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