Commercial real estate owners pay property taxes the same way that owners of non-commercial property do. Except, with commercial real estate, there are more types of taxes to pay. In this article, we’ll review everything you need to know about commercial property taxes.
Four Different Types of Commercial Property Taxes
Many beginning commercial real estate investors believe that property taxes are the main tax burden on investment property. But there are actually four different types of taxes on commercial property:
The county government levies property taxes on the assessed value of commercial real estate. The property tax then becomes a lien on the property until paid.
Federal Income Taxes
Commercial property owners must pay federal tax on the net income from the property. So, it’s important to accurately track and deduct all operating expenses related to the property.
Investors should also remember that tenant deposits are not income, but rather they are held as a liability on the balance sheet. If a deposit isn’t returned to a tenant, the deposit amount can be used for repairs or other work which, in effect, reduces taxable net income.
State Income Taxes
Some states tax income of commercial property. As with federal tax, state income tax is paid on net income and not on gross income.
Some cities and counties also collect a tax on the net income commercial real estate generates. Even though the commercial property owner is responsible for paying these taxes, its good practice to factor these tax amounts into the rental rate charged to tenants as an expense pass through.
How Commercial Property Taxes Are Assessed
Commercial property taxes are paid based on a percentage of the assessed property value. Property includes improvements such as buildings and the land on which the improvements stand.
Keep in mind that assessed value is different from appraised value. Commercial real estate is assessed for taxation purposes, and it is appraised to determine the fair market value. Assessed values used for taxation are usually much, much lower than appraised values.
Every one to five years, depending on the commercial property’s county, assessors will calculate the value of commercial real estate and use a mill levy to ensure the correct tax amounts are collected from the property. A mill levy is the property tax rate, with one mill equaling 1/10th of 1 cent or .001.
Depending on the market, different governmental bodies have the power to levy property taxes. Usually, these include school districts, water districts, the city, and the county. Each government body determines how much money it needs to operate, then determines a mill levy.
For example, if a county needs $20,000,000 for its fiscal year and the value of all commercial real estate in the county is $1 billion, then the mill rate from the county would be: $20 million / $1 billion = .02 or 2%. The other taxing bodies would also calculate their own individual mill rates. Then the individual mill rates are added together to determine a total mill levy to be charged against a commercial property’s market value.
Three Ways Commercial Property Market Value Is Determined
Tax assessors estimate the market value of commercial real estate using three different methods. The assessor may use one, two, or all three methods to determine the market value of a property for property tax purposes.
The assessor will look at sales comparables of similar property within the county, making adjustments for improvements and overall conditions in the commercial real estate market.
With the cost method, the assessor will calculate the replacement cost of the property, taking into account depreciation and the current cost of building materials and labor.
The income method is used by the assessor to calculate how much net income the property would generate if it were fully rented, with deductions made for vacancy, operating expenses, and what a reasonable return from the property should be. Some counties require commercial property owners to submit an annual income and expense form to assist with the income method valuation process.
Using an Assessment Rate to Determine Assessed Property Value
Once the market value of the commercial property has been determined, the assessor will calculate the assessed value of the property by multiplying the market value by an assessment rate. The assessment rate is a uniform percentage that varies from county to county.
If the assessor determines that the market value of a commercial property is $10,000,000 and the assessment rate is 7%, then the assessed property value would be: $10,000,000 x 7% = $700,000.
This assessed value is then multiplied by the total mill levy to determine the property tax. For example, if the combined mill levy from all taxing bodies – such as school and water districts, city, and county – is 5%, then the property tax due on the property would be: $700,000 assessed value x 5% total mill levy = $35,000 property tax.
Property Tax Notices
Commercial real estate owners are then sent two notices relating to property tax due: 1) Assessment of the property value for tax purposes, and 2) Property tax bill.
There is usually a 30 to 60 day period between the time the assessment notice is sent and property tax bill notice is sent. This gives investors the opportunity to contest the property’s valuation. Sometimes a county tax assessor will overestimate the strength of the commercial real estate market or miscalculate the actual square footage of an improvement.