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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 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