LA Home Dude

One of the most important aspects of owning real estate is taxes. Get it right and you can retire early. Get it wrong and you can lose your home.

Before we begin, admit you are powerless over taxes. They are the cost of living in the greatest country in the world; and the most excellent state in that country, California. The sooner you just accept taxes as a fact of life, the better off you will be from a mental health perspective.

My biggest piece of advice is to hire a professional. I am a licensed broker, but I am not a CPA or a lawyer. CPA’s go through a rigorous licensing process and are supposed to keep up to date with changes in the tax code. They know the tricks and loopholes to save you money. This is not an area to “shop around” for the best price. Get referrals from your smart friends and use the best CPA you possibly can.

Generally, there are two main topics of discussion when talking about residential real estate and taxes. The first is how real estate ownership can lower federal and state income taxes. Congress has seen fit to promote home ownership via a deduction for mortgage interest. In fact, all interest used to be deductible as it was considered a business expense since only businesses used credit. Over the last hundred years, as individuals have increasingly taken advantage of credit, those deductions have been removed from the tax code. But the mortgage interest deduction has remained. Most homeowners with a mortgage experience significantly lower taxes thanks to this deduction.

The second main topic of discussion when talking about residential real estate and taxes is property tax. In states with low property prices, property tax is a few hundred dollars a year. No big deal. In California, with our high prices and high turnover, coupled with special assessments and Mello-Roos, property tax can break the average homeowner’s budget.

California has a long history of property tax policy debate. In 1978, Prop 13 threw the state into hysteria and created an anti-tax folk hero. The proposition was ultimately approved by voters and the California state constitution was amended. Since then, property tax cannot exceed 1% of the assessed value of a property, and the assessed value of a property cannot be increased more than 2% per year. The 1% limitation applies to state tax, which is assessed and collected on the county level. Each county also adds their own tax, usually around .25%, that they include on the tax bill as a separate line item.

Even with the limits Prop 13 imposed, an elderly couple (who may have paid off their mortgage years ago) with a house assessed at $800,000 is going to pay $8,000 per year plus county tax and any special assessments (though they may qualify for an exemption). That’s almost $700 per month – not easy on a fixed income.

The 2% per year increase does not apply if the property changes ownership. In that case, the property’s value can be re-assessed at market value. This is controversial for several reasons:

1. It discourages property transfer because people want to keep their low property tax rate. As a real estate broker, property transfer is my business, and I believe unencumbered property transfer is beneficial for both buyers and sellers. The argument can be made that this artificial dis-incentive to sell even raises real estate prices because it reduces supply, thus creating the very bubble markets that it was intended to protect property owners from.
2. It’s not fair. Two houses can be side by side, identical in every way, and both worth $550,000. But one was bought last year for $525,000 and the other was bought in 1982 for $170,000. Why should the owners of the first be liable for over 3 times more in property tax?
3. It offers a loophole for commercial property owners that is not available to the average homeowner. The owners of the least valuable properties in a community (single family residences) generally pay more than the owners of the most valuable properties (apartment buildings, industrial buildings such as factories, commercial buildings such as shopping centers). Why? Because single family residences are owned by individuals in their own names. Commercial and industrial properties are owned by LLCs and corporations. When the corporation that owns a commercial building is sold to a new owner, the deed of the property does not need to be changed, since the corporation still technically owns that commercial property. Therefore the property continues to be taxed at the lower assessed value. Meanwhile, most residential property owners cannot do this due to mortgage rules and the expense of setting up a corporate structure. Therefore, residential property owners typically pay property tax that is a higher percentage of the market value of their property than commerical property owners. That’s also not fair.

Who is doing this “assessing” on your property, by the way?

Each county has one or more elected officials in charge of property taxes. In Los Angeles County, Rick Auerbach is our assessor. (By the way, I highly recommend you read his “Message to Homeowners”.) In addition, in Los Angeles County we have an elected Registrar-Recorder/County Clerk, Auditor-Controller, Treasurer & Tax Collector, and Assessment Appeals Board. The offices of all these public servants can come into play when dealing with real estate taxation issues.

If there is one thing you take away from this article, let it be this: California state law says that YOU NEED TO PAY PROPERTY TAX REGARDLESS OF WHETHER YOU GET A BILL. This is your responsibility as a property owner; the law assumes that if you are savvy enough to own real property and enjoy its benefits, then you are savvy enough to pay your taxes without being reminded. The due dates can be confusing so be proactive. Call and ask questions. Pay a little early. You can even pay online in many cases, and if you use a credit card you can earn frequent flier miles or cash back depending on your card.

In general, if you buy a property, there are three property tax payments you need to make:

1. Half the property taxes (based on the new assessed value after the sale). Must be received by the Tax Collector on or before December 10th.

2. The other half of the property taxes. Must be received by the Tax Collector on or before April 10th.

3. The supplemental tax bill. Prorated for the remainder of the year after you buy your property. The fiscal year for property tax is July 1 to June 30. So if you close escrow on October 1, you have 9 months to pay and not 3. This tax will be based on the difference between the assessed value pre and post sale. However, in today’s market of falling prices, you could possibly get a refund if your new assessed value is lower than the old assessed value.

The Assessor also provides a valuable public service via the publication of his Annual Report. I highly recommend you check it out for an unbiased overview of property value trends in LA County’s many cities.

Now let’s talk about Mello-Roos.

Mello-Roos, and its nearly identical cousin 1915 Act Assessments, allow municipalities to define boundaries for special districts. Then these municipalities issue bonds, which investors buy. The money that investors pay in exchange for the bonds is used to improve community facilities within the special district (including schools, roads, police, fire, medical, government buildings, libraries, community centers, etc). Then for the life of the bond (typically 20-30 years), property owners within the district pay a special tax which goes to the investors as principal plus interest payments. As a side note, owning municipal bonds usually provides tax advantages for an investor.

California law now requires sellers of real estate to disclose most of these special assessments. These laws arose because sellers weren’t doing that, and buyers were getting hit with thousands of dollars in special taxes that they weren’t expecting. Now, home buyers typically sign stacks of paperwork to say they have been notified of all the property tax they will need to pay. In addition, prudent buyers will order a tax report on the property from an independent company that specializes in providing that information. This should cost about $30.

Many buyers want to avoid purchasing property in special districts. Mello-Roos came about in 1982 as a workaround to Prop 13, and in many ways, it is more strict than standard property tax:

1. Mello-Roos taxes are not tax deductible on your income taxes.
2. Mello-Roos is not subject to the 1% total / 2% per year restrictions of Prop 13.
3. Special tax districts can initiate an “accelerated foreclosure” within 150-180 days of nonpayment. Compare this to 5 years for standard property taxes. The justification is the need for the municipality to make timely payments to bond holders.

If you do end up having to pay Mello-Roos, it will usually be a line item on your property tax bill. In rare cases, it will not be on there, but will be a separate bill mailed out by the municipality. Once again I encourage you to be proactive in this area, since the consequences for nonpayment are extremely severe and difficult to reverse.

It is common that your property taxes will be rolled into your mortgage payment. I recommend you avoid that. You do not need to pay your taxes into an impound account that your mortgage holder gets free interest on. You should keep your money as long as you can and earn interest on it yourself. The worst part is that sometimes they screw up and “forget” to pay your property taxes. Guess what? The government does not care about that. They will put a lien on your property (with a possible foreclosure if they don’t get the money within 5 years) and a collection note on your credit file regardless of who “forgot” to pay. So study your loan docs carefully (perhaps with the assistance of that CPA you just hired) and don’t allow yourself to be tricked into paying property tax into an impound account.

If you do go with the impound account because you are simply too busy to deal with this, keep in mind that it will usually not cover your supplemental property tax bill, so you will probably have to pay that one on your own.

Conclusion

If you made it this far, you are probably feeling pretty good. You know it all, right? Not really. In taxes, every rule has an exception or ten. So I will repeat my advice above and tell you to hire a tax pro who deals with this stuff all day long and can immediately tell you how to save money in ways you never thought possible. Cheers and good luck!

Disclaimer: This article is for general informational purposes only. For your specific situation you should consult a tax professional. If you believe there is an error above, please e-mail me at phil@lahomedude.com and I will address it. Thanks for reading.