So the Independent Budget Office has found that New York City’s property tax system is unfair. This is not a surprise. In a fundamental sense, property taxes are a tax on property wealth, and “fairness” requires that the tax be charged equally to all residential and commercial property owners based on the value of that wealth. This, however, has run into another definition of “fairness,” one based on income, with concern that people with high property wealth relative to income (such as senior citizens and, in rural areas, farmers) could be taxed out of their homes. This post will propose a different way to balance "wealth" fairness and "income" fairness.
Unfortunately, once the door was opened to tampering with equal taxation based on the full value of property, all kinds of deals and privileges have crept in that have nothing to do with either wealth or income. Each year brings more deals, exceptions, and adjustments, with the “Son of STAR” state check the most recent, and the incoming Spitzer Administration is proposing yet another layer, yet another deal. Not being a politician and not being tied to the past, I’m going to propose throwing all the existing deals in the trash and starting over.
First, a brief discussion of where we are and how we got here. Limitations on changes in assessments, and the ability to shift the share of the property tax burden among small homes, apartment buildings, and commercial buildings (a simplified grouping), date from the early 1980s. The value of small homes for tax purposes is determined by comparable sales – what similar homes sell for in the neighborhood. For income producing properties like apartment and office buildings, however, property value for property tax purposes is estimated based on net operating income (something that mystifies me, given that property tax is a substantial factor in determining NOI, making the calculation circular). It doesn’t matter much what commercial and apartment buildings sell for. In theory, the sales price of small homes is constrained by the income of the buyers, while the value of income producing property determines its sales price. In theory, therefore, whether income or comparable sales is used as the basis of valuation should not matter much. But between 1982 and 2005, it has mattered greatly. And that is something no one has considered.
From 1982 to 2005, a period that began with low prices and included two housing bubbles and one bust (with another coming), the median existing home price in the New York Metropolitan area, as measured by the National Association of Realtors, more than tripled – even after adjusting for inflation. This during a period when all but the best-off Americans have struggled to keep their incomes even with inflation. Home prices have risen nationally as well, but by just 62% more than inflation. At the start of this period, the Northeast had been in a depression, and houses cost no more in the New York area than the national average. The taxable value of those houses was locked in, to an extent, just before they soared.
Meanwhile, market rate rents in New York, according to the real estate research firm where I am currently employed, rose by just 67% in New York after adjustment for inflation, far less than the increase for small homes. And the majority of New York apartments are rent regulated, with rents that do not rise much relative to inflation at all. Nationally, residential rents are up only 17% after inflation during this period. Given that the inflation-adjusted value of homes based on sales has risen relative to the value of apartments based on income, and this has not been reflected in the property tax, a gap between taxes and value has opened up between different types of housing. Absent rent regulations, and after a housing price bust, that gap would be smaller, but would still exist.
And commercial property? Manhattan office rents have fallen (that’s right fallen) 36% from 1982 to 2005 relative to inflation, according to my firm. Nationally, office rents have fallen 60% in real dollars. Retail and industrial rents have also dropped nationally. Why? There are various theories, one of which is that the suburbanization of commercial real estate has diminished the value of any one place relative to the others, thus reducing the land cost of commercial space. Another is that the professionalization of commercial real estate has reduced excess profits and cut costs. In any event, if the value of commercial space is based on income, then that value has crashed over the past 25 years, and in New York this isn’t fully reflected in property taxes either.
Of course, if the value of small homes for tax purposes was based on the income of homeowners, it wouldn’t be going up much either. So what to do?
There is an important distinction between a tenant whose rent increases are limited by rent regulation and a property owner whose tax increases are restricted by modifications to the tax code. In the end the property owner has gained wealth, which can be turned into income through a sale of the property. It is a legitimate question whether, for example, it is good public policy to subsidize an empty nester couple living in a large home, especially if they continue to occupy that large house only because a tax system set up to stick it to apartments would hit them harder if they downsized to something smaller. And it is a legitimate question whether such a couple, having been subsidized by such a break for many years, ought to be permitted to walk away with such a large windfall at the time of sale. Moreover, varying taxes property based on tenure and age enriches very fortunate seniors at the expense of struggling young families, one of many policies that does so.
Therefore I suggest the following. Property tax equity based on wealth should be restored, with all properties assessed at full value, and all property tax rates equal, everywhere in the state. All existing limitations on assesment increases, assessment ratios based on class, exceptions, kickback checks, etc. should be eliminated. However, homeowners should be allowed to defer payment of all taxes in excess of four percent of their incomes in New York City, which also has a local income tax, or six percent of their income in the rest of the state, which does not, to the time of sale. The deferred payments would be adjusted upward for inflation each year, but to account for a temporary housing bubble, the homeowner or estate would have the option of paying a recalculated tax for all past years based on a straight line increase in value from the time of purchase to the time of sale. This would prevent a homeowner from having to pay taxes based on 2005 “values” while selling for less. Although equal taxes based on full value assessments would mean that property wealth was once again taxed fairly, the ability to defer taxes based on income would prevent people from being taxed out of their homes, and thus their communities.
How would such a proposal affect my property taxes, as a one-family homeowner living near particularly privileged (if the IBO report is to be believed) Park Slope? They would go up a lot, because instead of paying about the same as I would in the suburbs despite the local income tax (in a city where the overall tax burden is much higher), I would be paying much more than I would in the suburbs. Not as much as one might expect, however, because if such a policy were enacted the value of small homes would fall (by more than it is going to anyway), because higher-income buyers would not be able to pay as much for the mortgage if they were going to pay more in taxes and. One could consider that a double hit – taxes up, property values down. And since small home property values fell by more than one-third relative to inflation in the early 1990s bust, I expect a similar decline in the next few years, even without any property tax changes.
Looking at the situation in a more broadminded way, however, the revision could help me. If I were to relocate to a smaller housing unit once the children were gone, my taxes would go down rather than up, because there would be more equity between homes and condos. Having empty nesters leave larger housing units would benefit New York City’s beleaguered families, since only one-third of New York City’s housing units have three or more bedrooms, compared with two thirds nationally. It is possible that the change would make it more likely that my children would be able to stay in Brooklyn someday, when they have children of their own. And, a limitation based on income would ensure that if illness, unemployment or age reduced our income, our tax burden would fall as well. Of course not all affluent people are so broadminded; the property tax is popular with them precisely because it hits less affluent people harder if they live in equally valuable homes. But the affluent would not be charged more according to this scheme; they would just have to pay it sooner.
To be fair, however, some changes have to be made for income producing properties as well. The same liquidity bubble that has inflated the value of homes relative to the income of their occupants has also inflated the value of apartment and commercial buildings relative to their rents. My firm provides two estimates of apartment and commercial building value. One is based on discounted cash flows, a method similar to that used to assess income producing properties for tax purposes. This estimates what the properties “should” sell for. A second estimates their value based on actual comparable sales. And based on comparable sales, the value of income producing properties is currently inflated relative to what those buildings earn, just as the value of small homes is inflated based on what their occupants earn.
If homeowners are going to be taxed based on nonsensical inflated prices, therefore, perhaps income properties should be as well, by also taxing them based on comparable sales. And, as for homeowners, perhaps property taxes in excess of (say) X percent of the rent roll could be deferred, to be repaid either at sale or at a time when an early-1990s-style property value collapse deflates value relative to underlying income.
If the same principles were applied to income properties as to homes, and after the circular effect of higher taxes on homes and lower taxes on other properties was accounted for, we might find that the shift in the tax burden to homeowners as a result of a reform would be lower than might first be assumed, though a shift there would be.
What would be the problem with this proposal? For one thing, a family of four with two parents working two jobs each would pay the same property taxes as a senior citizen couple who lived in an identical house next door and had the same income, but did not work and did not pay any state and local income taxes because all their income came from tax-free pensions and social security. This would be politically unacceptable. In New York State, it is assumed (and dare not be challenged) that despite equal income and wealth, despite having secure health insurance and pensions younger generations will never see, the seniors should pay less in property taxes as well as less in income taxes. Just ask them.
All this shows, however, is that wherever there is discretion, benefits flow to those with the most influence and greatest sense of entitlement, not those with the greatest need. Whether it is the property tax system in New York City or the school aid formula for New York State, attempts to eliminate injustice by adding rules to account for any and all individual circumstances leads in the end to more injustice rather than less. Because the more complicated things are, the easier it is for evil is to sneak into the dark corners. That’s why the rest of us are always better protected by simplicity and a hard clear line.