Home Ownership Costs: Property Taxes
Other necessary costs of ownership consume a quarter to half the amount borrowers could potentially put toward loan payments.
Repost from OC Housing News 2011-2016
When lenders calculate how much they are willing to loan to any particular borrower, they measure the borrowers income from wages and other sources and calculate how much of that monthly income is available to pay the debt.
One limitation on borrowing is the front-end ratio, generally 31% of verifiable gross income. Lenders assume that a borrower can afford to spend 31% of their gross income on all housing related expenses and still have enough money left over to pay all other obligations and have a life. This 31% is called PITI, or principal, interest, taxes, and insurance.
The lender is primarily concerned with principal and interest because this is the money coming back to them after they make the loan; however, they need to make allowances within the 31% maximum for property taxes (including special taxes like Mello Roos) and insurance. These expenses (1) reduce borrower payments to the lender, (2) reduce the amount they can borrow and bid, and thereby (3) reduce the value of real estate.
Property taxes have long been a source of local government tax revenues. Real property cannot be moved out of a government’s jurisdiction, and values can be estimated by an appraisal, so it is a convenient item to tax. In most states, local governments add up the cost of running the government and divide by the total property value in the jurisdiction to establish a millage tax rate. California is forced to do things differently by Proposition 13 which effectively limits the appraised value and total tax revenue from real property. Local governments are forced to find revenue from other sources.
Proposition 13 limits the tax rate to 1% of purchase price with a small inflation multiplier allowing yearly increases. In California, the first half of regular secured property tax bills are due November 1st, and delinquent after December 10th; the second half are due February 1st, and delinquent after April 10th each year. If the delinquent date falls on a Saturday, Sunday, or government holiday, then the due date is the following business day.
One of the problems with Proposition 13 is that two nearly identical houses with similar real estate values can pay taxes at very different rates. For example, if a homeowner bought in 1978 and locked in that tax basis, their taxes would be a small fraction of the tax bill from a neighboring house purchased today. What justifies one neighbor enjoying a drastically lower tax bill than another?
This becomes particularly problematic when the long-time homeowner with a low tax basis has refinanced their mortgage multiple times. At each refinance, the borrower had an appraisal — an appraisal they agreed with — that established the house was worth much more than the value on which they are taxed. Since the homeowner has expressed a tacit agreement with a higher value, why shouldn’t they be taxed at that value?
Automatic re-assessment for cash-out refinancing
An idea emerged from the aftermath of the housing bubble; limit HELOC abuse by making cash-out refinancing in excess of the original purchase price an event that triggers property tax re-assessment. The effect is to drive up the cost of borrower money and discourage the behavior. It would probably be very effective.
The lenders would cry foul, and in particular there may need to be an exception for reverse mortgages to accommodate seniors (I think reverse mortgages are a bad idea, but forcing retired people to leave their homes is probably worse). Despite the resistance, the legislation if passed would curtail HELOC abuse, but in an economy dependent upon Ponzi Scheme financing, such legislation is unlikely.
Municipalities would love the idea because their revenues would grow as long as there are Ponzis.
Proposition 8: hurting peak buyers
Despite widespread delusions to the contrary, real estate prices do go down, and when they do, property taxes go down with them. But there’s a catch: those that buy when prices are low get the locked-in lower basis, but those who bought at higher prices will see their tax bills go up once again.
What Proposition 8 giveth, Proposition 8 taketh away. California tax code section 51(e), enacted at the same time as Proposition 13, requires the tax assessor to annually adjust tax levies based on current full-market value. This was great when property values were falling and property tax bills fell dramatically. Now, property taxes are set to jump back up for homes bought during the bubble years.