How Local Governments Calculate Real Estate Taxes on Commercial Property
Wonder how your city calculates tax on your local apartment building or other commercial property? Read on for a basic overview.
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Every year local governments around the country will request commercial property owners to fill out and return an income and expense form. This form is submitted to the board of assessors and is used to determine the value of the property in question. But nothing on the form explains to you, the owner, how the assessors will use the information you provide to calculate your future property tax. Here is a breakdown of the most common approach.
The Income and Expense Form
The form itself will request commercial property owners to provide details on all of the rents received (income) and expenses you have incurred the past year.
Income and expense forms typically ask owners to break out rental income into the following category types:
- apartments and rooming houses
- commercial and industrial, and
- hotel, motel, inn, and B&Bs.
The income and expense form will also likely ask you for information regarding your purchase of the property and whether any additional changes occurred since the purchase, such as a capital improvement (including a building addition or new structure), or a demolition of a structure that previously existed. Local governments use this information to determine if there is additional (or less) property value that was previously unaccounted for in past assessments, and your tax assessment will change as a result.
It cannot be emphasized enough how critical it is that commercial property owners identify any and every expense related to operating their property. The form should guide owners on expenses to provide, but, whether they are listed or not, owners should include the following expenses as applicable:
- management fees
- outside agency fees, including commissions paid to real estate brokers
- legal fees, including LLC registration costs
- advertising fees
- payroll and payroll tax
- utilities, including electric, heat, water, cable, and phone
- cleaning and decorating
- repairs and maintenance
- trash removal
- snow removal, and
- replacement reserves, which are monies held aside to prepare for future costs.
If you understate your bottom line, you risk a higher valuation, resulting in higher property taxes. Cities and towns naturally want as much tax revenue as possible, but they also want your property to reflect positively on the town. Taxes that are too high place an unnecessary burden on commercial property owners and inhibit your ability to properly maintain and improve your property. Follow one simple rule when listing your expenses: List everything! Let the assessors determine if a cost isn’t relevant.
The Income Approach to Calculating Property Taxes
When the assessors receive your income and expense report they will often use a relevant cap rate to determine what the initial value of the property is. See the Nolo article Is That Residential Real Estate Investment Property Worth It? for more on the subject, including an explanation of cap rates.
For example, say your property is a “class A” office building in an area where the market determined that an 8% cap rate is a proper valuation tool for that commercial property type. If your net income last year was $100,000, then the assessed value of your property using the market’s cap rate of 8% is calculated as follows:
$100,000/.08(cap rate) = $1,250,000
Calculating Your Expected Tax
Now let’s take the assessed value figure to determine your expected local taxes for the upcoming year.
If the town your property operates in has a $12 tax rate for every $1,000 in assessed value, the taxes you could expect to pay would be determined as follows:
$1,250,000/$1,000 = $1,250
$1,250 * $12 = $15,000 in expected taxes
Loading the Cap Rate
The example above is meant to give you a quick, “back of the envelope,” method for understanding how your commercial property taxes are determined. Assessors will likely approach the valuation with a little more complexity by removing the taxes you currently pay out of your net income and then adjusting the cap rate to reevaluate the property. Sticking with the example above, let’s say last year you paid taxes of $12,000. The assessors will add the $12,000 back to your $100,000 net income figure. Now let’s say that the assessed value of your property last year was $1M.
Here’s how you get the additional tax rate to be added to the 8% cap rate to properly value the property:
$12,000 / $1,000,000 = .012 tax rate
.08 Cap Rate + .012 tax rate = .092 (your adjusted cap rate)
Using the new, adjusted cap rate of .092 (or 9.2%), and the adjusted net income of $112,000 (removing the original $12,000 from our bottom line), we get an assessed value as follows:
$112,000 / .092 = $1,217,391.30
$1,217,391.30 / $1,000 = $1,217
$1,217 * $12 = $14,604 in expected taxes
What This All Means to Commercial Property Owners
Knowing how the local governments determine value will help you do a better job of forecasting your property’s future performance. Every calculation tool you can utilize will lead to better property management and increase your ability to improve your return on investment.