What is Property Tax?
Property Tax Basics
Buying and owning a home is a huge financial step. Entering into a mortgage agreement means agreeing to a long-term debt commitment, that requires steady repayment, and tons of patience. Home loans by themselves have the potential to be heavy financial burdens on any homeowner, but there are actually additional components to a true monthly mortgage payment, such as unavoidable property taxes.
In the home finance industry, the acronym PITI stands for principal, interest, taxes, and insurance. During the home purchase process, it is all too common that home buyers discuss and negotiate principal and interest, and completely neglect to pay attention to the other components of a full mortgage payment. One such component, that accounts for a pretty decent chunk of a full mortgage payment, is the portion dedicated to paying property tax.
It is often joked about that everything in this country can, and almost always is taxed in some way. Uncle Sam doesn’t let a single penny slip through the cracks, and homeowners should expect nothing less of the same treatment. Buying a home and paying off the mortgage makes you the owner of that home, but the land it is located on is under the jurisdiction of a local government, and you had better believe that they intend to collect taxes from whatever entity resides on their land.
Enter the wonderful world of property taxes.
What is Property Tax?
Property tax, also known as the real estate tax, is a type of ad valorem tax (which means that it is based on the assessed value of an item) levied by local governments on real estate. Local governments collect these taxes from homeowners within their jurisdiction based on the assessed value of the real estate property (including land) of the homeowner. A real estate tax is an ongoing cost of homeownership, even after the mortgage on a property is paid in full.
Any homeowner can tell you, property taxes are not cheap. In fact, it is quite common to see a monthly mortgage payment that has been calculated based on solely principal and interest increase by hundreds of dollars with the inclusion of what is owed towards property tax. Still, the local governments that collect these taxes from homeowners put the money to good use, so it’s not something to be too upset about.
Collecting taxes is the most common way for governments of all scales to fund the many branches and services required to effectively govern an area and the people residing in it. By that note, property taxes are a great source of funding from the residents who live in any given municipality. Since property tax is ad valorem, it is also designed to tax residents accordingly based on the specific values of each property within the jurisdiction of the local governing body.
Why are Property Taxes Collected?
While having to dish out more of your hard-earned money each month for something like a real estate tax may seem like a loss, the truth is that property taxes are an essential component of how well a city operates. Like the many other forms of taxes that the average person pays throughout their lifetime, property tax is used to help fund various functions of the government, more specifically on the local level. These collected taxes serve the community as a whole, and it isn’t typically hard to see where your money is being spent.
Local governments collect property taxes from the homeowners with property within their jurisdiction in order to fund many of the public services the government provides. The proceeds from collected property taxes are used to fund a plethora of essential public services such as water and sewage management, public schools, law enforcement, fire services, public servants, and even road and highway maintenance. Anything that serves the community as a whole is typically funded at least partly through the collection of property taxes.
When you stop to think of all of the services listed above, you can begin to understand just how important property taxes are to any one community. If you take a harder look, you can begin to see which municipalities make the most out of the taxes they collect. As a matter of fact, researching the property taxes in the area of a property you want to purchase is an extremely helpful tactic that home buyers should employ.
Getting an idea of what is expected from homeowners in terms of property taxes is a two-fold benefit. On one hand, it is invaluable information when it comes to calculating PITI expense and budgeting ahead. On the other hand, property taxes in any given area paint a pretty decent picture of what you can expect out of whatever city you intend to relocate to.
Typically, but not always, areas with high property tax rates are the cities with high-end services. You can tell by the well-funded law enforcement precincts or even the general upkeep of the municipal property. While this may not always be the case, 9 times out of 10, the areas with higher property tax rates are visibly more appealing than the ones with lower property taxes. Not to mention the fact that as an ad valorem tax, property tax is assessed partly using the value of individual homes.
That said, its hard not to connect the two in a cyclical manner. Higher home value leads to higher property taxes paid by the homeowner, which in turn leads to more well-kept cities. Arguably, the more a city grows and advances, it drives up the home values, which drives up the property taxes, which leads to more funding for the city to advance.
Even in the opposite direction, you can make out a basic pattern. Low home values mean lower taxes levied, less funding leads to less upkeep of municipal services and property, which has a negative effect on property values. With that perspective, it’s pretty easy to see why some local governments raise taxes in an area for seemingly no reason.
How Are Property Taxes Determined?
Property taxes are not a uniform charge across the nation, instead, they are assessed on a local government basis, typically annually. The residents of any city usually pay the taxes without question as part of the normal cost of homeownership. Still, not many homeowners are even aware of why they are charged the amount they are charged in the first place.
While it is no secret, the process behind how property taxes are determined is as obscure as it is complex. Perhaps the complexity behind the process is part of the reason why many people don’t care to know how property taxes are determined. Even so, it is quite beneficial to know the details of how taxes are decided, and comforting to know the rates aren’t simply pulled out of a hat at random.
The first thing to keep in mind about how property taxes are determined is that every local government has a given tax rate. This tax rate is based on what is known as the mill levy. Fair warning, the idea behind the mill levy is a little complicated, but nonetheless, it is an essential part of understanding how property taxes are calculated.
What is a Mill Levy?
The mill levy is defined as the assessed property tax rate used by local governments and tax jurisdictions for the purpose of collecting revenue in order to afford the annual expenses of operating. The mill levy is calculated based on the total assessed property value of an area and the revenue requirements of each tax jurisdiction in that area. Tax jurisdictions are typically split between the city, county and school districts.
With that in mind, one mill is 1/1000th of a currency unit or $1 of every $1000 of taxable value. So let's say that the total assessed value of property in a given area is $100 Million. The county declares that it requires $1 million in revenue in order to operate for the upcoming year, the city requires $5 million, and the school district requires $10 million. To calculate the mill levy for each jurisdiction, the projected required revenue is divided by the total value of the property within the area. The totals are then added up in order to determine the mill levy for the entire area.
In this case, the county has a tax levy of 0.01 or 1% (1 million / 100 million), the city has a tax levy of 0.05 or 5% (5 million / 100 million), and the school district has a tax levy of 0.1 or 10% (10 million / 100 million). When all of the tax levies are added up, you get a total mill levy of 0.16 (16%) or 160 mills for the area in question. That mill rate is key to the calculation of property tax on the individual level, as we will show you soon.
Once the mill rate for an area is known, the next step is for the local government to assess individual properties for their taxable value in order to levy an appropriate tax.
How are Properties Assessed for Tax Purposes?
Local governments typically have dedicated tax appraisers who are responsible for estimating fair market values of each individual property in a tax jurisdiction and assigning taxable values to each property. Determining the value of a property is somewhat abstract, and there are many factors to take into consideration when assessing a property’s overall value. In definition, a property’s value is determined as the present worth of future benefits arising from the ownership of the property.
Property assessors must take into account the long-term benefits of each property as well as the many factors at work that affect the four pillars of value which are:
Demand: the desire for ownership of the property in comparison to the financial means to satisfy the desire
Utility: the ability of the property to satisfy future owners' desires
Scarcity: the fixed amount of competing properties
Transferability: the ease the transferral of ownership rights
It is also a common misconception that the price or cost of a home equal the home’s value. The price of a home is how much someone pays to purchase the property. The cost of the home is in reference to any expenditures in creating the property. While both may have an effect on the property’s value, they are not equivalent, nor do they determine the value of the property.
Properties may be significantly higher or lower in value than the price they are purchased for. A great example of this is with a short sale. In a short sale, the owner desperately needs to sell the home, so they offer it at an incredibly low price. For example, a homeowner with a home valued at $200,000 has $160,000 left to pay on their mortgage, but due to some unforeseen financial hardship, they have to put their house up for a short sale at the set price of $150,000.
In that example, the home is valued at a clean $200,000, yet a homebuyer can snag it for $150,000. That's a $50,000 difference between the value of the property and the price it was purchased for. In the same breath, cost becomes an insufficient measure of value as soon as the property is appraised and sold for the first time.
In any case, It is up to the government appointed tax assessor to estimate a fair market value for each property. The market value is an estimate of what the property will probably be sold for in a competitive and open market. If you’ve ever purchased or sold a house before, you may already have had a property appraised for its fair market value.
Once a value is established, then the assessor must determine the taxable value of the home, which is typically a percentage of the fair market value. In some cases, areas have tax exemptions in place for properties, like a homestead exemption of $50,000. That amount is to be subtracted from the market value assessment and the resulting figure is what is allowed to be taxed.
The last piece of the puzzle is the area’s designated assessment rate, which is the percentage of a home’s assessed value that can be taxed. The rate differs depending on the area in question, and exemptions are also to be considered when the assessment rate is applied.
Calculating the Property Tax on a Property
After the mill rate and the assessed taxable value of an individual property is determined, calculating property tax is easy-peasy. Basically, the mill rate is multiplied by the assessed taxable value of the home. The result is then divided by 1000. For a more exact view, the property tax for a specific property can be determined by using a simple formula:
Property tax levied on property = (mill rate x taxable property value) ÷ 1,000
Earlier we were able to come up with an example of a mill rate of 16% (160 mills) for a fictional area. Let's imagine that a homeowner has a property with an assessed taxable value of $250,000. That would mean his annual tax amount would be $4,000 (16 x 250,000). That $4000 can then be divided into 12 equal payments and added to a homeowner’s monthly mortgage costs.
It is important to note that governments usually assess tax rates and property values on a yearly basis. As such, the values for a specific property may change every year, leaving a little unpredictability in just how much taxes a homeowner is responsible for paying.
Can Property Taxes be Negotiated?
In short, yes. Property taxes can be contested with the local government of jurisdiction. It might not be an easily won battle, however, it can be accomplished.
While the actual tax rate is generally not debatable, a homeowner may be able to dispute the assessed tax value of their home. If they can prove that the taxable value should be lower, perhaps by calling into account any exemptions that were overlooked, then they may be able to pay less in property taxes.
Alternatively, understanding how property taxes are calculated could help a homeowner catch any mistakes made in the determination of the taxed levied on their property, which will be addressed and fixed if brought to the attention of the local government of jurisdiction.
How are Property Taxes Paid?
Once a homeowner purchases a property, typically they are notified of the annual tax amount that is due. The collection times for property taxes vary by local government. The payment of these taxes is crucial to maintaining ownership of the property, as a failure to pay property taxes can result in liens placed on the property, and even foreclosure.
In order to reduce some of the burden of having to cough up large sums of money once or twice a year, many mortgage transactions take property taxes into account and call for an escrow account where tax money can be collected on a monthly basis, and paid at the specified collection time by the lender on behalf of the homeowner. This allows homeowners the ease of making smaller contributions towards property taxes as part of their monthly mortgage payments. The escrow account is typically reserved for taxes and sometimes homeowners insurance.
Property Tax: In Review
If you’re a homeowner, you must expect to pay taxes on the property you own. Property taxes are an important stream of revenue for cities in order to carry out their operations and solidify their infrastructure. Property taxes can be quite expensive, but at least they are used for the greater good of the entire community in which your property is located.
Homeowners are expected to pay property taxes which will ultimately go towards funding essential public services such as law enforcement, education, and sewage maintenance to name a few. These taxes are easy to calculate, providing you can navigate the complex origins of specific values that are components to the overall property tax formula. It helps to find out the mill levy for the area a property is located in as a start, as well as the current assessed taxable value for the property in question.
It may seem like a ton of math mumbo jumbo, but understanding why you are required to pay what you are expected to pay in property taxes can be quite beneficial for a homeowner. Property Taxes play a large roll in every homeowner’s PITI calculation, which is the full monthly mortgage payment on a property. At the very least, knowing a bit more about property taxes and how they are calculated could help you contest the taxable amount on your home and bring the price down a smidge.
Regardless of how you utilize this information, the team at home.loans is always standing by to advise you on any questions you may have about home buying or homeownership. If you’d like a risk-free consultation with a mortgage expert, don’t hesitate to call the team at home.loans for you personalized mortgage solution!