Re-thinking Residential Real Estate Property Taxes, Terry Maynard

By Terry Maynard

Probably no local political issue is as unending as the real estate taxes homeowners must pay on their residences.  This is especially so at budget time, the annual phenomenon we are once again going through here in Fairfax County.  At least here in Virginia, those taxes are based on the market value of their homes calculated on comparative prices of other recently sold homes in their neighborhood.  From this homeowner’s perspective, the valuations are reasonably accurate, at least here in Fairfax County. 

Then comes the hard part:  The County Board of Supervisors must set a tax rate on that property—which must be equal across all types of property (commercial and residential)—to generate the revenue it needs to provide the bulk of the county’s services.  No elected official likes to raise tax rates, and it’s especially difficult politically and maybe personally if you’re raising those taxes on your neighbors.  Of course, when the Board must raise taxes, they get hammered by their constituents and various special interests.  Sometimes (albeit it rarely in Fairfax County) a decision to raise tax rate leads to an election loss.

We can argue endlessly whether the local government should raise tax rates or whether it should cut spending, but one thing is universally true for residential homeowners:  The residential real estate property tax homeowners pay is absolutely disconnected from their ability to pay it.  From a strictly Reston point of view, this fact runs counter to the core Reston planning principle that the community should provide housing for people of all incomes. 

That is unfair and inequitable, especially since a large group of real estate property owners do have their real estate property taxes based at least partially on their ability to pay:  commercial real estate (CRE) owners. 

The key to this difference is that CRE owners use a capitalization rate (or “cap rate”) to adjust the valuation of their property based on their net operating income.  This is a two-step process:

• First, the CRE owner calculates the cap rate.  The cap rate is determined by dividing the calculated net operating income of a recently sold nearby comparable CRE holding by the value of its sales price.   For example, a neighboring CRE owner generated $750,000 income on a taxable property.  The property sold last year for $10 million.  The cap rate = $750,000/$10,000,000 = 7.5%.
• The CRE owner calculates the value of his property by dividing his own property’s net operating income for the property (say $400,000) by the cap rate.  The value of the owner’s CRE property = $400,000/7.5% = $5,333,333.The CRE property is then taxed at the going local tax rate—which must be the same for all classes of real estate property owners.  For example, at a tax rate of $1.08 per $100 valuation, the property owner’s tax bill would be $57,600.  That’s {$5,333,333/$100} x $1.08 = $57,600.   

Now there are a thousand ways to manipulate those calculations and still remain within accounting standards, but that describes the basic principle behind commercial real estate tax property valuation and bills.  

For those not steeped in accounting, the important thing to take from this process is that the commercial real estate property tax paid is based largely on the income produced by the property.   In a good CRE market with high demand leading to high rental and low vacancy rates, the taxes are higher.  In a poorer market where the taxes are lower as vacancy rates are elevated and rents suppressed —as we are now experiencing throughout the Washington region—net operating income is lower and so are commercial property tax bills.  The weaker commercial property market is the key reason why our County Board of Supervisors needs to increase the county-wide tax rate this year, leaving homeowners to pick up the revenue slack.

Residential property owners get no such income-linked break on property taxes.  For example, people who have lived in their home for a number of years generally see their property values escalate—a case especially true here in Fairfax County notwithstanding the recent Great Recession.   They may or may not have seen comparable increases in their incomes.  This is especially true for people who retire and are on a fixed or inflation-adjusted income.  It is also certainly true of people locally who lost their jobs as a result of the recession, federal budget cuts, and ensuing corporate layoffs.  They could be trying to live in their home on savings and unemployment or low-paying temporary wage compensation.  

Should county governments drive people from their homes because their incomes have not kept up with the valuation of those homes and they are unable to pay property taxes, especially while corporate landowners can reduce their property tax bills based on the slack in their net operating incomes?

No.  It is grossly unfair and inequitable.   Moreover, here in Fairfax County where affordable housing (not subsidy programs, just reasonably priced homes) is a major and growing issue, this would likely make more housing affordable to those who already live here.  

My proposal is a simple one:  What is good for the goose is also good for the gander.  Specifically, homeowners should also be able to adjust their property tax bill based on their ability to pay.  

How do we do that?   

First, I am comfortable with the valuation process that is already in place at least here in Fairfax County.   In a hypothetical example, we’ll say the County assesses the value of his property at $500,000 (about the Fairfax County average).  

Second, the County Board needs to have the flexibility (loathe as it is to use it) to raise (or lower) the rate of tax on those properties based on budget needs.   For simplicity’s sake, we’ll assume the County sets the tax rate at $1.10 per $100 valuation (or 1.1% of a property's value).  So a $500,000 home generates a $5,500 basic property tax bill.

But here is the kicker:  The individual homeowner’s tax bill is adjusted by the percentage his/her income increased or decreased over the preceding year.  The only reasonable way I can think to calculate that adjustment is by using the percentage change in the homeowner’s taxable income as reported on his/her Virginia tax bill.  So, for example, if a homeowner retired last year, the tax bill would be adjusted by the percentage difference in his Virginia taxable income over the last two years.  If the homeowner reported a Virginia net taxable income of $100,000 in 2012 and then $75,000 in 2013 after retiring, his tax bill would be adjusted by the change in his income ($75,000/$100,000 = 75%).   In this hypothetical example, the retiree’s tax bill would be $4,125 instead of $5,500.

Please note that, in contrast, a big raise or promotion could see the homeowner’s tax bill escalate more than the base tax rate.  For example, a homeowner earning $100,000 in 2012 earns $125,000 in 2013 according to state taxable income as a result of a promotion would see his property tax bill increase 25% as well.   This newly promoted homeowner with a $500,000 home would pay $6,875 instead of $5,500 under the current property tax system.

And that’s the point!  The people who are most able to pay residential property taxes are the ones who pay more.  In essence, this proposal incorporates to some degree the same fairness and equity found in our progressive federal and state income tax approaches.   And it treats residential property owners with the same equity and fairness as commercial property owners.   Moreover,  as household incomes as well as property values generally increase over time, the income-based residential property tax would, in general, generate more real estate tax revenue than a comparable base tax rate. 

 

Now I know that there are huge, quite possibly insurmountable, political and technical obstacles to making such an approach to property taxes part of state or county law.  I would guess it would be impossible now in the current Virginia General Assembly—from whom all county authorities flow in this Dillon Rule state—which can’t even pass a budget.   And this may well require a Virginia constitutional amendment.  There are also at least a thousand critical, but small questions about implementation that would need to be addressed even if there were enough good will to consider this approach.  But since implementation is not a planning matter as we’ve recently learned from our County leaders, I’ll let others sweat the details for the time being.

I also know that an idea will not be discussed until someone proposes it.  That is why I am putting this idea out there.  No doubt there are critics and probably also a few people who want to push the idea further than I have. . . but this is a start and that is my intention.   

The views expressed in this post are those of the author and do not necessarily represent those of the Reston 2020 Committee or Reston Citizens Association.   This blog welcomes alternative views.