeists, reportedly seen by defendant seller and members of her family on numerous occasions over [many] years.”

The case was quickly but “reluctantly” dismissed by a lower court that held the buyer had no remedy at law. However, a court of review found that the facts of the case “clearly warrant[ed] a grant of equitable relief to the buyer who, as a resident of New York City, [could not] be expected to have any familiarity with the [local] folklore.”

The house in question was an elderly, 18-room Victorian mansion at 1 Laveta Place, Nyack, New York, reportedly reminiscent of the home at 1313 Mockingbird Lane once occupied by Herman and Lilly Munster. Nyack, New York, for those who don’t know, is located about 20 miles north of New York City, directly across the Hudson River from the real Sleepy Hollow that inspired Washington Irving’s famous Halloween tale of the same name.

From the late 1960s to 1991, the house was occupied by the Ackley family. During their years there, they reported many strange experiences and sightings. The Ackleys believed the house to be occupied by three ghosts; an old man, a lady and a Revolutionary War soldier, all of them good-natured and friendly.

Mrs. Ackley often spoke publicly about the house’s other-worldly occupants. So much so that the house was well known as a haunted place, finding its way into news print and a feature article in Reader’s Digest, one of the worlds most widely-read publications.

According to the Ackleys, the ghosts were a lively crew. There were the usual swaying lamps, footsteps on unoccupied stairs, and closing doors. More unusual was the ghost (they weren’t sure which one) who would wake the children for school by shaking their beds. During spring break, Mrs. Ackley would loudly announce that it was spring break and no one needed to get up for school, and the shaking would stop. Mrs. Ackley claimed to have actually conversed with one ghost, the dapple-cheeked old man, while painting a room during substantial renovations. She asked if they liked what the family was doing with the house, and he reportedly nodded yes. The ghosts also loved to give gifts, often leaving baby rings and small silver objects with the family’s other personal effects.

When the Ackleys listed the house for sale in 1991, Jeffery Stambovsky, a New York City Bond trader, fell in love with it and offered $650,000, which the Ackleys accepted. Shortly thereafter, Mr. Stambovsky was visiting the house when a neighbor walked by and asked, “so, you’re buying the haunted house?” Mr. Stambovsky investigated further and discovered the house’s paranormal reputation. Although he did not believe in ghosts, his pregnant wife did and refused to move in.

Mr. Stambovsky cancelled the closing and demanded his deposit back. “We were the victims of ectoplasmic fraud,” he would tell the press. The Ackleys refused, asserting the well-known legal maxim “caveat emptor.”

Thus followed the law suit. While the higher court held that the Stambovsky’s “[hadn’t] a ghost of a chance” of recovering from the broker, it held that the Ackleys were equitably estopped from denying that the house was haunted, due to the fact that they had so publicly promoted it as such over a long period of time. As a result, the court reasoned, the Ackleys had caused the house to acquire a reputation that could affect its resale value, and which a non-local buyer would be unable to discover upon reasonable inspection. Regarding conditions of this nature the court asked, “who you gonna’ call?”

Therefore, the court stated that it was “moved by spirit of equity” to allow the buyer to seek rescission of the sale contract, holding as follows:

“Applying the strict rule of caveat emptor to a contract involving a house possessed by poltergeists conjures up visions of a psychic or medium routinely accompanying the structural engineer and the Terminix man on an inspection of every home subject to a contract of sale. It portends that the prudent attorney will establish an escrow account lest the subject of the transaction come back to haunt him and his client - or pray that his malpractice insurance coverage extends to supernatural disasters. In the interest of avoiding such untenable consequences, the notion that a haunting is a condition which can and should be ascertained upon reasonable inspection of the premises is a hobgoblin which should be exorcized from the body of legal precedent and laid quietly to rest.”


Prepared by: Douglas Oliver © 2006. Staff Attorney
Freedman, Anselmo, Lindberg & Rappe, LLC.
Thomas Anselmo, Real Estate Practice Partner

Tuesday, September 05, 2006

Demystifying Tax Proration: New Construction of Single Family Residence

In the past two articles on tax proration, we have looked at how taxes are prorated to the date of sale when residential real estate changes hands. Those articles assumed an existing, single-family residence. There are two other situations that come up frequently that also deserve to be addressed. These are new construction of a.) single family residences and b.) condominiums. These two situations present special problems for real estate tax proration because new construction represents a change in the use of the real estate in question. The new residence may not even have its own tax i.d. number at the time of closing and may, for tax purposes, simply be a portion of a larger, undivided tract of land.

Therefore, the county in which the real estate is located will, at some point in the near future, reassess the value of the property for tax purposes. As a result, tax bills from previous years either provide no guidance as to the amount of the coming bill, or at the very least are a much less reliable predictor. At the time of closing, all the parties know is that the tax bill will go up. They do not know how much and they do not know exactly when. This article takes a look at how the issue of tax proration is typically resolved in the case of new construction of a single family residence. The next article will address new construction of condominiums.

New Construction of Single Family Homes

When new single-family homes are constructed, there is usually a drastic change in land use. Usually, either farm land is being converted to suburb or an older and less valuable property has been torn down. The tax bill for the year of closing can be expected to change about as drastically as the land use changes.

The seller of new construction is the builder, and the builder’s construction contract is what governs the issue of tax proration. There are as many methods as there are builders, however the tax proration provisions tend to share some common features that are included in the following example, excerpted from a an actual builder’s contract:

(d) Real Estate Tax Prorations: Seller shall pay the real estate taxes directly to the County for the year prior to closing when the bill is issued in the year of closing.

Seller shall calculate the proration of real estate taxes for the year of closing and pay its portion when the bill is issued in the year subsequent to closing. If the Property has been assigned it’s own tax ID and bill (i.e., divided), Purchaser shall furnish Seller with a copy of the bill and Seller shall calculate its portion of the bill and mail a check to Purchaser within fifteen (15) business days after receipt of the real estate tax bill. Seller shall not be responsible for any penalties for late payment.

If the Property is undivided (tax bill includes more than one property), Seller shall compute the respective portions allocable to Purchaser and shall notify Purchaser of Purchaser’s portion. Purchaser shall pay to Seller Purchaser’s portion within fifteen (15) days after notification of the amount due. Seller is not obligated to pay the tax bill unless and until Purchaser has remitted Purchaser’s portion to Seller. Seller shall not be responsible for any penalties for late payment resulting from Purchaser’s late payment.

Real estate taxes shall be adjusted such that purchaser will be responsible for taxes computed on both land and any improvements thereon whether or not assessed as fully completed, from and after the closing date and Seller shall be responsible for the portion of the tax bill applicable to the period prior to the closing date, but only for the assessment attributable to unimproved land.


The gist of this provision is that the builder pays real estate taxes through the date of closing, but only on the value of the land as unimproved. The builder will not pay any taxes that result from the new construction because the benefit of that construction belongs to the buyer.

To illustrate how this would work, let’s assume the closing is on June 1, 2006 and the new house sits on a 1/4 acre lot. The tax bill for 2005 is out and the tax was $12,000 per year, because that land was a 100-acre farm prior to construction. The tax bill for 2005 would be paid prior to or out of closing.

Let’s further assume that construction started March 1, 2006, was completed on May 25, 2006, and was given it’s own p.i.n. number prior to closing. When the tax bill for 2006 comes out in 2007, it will be assessed at a much higher value than when it was used as a farm. The county township assessor will likely consider that higher value to attach at some time prior to closing. The higher value might also include a period of time for which the land is only partially improved since the new house was under construction but not yet completed for some period of time in 2006. But none of that affects our proration under the builder’s contract, unless for some period of time in 2006 that higher value applies only to the land as unimproved. For this example we will assume the county township assessor considered the value of the land as unimproved to be the same as when it was farm land.

Under the builder’s contract, we prorate through the date of closing based on the unimproved value of the land. The builder would find out from the county township assessor what the tax was for the land as unimproved. Since we are assuming it is the same as when the land was a farm, it would be $250 per year (the amount of $12,000 attributable to 1/4 acre out of a 100 acre parcel). We would divide $250 by 365 to find that the builder’s obligation for 2006 taxes on a per diem basis would be 68¢. Since our closing is June 1, there would be 152 days of 2006 through the day of closing. To find the builder’s portion of the real estate tax, we would just multiply .68 x 152, which gives us $103.36. Anything over and above that amount would be the buyer’s responsibility under the contract. The contract above provides for the builder to pay its share of the tax when the bill comes out, thus there would be no credit to the buyer for 2006 taxes on the HUD-1. Other contracts do provide for a credit, and in that case the HUD-1 would show a credit to buyer of $103.36 for real estate taxes (and a corresponding charge against seller’s proceeds), with the buyer knowing that the actual 2006 bill will reflect a much higher tax rate, perhaps even for some period of time prior to closing.

But whether or not a credit is reflected on the HUD-1, the upshot is that the builder will be responsible for a small portion of 2006 taxes and the buyer will be responsible for the balance of the bill. The example above contemplates that the 2006 bill may go either to the seller or the buyer, and provides that whoever gets the bill must notify the other so that each party can pay its share within an appropriate amount of time.

If the property is not divided into separate parcels at the time of closing and is still considered by the county to be a part of a 100 acre farm, then taxes will have to be “reprorated” later when the land is divided into parcels and tax bills are issued for each parcel. Many contracts contain the term “reproration,” and although the above example does not, it provides for reproration where it state “Real estate taxes shall be adjusted such that purchaser will be responsible for taxes computed on both land and any improvements thereon whether or not assessed as fully completed, from and after the closing date and Seller shall be responsible for the portion of the tax bill applicable to the period prior to the closing date, but only for the assessment attributable to unimproved land.” Under the contract provision set out above, no credit would appear on the HUD-1 for 2006 taxes. Instead, the seller and the buyer would calculate the tax (using the same method as described above) at the time the 2006 bill was issued.

If the contract provided for a credit to buyer, the HUD-1 would show a credit to buyer of $103.36 (and a corresponding charge against seller’s proceeds) for 2006 real estate taxes because that would be the amount attributable to 1/4 acre of the 100 acre total. However, perhaps when the land is divided and reassessed, not all will have the same unimproved value. Therefore, even though there was a proration at closing, the tax obligation would be adjusted accordingly, or “reprorated,” when the 2006 bill is issued 2007.

If a builder contract allows an attorney review period, we argue for tax proration through the date of closing without reference to the improved or unimproved value of the land, just to make sure our clients are protected in the event that the property was assessed as improved prior to the closing date.

Prepared by: Douglas Oliver © 2006. Staff Attorney
Freedman, Anselmo, Lindberg & Rappe, LLC.
Thomas Anselmo, Real Estate Practice Partner

Wednesday, August 16, 2006

Demystifying Tax Proration: Cook County

In order to fully benefit from this article, please read our previous article, “Demystifying Tax Proration,” which was published on our blog last week.

The purpose of this article is to build on the information previously provided to point out how Cook County real estate taxes are different from surrounding counties, and how that affects the tax proration for real estate closings on Cook County properties.

Cook County taxes are prorated just the same as they are for any other county. The difference is that Cook County uses an alternative method of determining the amount and timing of real estate tax bills. Whereas other counties issue only one tax bill per year, payable in two equal installments, Cook County issues two tax bills per year, a “first-installment” bill and a “second-installment” bill. Furthermore, the second-installment bill is almost certain to be larger than the first (although theoretically it can actually be less).

Therefore, to understand how to properly prorate real estate taxes for Cook County, the only additional knowledge you need is how to ascertain the status of the tax liability. Here’s how it works.

Like all counties in Illinois, Cook County bills for taxes in “arrears,” i.e. 2005 taxes are billed and payable in 2006. However, the “first-installment” tax bill for Cook County is issued in mid to late January, is always due the first business day in March, and is always (with few exceptions) equal to one half of the previous year’s tax obligation. For example, if the total tax liability for a particular parcel was $8,000 for 2004, the first-installment tax bill for 2005 would have been $4,000. That first-installment bill would have been mailed out in late January, 2006 and would have been due March 1, 2006.

The date and due date of Cook County’s second-installment bill varies because the second-installment bill reflects any and all changes in assessed value, changes in tax rates applied by Cook County and other taxing authorities, tax appeals, exemptions, or whatever else might affect the amount of the bill. The information needed to determine the amount of the second-installment bill therefore comes from a variety of sources and Cook County does not issue its second bill until it has the information needed to issue a correct bill. When the process nears completion, the Cook County Treasurer’s Office publicizes the date it expects to issue the second-installment bill.

Generally, the Cook County second-installment bill might be issued as early as July or as late as October, but they usually come out in August. Once issued, the second-installment bill will be due just over 30 days after it is issued. For example, the second-installment bill for 2005 taxes was issued at the end of July, 2006 and is due September 1, 2006.

For purposes of closing a real estate transaction, just as with any other county, to determine the status of an issued tax bill we simply look at the title commitment to see whether it is paid or unpaid. For example, assume we had a closing on property located in Cook County on July 1, 2006, and the total real estate tax liability for 2004 was $8,000. There would have been a first-installment bill for Cook County real estate taxes issued at the end of January, 2006. The bill would have been for $4,000 and it would have been due March 1, 2006. To check on this, we would have looked at the title commitment to see if it showed the first-installment bill paid. If paid, those taxes would not have been an issue in the closing. If unpaid, the tax, and any penalty due, would have been shown on the HUD-1 as a credit to buyer and as a liability against seller’s proceeds. In the alternative, if the title company was paying the tax out of the proceeds of the closing, the tax would have shown on the HUD-1 as a liability against the seller’s proceeds with no credit to the buyer.

What about the as-yet-unissued second-installment bill for 2005 taxes? Continuing with the above example, as of our July 1, 2006 closing, the amount of this bill would have been unknown. Therefore, we would have turned to the real estate purchase contract for guidance. As we discussed in our previous article, the real estate purchase contract would have stated a factor by which the last-available full year’s tax obligation would be multiplied to reach a fair guess as to the amount of the unknown bill. For our July 1, 2006 closing, the last full year’s tax obligation would have been 2004, and we said that was $8,000. Let’s further assume our agreed upon factor was 110%. We would have multiply $8,000 by 1.10 and find that our fair guess was that the full year’s bill for 2005 taxes would total $8,800, regardless of the amount of the first-installment bill. We have already dealt with the first-installment bill for 2005, and it was $4,000. Therefore, the difference between the first-installment bill and the estimated full year’s tax liability would have appeared on the HUD-1 as a credit to buyer and as a liability against seller’s proceeds in the amount of $4800.

This leaves one further question. What about taxes from January 1, 2006 to July 1, 2006? We would have handled this issue slightly differently than the second-installment bill for 2005 because instead of figuring the likely amount of the second-installment bill, we would have had to prorate over a number of days. Again, the real estate purchase contract would have been our guide. Our last-known full year tax obligation would have been 2004 at $8,000; multiplied by 1.10, that is, again, $8,800. We would have divided 8,800 by 365 to find that the estimated amount of tax accruing per day during 2006 was $24.11. We would have then simply counted the number of days from January 1, 2006 up to and including July 1, 2006, which is 182 days. We would have multiplied the tax per day by the number of days ($24.11 x 182) to find that the seller’s estimated liability for Cook County real estate taxes from January 1, 2006 to July 1, 2006 was $4,388.02. This amount would have appeared as a credit to the buyer on the HUD-1 and as a liability against seller’s proceeds.

The appropriate factor for prorating Cook County real estate taxes can be a tricky issue. Cook County reassesses one third of all real property within its boundaries every year, so that all real property is reassessed every three years. In addition, Cook County tax rates tend to go up more quickly than in surrounding counties. If a transaction is closed in a year when the property in question is to be reassessed, the reassessment coupled with rising tax rates can result in a dramatic increase in real estate taxes over previous years.

Prepared by: Douglas Oliver © 2006. Staff Attorney
Freedman, Anselmo, Lindberg & Rappe, LLC.
Thomas Anselmo, Real Estate Practice Partner

Tuesday, August 08, 2006

Demystifying Tax Proration

Demystifying Tax Proration
(outside of Cook County)


The real estate tax proration that is a part of virtually every real estate transaction can seem intimidating but it’s actually not that difficult. Once you understand just a few basics about how and when real estate taxes are billed and paid, there is no mystery and prorating them becomes a simple matter of arithmetic. The goal of this article, and a couple of additional articles to follow, is to demystify tax proration.

To start at the most basic principle first, and at the risk of insulting the reader, the typical real estate transaction involves the transfer of title from a seller to a buyer. Although anything can be negotiated, it is generally agreed that the seller will pay whatever real estate taxes accrued while the seller owned and benefitted from the property, while the buyer should pay those real property taxes that will accrue after he or she acquires title. To make this happen, real estate taxes are prorated to the date of sale.

The Mechanics of Real Estate Taxes


Knowing when and where real estate tax bills come from is the first step in understanding how to prorate them. Real estate tax bills come from county government. This dates back to the first local governments organized by European colonizers of North America, when locally organized government was virtually all there was. Still today, county governments are the principle recipients of real property tax revenues which are raised and spent locally, and which are now shared with other local governmental units with taxing powers such as fire protection districts, school districts, and the like. Fortunately for the taxpayer, no matter how many local governmental units might have the power to tax a particular parcel, only one tax bill is issued at the county level. This is one reason for the timing of tax bills, as we are about to see.

Except for Cook County, at which we will take a separate look in another article, all of the counties in the Chicagoland area follow the same basic procedure for issuing and collecting tax bills. Every spring, most often in May, the county issues a tax bill for the previous year’s taxes. The bill issued in May 2006 is for calendar year 2005 taxes. That the bill comes out in May creates the confusing appearance that real estate taxes are billed according to some mysterious fiscal year rather than according to the calendar year. Not so. Taxes are billed based on the calendar year.

Why are tax bills issued for the previous year and not the current year, you wonder? It is widely believed that delayed tax bills originated during the Great Depression as a form of tax relief. And it is a historical fact that there were an abundance of real estate tax delinquencies and even violent tax protests during that time. However, it is also true that as society has become more complex, property values and property uses change more frequently during the tax year in ways that affect the taxable value of the property. Therefore, it is practical to bill after the tax year has closed because changes that occurred during the tax year can then be reflected in the bill.

Why does the bill come out in May or so and not January you ask? Because to issue an accurate bill, the county must gather information from other local taxing authorities, such as school districts and fire protection districts, whose taxes are rolled into the bill. The county gives these other taxing authorities plenty of time to get their act together in an effort to make the process of billing and collecting reliable and predictable.

By state law, the bill that is issued around May for the previous year’s taxes is due in two equal installments. State law also allows the taxpayer at least 30 days to pay the first installment, so the bill usually states that the first installment is due between 30 and 35 days after the county issues the bill. For example, if a bill for 2005 taxes is issued May 1, 2006, the bill will generally show a due date of June 1, 2006 or shortly thereafter; if issued May 15, the bill will be due June 15 or shortly thereafter, and so on. The second half of the bill is generally due about 90 days after the first bill is due. So if the first half was due June 1, the second half is probably due about September 1, etc. The bill itself will tell you the exact dates, but the methodology remains the same.

We now possess an understanding of some important aspects of real estate taxes: if your client is the seller in a transaction, the bill your client got in May of 2006 was for taxes that accrued during the calendar year 2005. Your client waited several months for the bill because he or she was billed only after the local authorities with taxing powers got on the same page about the size of the bill. When your client got that bill, he or she had about 30 days to pay half of it and then about another 90 days to pay the other half.

Checking the HUD-1 For Taxes Already Billed


Armed with these insights, we are now able to understand whether the HUD-1 is correct for any tax bill that was issued before the date of closing. We simply look at the title commitment to see whether it shows the bill paid. Any portion of the bill that the title commitment shows as unpaid should be shown on the HUD-1 as a credit to the buyer and as a liability against the sellers proceeds. It would also be acceptable if the HUD-1 showed the outstanding tax as a liability against the seller’s proceeds but with no credit to the buyer, if the title company is paying the outstanding tax directly to the county out of the seller’s proceeds.

Example: Assume a transaction closes July 1, 2006, and in May 2006 a tax bill issued for 2005 taxes in the amount of $8,000. The first $4,000 of that bill would have been due around June 1, 2006 and the title commitment should show it as paid. If that first installment is not shown as paid, then whatever amount the title commitment shows as due (which could include a penalty) should be paid from closing and shown as a liability against seller’s proceeds on the HUD-1, or it should be credited to buyer and against seller on the HUD-1. The amount of the second installment of the 2005 tax bill is $4,000. The HUD-1 should show a credit to buyer and a liability against seller’s proceeds in the amount of $4,000 for the second installment of 2005 taxes or, if the title company is paying the second installment from closing, the HUD-1 should show a liability against seller’s proceeds but no credit to buyer in the amount of $4,000.

Taxes That Have Accrued But For Which No Bill is Yet Available


Because counties issue real estate tax bills once per year and several months after the tax has accrued, in every transaction there is a period of time for which taxes have accrued but for which no bill is yet available. There is never a bill for the year in which the closing takes place. If the closing is early in the year, say March, there will not be a tax bill for the previous year either.

We can illustrate this by taking the above example a step further. If the transaction closes July 1, 2006, we know the situation with respect to 2005. But taxes also accrued from January 1, 2006 to July 1, 2006, but there is no bill and we don’t know the amount.

As stated above, the parties typically agree that the seller will pay taxes to the date of closing and that the buyer will pay anything that accrues thereafter. The problem is that the assessor doesn’t know about the parties’ agreement and will simply issue one bill per year, as usual. The real estate tax for 2006 cannot be paid from closing because the assessor has not yet issued a bill. Yet if any portion of 2006 taxes go unpaid, they will become a lien against the property. Therefore, regardless of the parties agreement about taxes, whoever owns the property when the assessor comes calling will have to pay the tax or suffer the consequences. This circumstance forces the parties to prorate 2006 taxes without knowing the exact amount of the bill.

The parties lay the groundwork for solving this problem during contract negotiations. Every real estate purchase contract has a provision that states a factor, usually 105% or 110%, by which the last known, full-year tax bill will be multiplied for proration purposes. Again taking the example above, the parties would have a tax bill for 2005. Let’s assume they agreed to prorate taxes on the basis of 110%. Let’s again assume the 2005 tax bill was an even $8,000. In that case, they would simply multiply 8,000 by 1.10, and regard the result, 8,800, as the amount of the yet-to-be-issued 2006 tax bill.

The parties would then divide 8,800 by 365 to find the amount of tax that would accrue for each day of 2006, in this case $24.11 per day. They would then simply count out the number of days up to and including closing, multiply by 24.11, and treat the result as the seller’s obligation for 2006 taxes. In our example, January 1, 2006 through July 1, 2006 encompasses 182 days. So the parties would multiply 24.11 by 182, and find that seller’s liability for 2006 taxes should be $4,388.02. The actual 2006 tax bill would still be unknown, so the buyer would either pocket or pay the difference between $4,388.02 and the yet-to-be issued tax bill. The factor of 110% is simply a guess the parties have agreed is fair.

Again, because there is no 2006 tax bill, the title company cannot pay the seller’s 2006 tax liability to the county from closing. There is no way for the parties to address it other than to give the buyer a credit for the agreed amount. Therefore, the HUD-1 should show a credit to the buyer of $4,388.02 and liability against seller’s proceeds in the same amount.

What if the closing is early in the year, say March 2006, and there is no 2005 tax bill? The real estate purchase contract provides the answer. Many contracts provide that the proration will be based on “the most recent ascertainable full year tax bill.” So if you had no 2005 bill, you would take the 2004 tax bill, multiply it by 110% to find the 2005 tax liability, and then prorate for 2006 as described above. The results would, again, appear on the HUD-1 as a credit to buyer and as a liability against seller’s proceeds.

See? It’s not that bad.

Prepared by: Douglas Oliver © 2006. Staff Attorney
Freedman, Anselmo, Lindberg & Rappe, LLC.
Thomas Anselmo, Real Estate Practice Partner

Tuesday, August 01, 2006

Part Two in our dissection of the new Multi-Board Residential Real Estate Contract (4.0)

Part Two in our dissection of the new Multi-Board Residential Real Estate Contract (4.0) involves changes to the ever important mortgage financing contingency.

We are confronted with an industry now where attorneys are constantly seeking to extend financing contingencies in contracts. Why? Are lenders simply not getting their job done quickly enough? Is it that difficult to check a person’s credit and order an appraisal for the property in question? Or is it attorneys who are being overly technical in their reading of commitment letters, and doing everything possible to try and protect their buyer clients?

A key change in Form 4.0 is the fact that a “firm” written commitment is now required as opposed to an “unconditional” mortgage commitment as was required under Form 3.0. The hope in this language change is that it will eliminate numerous requests for extensions of the financing contingency because of some minor clerical condition or because of some ambiguous or over-broad language in the mortgage commitment letter.

Both forms indicate that exceptions as to title and survey and matters totally within the buyer’s control do not constitute conditions that would allow a buyer to request an extension of the financing contingency. However, it is very common to see mortgage commitment letters that just don’t want to commit. Although the letter sets forth the basic terms of the loan (loan amount, interest rate, amortization period, etc.), there are general catch-all conditions such as “subject to further review and final underwriting approval.” This doesn’t really tell anyone anything as far as what is needed to satisfy the condition. Further, if there needs to be final underwriting approval, is the loan even approved at all?

The cautious buyer’s attorney would ask for an extension of the financing contingency after receiving a commitment letter with a condition as noted above. The frustrated seller’s attorney would then explain to his client that the buyer needs an extension of the financing contingency but no one is really sure why, other than the contract is subject to the buyer obtaining an “unconditional” commitment. The ambitious seller’s attorney might try calling the buyer’s lender only to be told that this is how all their commitments read and there is nothing that can be done.

Although the request to extend the financing contingency seems somewhat commonplace in our industry, the fact is it involves a significant amount of time and effort on the part of both attorneys, and increases the stress and frustration of both the buyer and seller. As the contingency date arrives with no commitment letter in sight, or one as noted above, buyer’s counsel now must call the lender and the buyer to see if the commitment is unconditional. When it is determined that it is not unconditional, buyer’s counsel needs to prepare and send a letter to seller’s counsel asking to extend the financing contingency; seller’s counsel must in turn review with the seller for approval and oftentimes will require additional phone calls to see exactly what is the hold up. Add to this mix the seller client that always wants to have the upper hand, and who will only agree to extend the contingency until August 7, even though the buyer requested August 9 and the lender has indicated the appraisal will not be complete until August 8............you get the picture!

Alas, Form 4.0 only requires a “firm” commitment. The above scenario where the buyer has a commitment letter setting forth the loan terms with the general catch all language should be viewed as a “firm” commitment which will eliminate the need to request extensions, or at the very least, if an extension is requested, it will probably garner a response from the seller’s attorney that he or she deems the condition satisfied.

Of course, attorneys being the argumentative bunch that they are may still quibble about the meaning of “firm commitment.” If a commitment letter is still subject to appraisal is it firm? Probably not. If it is subject to a general catch all such as “subject to final underwriting review?” A better argument could be made that this is a firm commitment, however, the cautious buyer’s attorney may still seek an extension so as not to be the one blamed when the lender later cancels the commitment due to some underwriting condition that the buyer cannot satisfy. Obviously, with a term like “firm” being used in a contract, the above is only this author’s opinion, as a firm commitment to one attorney might appear to be no commitment at all to another attorney.

One final note regarding Form 4.0, the financing contingency still retains the language of Form 3.0 regarding a condition in a mortgage commitment that the buyer must sell their existing residence. The contract does NOT allow buyers to back out of the deal if they receive such a commitment unless the parties have specifically agreed that the contract is contingent on the buyer selling their existing residence. In some form contracts, buyers have the ability to make an offer which is not contingent on selling their existing residence (attractive to the seller), only to be able to “back door” the seller when they cannot satisfy the financing contingency because of a condition in the mortgage commitment that the buyer must first sell their existing home. If a buyer tried this with Form 4.0 (or 3.0 for that matter), they would find that it would be a miserable failure with the probable loss of earnest money and possible additional damages.

As always, we invite your comments and questions and thank you for your participation in the FAL&R Blog.

Robert H. Rappe, Jr © 2006. Senior Partner
Freedman, Anselmo, Lindberg & Rappe, LLC.
Thomas Anselmo, Real Estate Practice Partner