Einstein had it right. Taxes can be needlessly complicated and difficult to understand, but luckily for us, real estate taxes are really pretty simple.
There are two types of taxes involved in a real estate transaction. The first group of taxes are called property taxes. These are the taxes that a property owner must pay yearly based on the assessed value of the property.
The second type of tax is called a transfer tax. This is a tax that is charged when real estate is sold and is a one time tax, a percentage of sale price. You can learn more about the transfer tax here in our article about closing costs.
In this article we’re going to discuss property taxes, how they are calculated (assessed) and how they are handled at closing.
STEP 1: types of property taxes
Property taxes are also sometimes generally referred to as real estate taxes.
The only time you pay these is when you own property.
They are completely unrelated to your income and are based solely on the assessed value of your property.
There are three taxes on a property:
- School Tax
- County Tax
- Local Tax
There are no Federal Taxes on property and the state only charges transfer tax when a property is sold, as mentioned above.
STEP 2: how taxes are determined
In order to calculate property taxes, you need only know two things – the value of the property and the tax rate.
The value of the property is called the “assessed value” and the tax rate is called the “millage rate”.
Property taxes are determined by multiplying the millage rate and the assessed value of the property.
Millage Rate x Assessed Value = $Property Taxes$
Determining Value
The value of a property is not the same as the sale price or even past sale prices.
The assessed value is the value assigned to the property by the local tax assessor.
Properties can be assessed in many different ways and this depends wholly upon local custom, but in general, the assessor will determine the value of the house based on market value.
Market value is value of a property as determined by several factors, including location, property details, and other sales in the area. You can think of it as the “going rate” in a sense.
An assessor’s office can determine market value manually, meaning a person will review each property and will assign a value, or they may use software that applies a value based on an algorithm.
After market value is determined, the assessor may multiple that by some predetermined factor or apply a formula to come up with an assessed value.
In some areas, the assessed value changes each time the property is sold. A municipality may choose to use sale price as a determining factor of market value. This is how our neighboring state, New Jersey, assesses properties.
In other areas, the value is assessed at set intervals and does not change when the property is sold, though it is still calculated using a set percentage of the determined market value.
Here in the Lehigh Valley, properties are assessed at intervals and the taxes do not change each time the property is sold.
When the local municipalities want to raise taxes, they change the millage rates.
That makes our job easy – we know what the taxes are going to be at the time of settlement based on the current rates because they will not change and millage rates are published just once a year.
Millage Rates
Millage is simply an old-fashioned way to say “one thousandth of a dollar”.
When applied to real estate taxes, that means that one mil is equal to one dollar per one thousand dollars of assessed value.
It is helpful to think of it as a tax rate because that is exactly what it is.
The millage rate is determined by the local government and is a set number. There is a millage rate for each of the three types of taxes and the “total” millage rate is the combined total of all three.
To calculate taxes, you first determine how many “thousands” are in the assessed value. To do that, simply divide the assessed value by 1000.
So an assessed value of $43,500/1000 = 43.5.
This is the value you multiply by the given total millage rate.
In this example, let’s say the millage rates are as follows:
- School Tax – 68 mils
- County Tax – 15.5 mils
- Local Tax – 7 mils
68 + 15.5 + 7 = 90.5 mils.
Multiple the total mils times the assessed value divided by 1000:
43.5 x 90.5 = $3936.75
The total taxes on this property will be $3936.75.
Millage rates vary depending on the type of assessment system that is in place locally.
If the assessed values are high, the millage rates tend to be lower.
In places where assessed property values are lower, millage rates will be higher.
Here in the Lehigh Valley, properties are assessed infrequently with sometimes as much as 20 years or more in between county wide assessments.
That means that assessed values such as the one in the example can be seen on properties that sell for several hundred thousand dollars, but the millage rates go up each year to compensate for stagnant assessed values.
STEP 3: What are prorated taxes
Now that we know how to calculate property taxes, all that’s left is to figure out what this all means for us when we buy or sell a property.
First, if you haven’t heard the word “prorate” before, it simply means “to distribute something over time”.
When you pay your taxes, they are paid in advance for the year to come, for time you have not yet “used”, unlike other services like rent, that are paid in arrears, or after you have used the service.
At settlement, taxes are prorated so that the buyer and seller each pay for only the time they will “use” the property.
Here’s a simple example. Imagine you buy a cell phone with $100 prepaid minutes.
You decide to sell the phone for $300, but there are still some minutes left on the plan and those minutes have value.
You would expect the person who buys the phone to pay you for the unused minutes – those minutes they will get to use once they own the phone.
If you used $25 worth of minutes, they would pay you the price of the phone plus the value of the unused minutes, or $300+$75 = $375.
Property taxes are just like that. The seller has “used” some of the property taxes for the period of the year in which they have lived in the house and the buyer will need to compensate the seller for the portion they have “prepaid” because that use and enjoyment now transfers to them.
Now that you understand the basic premise, we can learn how to calculate the prorated taxes.
STEP 4: how to prorate taxes
Once you understand the concept, calculating the estimated proration is easy.
First, determine the total amount of taxes paid to each municipality for the period.
We know from above how to determine the taxes by multiplying the assessed value and the millage rates (plus it is shown on the tax records and the real estate listing if you want to cheat).
Second, determine the total period for which they were paid and how much of that period will be left at settlement.
Since taxes are paid yearly, the period for which they are paid is one year.
That period begins with the official due date of the tax, not the date it is paid.
County and local taxes are due on January 1 so the period for those taxes begins on January 1 and ending on December 31.
School taxes are due on July 1 and run between July 1 and June 30.
We simply need to figure out how many months or days have elapsed since the due date of each tax.
Let’s use our prior example and assume an assessed value of $43,500 and the following tax millage rates:
- School Tax – 68 mils
- County Tax – 15.5 mils
- Local Tax – 7 mils
$43,500/1000 = 43.5
- School Tax – 68 mils x 43.5 = $2958
- County Tax – 15.5 mils x 43.5 = $674.25
- Local Tax – 7 mils x $304.50
To do that, we need to know when settlement of the property will be.
Settlement is often done at the end of the month, so let’s assume for this example that settlement is scheduled for September 30.
It is also important to remember that you can either calculate how much time the seller has “used” or you can calculate how much time is “leftover” for the buyer, but be sure you know which you are calculating, otherwise you won’t know who owes what at settlement!
We are going to determine how much time the seller has “used” for the purposes of this estimate and we’ll use full months instead of exact days to keep it simple.
Let’s look at the due dates and settlement dates of each tax:
- School Tax – July 1 – September 30 = 3 months out of 12
- County Tax – 15.5 mils = January 1 – September 30 = 9 months out of 12
- Local Tax – 7 mils = January 1 – September 30 = 9 months out of 12
- School Tax = 3/12 = 0.25 or 25%
- County Tax = 9/12 = 0.75 or 75%
- Local Tax = 9/12 = 0.75 or 75%
- School Tax = $2958 x 0.25 = $739.50
- County Tax = $674.25 x 0.75 = $505.69
- Local Tax = $304.50 x 0.75 = $228.38
This total, $1473.57, is the amount of tax which the seller has “used”.
They should be reimbursed for the remaining amount at settlement, so let’s find out how much tax time is “leftover”.
Total taxes of $3936.75 – $1473.57 = $2463.18.
This is the amount the buyer will pay at settlement to the seller to reimburse them for the prepaid taxes.
That is proration in a nutshell.
Some notes
- The title company will prorate taxes to the day at settlement, you need not worry about this, but it is useful to have this information in advance.
- A real estate agent is required asking by law to give you an estimate of your closing costs. Some agents will opt to use the estimate provided by your mortgage company as they are also required to give you an estimate of closing costs, but a good agent will always be able to calculate your costs themselves and can help you understand what each line item is and how it is calculated.
- If you want to calculate an exact amount of prorated taxes, to the day, use the example above, but instead of months used out of 12 total, use the total number of days out of 365. You can cheat here by asking Google how many days are between dates – it’s so much faster than counting them manually!
- If you live in the Lehigh Valley, you can view out local current millage rates here:
- Here in the Lehigh Valley, because assessed values are determined infrequently, large, older homes can sometimes be valued at less than smaller, newer homes. That’s because the assessment on one might have been done in 1995 whereas the other may have been done in 2017, if that is when the home was built. Relative values change quite a bit over the years. That is why it is so important to account for total taxes when you determine how much home you can afford. Don’t leave that blank when you use our mortgage calculator.
- You can fight an assessment if you feel your home is not valued correctly. The first step is to file a request for reassessment form the county assessor’s office. They will evaluate your case and will reassess your property. But beware – your assessment value can go up just as easily as it can go down if you get a reassessment. Talk to a knowledgeable real estate agent or appraiser before you go to the county to be sure you know the real market value of your property.
As always, if you have any questions or would like us to review the value of your property, feel free to contact us. We’re always happy to help.
