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