“What are the Taxes?” — Why that is not always easy to answer.
The taxes currently being paid on the property will change when it is sold, so whatever the property owner is paying now, especially if he has owned it for a long time, is not relevant to what you will pay. The tax system is a complex process that can produce varying results, and will be influenced by choices that you make, some of which are summarized below.
“Millage” is the tax rate levied against property, expressed in tenths of a cent. For example, “38.41 mills” = $0.03841 per year, which is multiplied times the new State Equalized Value (SEV) of your property to determine the tax owed. In this example that would be $38.41 per thousand dollars of SEV.
Commercial Forest Act
The Commercial Forest Act is relatively unknown and unused below the Mackinaw Bridge, but it has had a significant effect on life in the U.P. Half the land in the U.P. is in public ownership. The majority of the rest is owned in large tracts by timber and mining companies. The Act bypasses the local assessment and millage tax system described here and instead currently offers reduced tax rates of $1.25/acre for owners of 40 acres or more when property is properly registered and used solely as commercial forestland. In return, public access to this land is required for the walking public for purposes of hunting and fishing. (Landowners retain all other private property rights.) It is this act that has made so much of the U.P. accessible to the public and it can significantly reduce the taxes on your property.
CFR land can be transferred and can also be withdrawn from the Act at any time on payment of a penalty that amounts to the difference between the ad valorem tax rate and the rate actually paid under CFR (usually about a third of the typical ad valorem rate). Usually I have found that the penalty for property that has been held for seven years or more runs $25 – $30/acre. Copies of the Act are available from the Michigan DNR, and you can read all about it on the official state website at Commercial Forest Act. You will see “CFR” in the plat book on tracts that have been so designated. For more information search “Michigan CFA” or go to https://www.michigan.gov/dnr/0,4570,7-350-79136_79237_80945_83262—,00.html.
Qualified Forest Program (QFP)
The owner attests in an affidavit that their land is forestland and will remain in forestland. A forest management plan is required. To qualify parcels must be 20 – 640 acres in size. Tax benefits include exempting the property for up to 18 mills of school operation tax. If a new purchaser executes a Qualified Forest School Tax Affidavit (QFSTA), his taxable value would remain capped at the level of the previous owner. (!) Structures are permitted on QFP land and the public has no right of entry for hunting and fishing, as is required in the CFA program. For much more including updates to this program see www.michigan.gov/pfi.
“Homestead” designation has a big effect on taxes. Your designated home in Michigan qualifies as “Homestead” property, which is taxed at 18 mills or $18 per $1,000 of taxable value less than other real estate such as vacant land, a vacation home, or commercial property. You can only have one Homestead property, but interestingly an attorney friend tells me the law considers “home” to be where the heart is, not necessarily where you spend most of you time.
Taxable Value, Assessed Value, True Cash Value, & State Equalized Value (SEV)
Brokers are advised and assessors recommend that you use the price you expect to pay for the property when you estimate its likely “true cash” value. That should be the “worst case” for estimating your future taxes, so that has to be what I advise and I do. However…
When property is transferred the local assessor is required to re-assess the property based on all the comparable sales in his taxing jurisdiction over the last three years and ignoring what you paid for it. Note that this is a back-loaded process that by definition does not reflect the current value unless the three-year-old sale prices are adjusted for time. Under Michigan law the value he places on the property is the “true cash” value. In theory (but rarely, in my experience, in practice,) is the price the property will sell for in the marketplace.
As a practical matter you may also wish to look at the valuation of comparable properties in the area of your interest. I frequently see “true cash” that are less that market value, in some cases much less. We all complain about our taxes and think we are over-assessed, and you can relate to this wherever you are with respect to your own taxes, but in fact I rarely find a seller who is willing to sell his property for its “true cash” value. When that happens if you use the anticipated purchase price in estimating your “true cash” value and your future taxes, you may not be dealing with a real world number and may elect to not buy the property for the wrong reason. Typically rural properties will seem to be assessed lower than more developed areas. Look into this on your own and make your own decision.
I have attached below a PDF of a 2006 memo from the State Tax Commission to Boards of Review Assessing Officers. It clearly states, “… the SEV of the property will not automatically or necessarily equal 1/2 of the sale price of the parcel.” And, “THE PRACTICE OF ‘FOLLOWING SALES’ IS A SERIOUS VIOLATION OF LAW.”
Click here to see the PDF for the complete memo on how it is supposed to work.
At minimum your assessment will not be less than the current SEV unless you are successful in an appeal, and the SEV/first year Taxable value, will probably be increased by the Assessor. Real estate tax obligations can change significantly when property is transferred. Under Michigan law property is taxed at 50% of the “true cash” value. The county reviews the total value of the property in each category and may require the local assessor to make an adjustment to the total valuation in his jurisdiction. The final result is the “state equalized value” or “SEV”.
In the first year of ownership your SEV will also be the property’s “Taxable Value”, the amount on which you are taxed. After the first year in Michigan under Proposition “A”, increases in TV are limited to the lesser of the rate of inflation or 5% (plus any improvements to the property). Over time this will encourage owners to hold and improve property, as a parcel that has been owned for a long time will pay less tax than an identical adjacent parcel that has transferred more recently. California has a similar system and that has been a result there.
Summary: True Cash/2 = Assessed Value/SEV = the 1st year Taxable Value. Subsequent years SEV may rise but TV is capped at the lesser of 5% or the rate of inflation multiplied by the voted millage = your tax. If the property is Homestead property the millage will be 18 mills less than any other property you own.
I do not set your future taxes, have no precise way of estimating actual taxes, they will be set by assessors who may have their own notions as to how this should be done and I have no control over it, so if you want further information call the local assessor or the Equalization Office in the governmental jurisdiction where the property is located and talk to them directly. I have found the people who work in these offices to be most helpful and informative.
Capital Gains and Losses
When you sell real estate, the difference between the adjusted basis in the asset and the amount you realized from the sale is a capital gain or a capital loss. Generally, an asset’s basis is its cost to the owner, but if you received the asset as a gift, inheritance, or it is your main home, other rules apply. You have a capital gain if you sell the asset for more than your adjusted basis. You have a capital loss if you sell the asset for less than your adjusted basis.
Capital gains and losses are classified as long-term or short-term. If you hold the asset for more than one year before you dispose of it, your capital gain or loss is long-term. If you hold it one year or less, your capital gain or loss is short-term. Net short-term capital gains are subject to taxation as ordinary income at graduated tax rates. To determine how long you held the asset, count from the day after the day you acquired the asset up to and including the day you disposed of the asset.
If you have a net capital gain, a lower tax rate may apply to the gain than the tax rate that applies to your ordinary income. The term “net capital gain” means the amount by which your net long-term capital gain for the year is more than your net short-term capital loss for the year. The term “net long-term capital gain” means long-term capital gains reduced by long-term capital losses including any unused long-term capital loss carried over from previous years. The tax rate on most net capital gain is no higher than 15% for most taxpayers. However, a 20% tax rate on net capital gain applies to the extent that a taxpayer’s taxable income exceeds the thresholds set for the 39.6% ordinary tax rate. In addition there will be State taxes and charges for the Affordable Care Act, which for some taxpayers may bring the capital gains rate to near 30%.
NOTE: This is a general overview. The rules are complex and change all the time. U.P. Waterfront Company is not licensed to give tax advice, and does not. The rules are complex. See your CPA or tax advisor for how taxes will affect your personal situation.
Tax evasion is illegal. Tax avoidance is not. Disposing of one parcel of real estate and acquiring another with a properly structured 1031 exchange defers capital gains taxes until the replacement property is sold. However it can be exchanged again, deferring capital gains taxes further into the future. In this way the tax can be deferred indefinitely. A tax deferred is in effect an interest free loan from the government. Can you make money with an interest free loan? You bet. It is however critical that the letter of the law, not just the intent of the parties, is followed precisely to have a successful exchange, and there are some traps for the unwary. See your tax consultant and/or attorney.
No less an authority than a former Chief Justice of the Supreme Court has said, “The 1031 tax deferred exchange is the finest tax loophole available to the average American.” He added: “It is the duty of every American to his family to pay the minimum tax that he is legally required to pay under the law.”
“Section 1031” property is “property used in a trade or business or held for investment.” Essentially that covers any real estate but your house. (Second homes may or may not qualify, depending on the circumstances.) “Held for investment” is a matter of intent. A typical exchange involves three or more people, not two. They are a person, “A,” who wants to dispose of a property and defer capital gains taxes, “B” who owns a parcel “A” would like to acquire, and “C” who is willing to buy the parcel “A” no longer wants.
The first step for “A” is to find a buyer for the property he has. When “A” gets an acceptable offer, he accepts it with language that says, “subject to structuring a 1031 exchange.” “A” now has a contract and knows how much he has to acquire a new property. The basic rule is that to achieve a totally tax deferred exchange one has to acquire a new property of equal or higher value. “A” negotiates the purchase of a new property he wants just as if he were “buying” it for cash, but he makes his offer to buy “subject to completing a 1031 exchange.” This does not affect the “B” or “C”, and their attorneys or tax advisors will tell them so.
In essence what happens at closing is “C” buys “B’s” property for cash (taxable for “B”), and swaps that property for the parcel he wants from “A”. “A” then has the property he wants and capital gains tax is deferred.
1031 exchanging is a big subject and cannot be boiled down to a few paragraphs. There are many additional advantages to exchanging. It is possible to get cash out tax-free by financing before or after the exchange. A free and clear smaller property can be exchanged into a much larger leveraged property. You can move from one type of property, vacant, income, management free or management intensive, to another.
A vacant parcel held for investment that has negative cash flow can be exchanged for a net leased income property with positive cash flow. An income property that demands constant management can be exchanged for a free and clear vacant parcel. If you are interested in 1031 exchanging call U.P. Waterfront Company for a more complete explanation than is possible here. Again, all of this must be done precisely within the rules, they are complex, it adds a level of complexity, and usually takes more time, but if there is big capital gains the savings are significant, and the law is clear.