Lessons learned: Courtesy of the PROPERTY TAX CODE

[Chris McKinley]

I recently learned a few lessons in property taxes courtesy of the tax code and my mortgage company that I wanted to share so they don't catch anyone else off guard.

In 2014 I purchased my first house down in Phenix City, Alabama which is right outside of Fort Benning (I'm military). I purchased the house with a 0% down VA loan and got a great deal on it because it was a foreclosure. I immediately went into the house hacking strategy that I've heard @Brandon Turner talk about so many times (though admittedly I didn't know that's what I was doing at the time haha). The house was a 5bd/3br with 3,100 sq ft that I got for 153k...unbelievable price since it was valued at over 170k then. I immediately moved in along with 4 of my friends (making it my primary residence) and they began to pay rent which covered my mortgage.

Since we are all military we were only there for a year. We all left and I got a property manager to list the house and I began collecting rent the month after I moved out. Everything was going smoothly with the house until just recently I was notified that my monthly payment to my lender went up nearly $300!! I inquired with them and came to find out it was because my escrow account was dramatically short of funds for some reason.

Upon further investigation I found out that my property taxes on the house more than doubled, going from $937 to $2,021. Because of this my mortgage company had to back fill that money over the course of the next year. They split it across the next 12 months which increase my monthly expenses by about $150 in addition to the increase in taxes I had to pay.

I called my county tax assessor to figure out how it was possible that my taxes could more than double in the course of a year. Especially since I check out comps in the area that had taxes below $1000 still. That is when I learned about the HOMESTEAD TAX EXEMPTION. This tax exemption basically states that if a house is your primary residence there can be a certain portion of that house that is exempt from being taxed. This is largely dependent upon the state you live in. I encourage everyone to check out what their state tax law says.

So, in conclusion, what I learned and wanted to share with you all is that if you are planning on using the house hacking strategy be wary of tax implications should you ever want to move out of the house. Once the house is no longer your primary residence you step into a vastly different world in terms of taxes.

I hope this post helps and keeps someone else from making the same mistake I did!! 

I'm also curious to find out any other tax laws people have found themselves caught up by so others can avoid them. Please share if you have any stories!!

Cheers

-Chris

P.S. don't worry too much about me and this property, I was making such good cash flow month to month that I'm still in the green even with the extra $300 payment (which will go down by $150 at the end of the year once the escrow account in fully backfilled).

[Denise Evans]

Hi @Chris McKinley, I'm sorry about your bad experience.  I'm considered the property tax expert in Alabama, so I'll share some advice with you and with everyone else on BP.

First, property is appraised by the county Tax Appraiser's office. Let's say that number is $170,000.  

If you claim a homestead exemption, $20,000 is deducted from that value, to reach $150,000.

In order to claim a homestead exemption, the property must be owner occupied residential. Such properties are assessed at 10% of the adjusted appraised value. That is 10% of $150,000, or $15,000

For commercial property, or rental properties, or unimproved small parcels, the assessment rate is 20% of the full appraised value.  That is 20% of $170,000, or $34,000.

Once you reach the assessed value, you then apply the millage rate to determine the taxes.  Millage rates have various components, with part for the city, part for the county, and part for the state. As a result, every city is different. For Phenix City, they all add up to 5.9% 

For owner occupied residential property with a homestead exemption, assessed at $15,000, the taxes will be 5.9% of $15,000, or $885.

For rental property assessed at $34,000, the taxes will be $2,006.

To find out local millage rates, you can either call the local Revenue Commissioner's office, or the local Tax Collector. Counties have different officials, depending on what they voted for.  Or, you can try searching online with the county name and the word "millage" in your search string.

If you don't pay your property taxes, it will be auctioned at the spring auctions. The successful purchaser might pay vastly over the actual tax amount and receive a tax certificate. That entitles them to immediate possession, but many do not even attempt possession. They lay low, and then pounce on you years later and sue to kick you off the property, or you can redeem.

If you've remained in possession of your property, this might happen years later, even after the investor received a deed. You will still be able to redeem, but the interest will be huge.

In Alabama, the bid amount over the taxes is called the "excess bid." Investors earn 12% per year interest on the taxes, plus all taxes they pay after the sale. They also earn 12% on a portion of the excess bid. That money is sitting in a bank account at the county, and the principal is repaid to the investor when you redeem.

That portion of the excess bid that is equal to, or less than, 15% of the tax appraised value of the property earns interest at 12% per year.

If your property is tax appraised at $170,000, then $25,500 of the excess bid will earn 12% interest, and also the actual taxes. Everything over that earns 0% interest.

Let's say your property is sold for unpaid taxes due of $2,006 and the winning bid is $30,000. Let's say you redeem exactly one year later. We won't worry about additional taxes due in the meantime, for purposes of this example.

You will owe $2,006 plus $240.72 of interest.

On the excess bid of $27,994 ($15,000 - $2,006), a full $25,500 will earn 12% interest. That will be another $3,060. The final $2,495 of the excess bid earns no interest.

After one year, you will owe a total of $2,735.72 interest on a tax bill that was only $2,006 to start with. That makes your effective interest rate 136%  Even the IRS doesn't charge interest that high. 

The lesson: Even if you have to put it on a credit card, always pay your taxes before the annual auctions!

While this is all bad news for property owners, it's good news for investors. Whichever one you are, understand the law and make decisions accordingly.