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Rule B or Not Rule B - The Dark Side of Property Tax Reform Under Proposition 117By James R. NearhoodStrap into your time machine and set the date for five years into the future. Property values have skyrocketed, and you decide to finally build that room addition to your home. Imagine your shock when you receive your next tax assessment, and realize that your 300 square foot room addition has caused your property tax bill to double, permanently. To add insult to injury, yours is now the highest taxed home in the subdivision.Science fiction? No, it is one of the very real unintended consequences of Proposition 1171 enacted by Arizona voters in 2012.Proposition 117 was touted as a way to simplify Arizona’s property tax valuation system and insulate homeowners from spiraling tax liability. In operation, however, the interplay of Proposition 117 with A.R.S. § 42-13302(A), commonly referred to as "Rule B," can cause a dramatic and permanent spike in tax liability for all types of property that undergo owner initiated changes, such as subdivision or consolidation, construction or demolition, or change in use. Thus, starting in 2015, the question facing property owners contemplating changes to their property will be, "Rule B or not Rule B".2I. Background.Since territorial days, Arizona has assessed a property tax.3 The tax is assessed in rem, and it is the property, not the owner, that owes the tax.4 Payment is secured by a super-priority tax lien against the title to the assessed property.5 Black’s Law Dictionary defines a property tax as "a tax levied on the owner of property, usually based on the property’s value" (emphasis added)6. As will be discussed in greater detail below, beginning in 2015, property tax in Arizona is only loosely based on market value.The formula for calculating the annual property tax under Arizona law is expressed as follows: Property Tax = Value x Assessment Ratio x Tax Rate. The Tax Rate is set annually by the County Board of Supervisors, and consists of the aggregate of the levies by the various taxing districts in which the property is located.7 The Assessment Ratio is the percentage of a property’s value used to determine the property’s assessed value (i.e., the value against which the property tax rate is applied). The Assessment Ratio is set by the legislature and varies according to the use to which the property is devoted (i.e., the classification for tax purposes).8 In this way, the legislature allocates a greater (or lesser) share of the property tax burden against different kinds of properties. The following is a list of the four most common property tax classifications and their respective Assessment Ratios:Property Classification/Assessment Ratio 20152016Class One:Commercial/Industrial18.5%18%Class Two:Agricultural/Vacant Land16%16%Class Three:Owner Occupied Residential10%10%Class Four:Residential Rental10%10%
The Value of locally assessed real property9 is set annually by the assessor in the county in which the property is located.10 Under the current tax code, that Value is known as the full cash value ("FCV"), which is defined as "the value determined as prescribed by statute" and if no statutory valuation formula is prescribed, "full cash value is synonymous with market value."11Prior to 1980, the taxation of locally assessed real property was derived entirely from this market-based formula. That notion changed in 1980, when Arizona voters enacted Art. IX, § 18 of the Arizona Constitution, creating the limited property value ("LPV") as a means to control rapidly increasing property taxes. Under this 1980 amendment, the tax rate was divided into two components: the primary tax, generally comprised of the tax used for governmental expenses, and the secondary tax, generally comprised of the tax used for local taxing districts and debt service. The primary tax, which represents approximately 65% of the property tax bill, was applied to the LPV, and the secondary tax was applied to the FCV.12As quoted above, the FCV is typically based on market value, with no limit on increases (or decreases) from one year to the next. In contrast, the LPV is derived by a formula based upon the LPV of the property in the prior tax year. Specifically, the LPV is the sum of "the limited property value of the property in the preceding valuation year" plus the greater of either: (a) 10% of last year’s LPV, or (b) 25% of the difference between the FCV in the current year and last year’s LPV.13 Under this formula, in periods of high market value inflation (i.e., when the increase in FCV exceeds 10%), the LPV lags behind, thereby mitigating against huge increases in property tax bills from year-to-year.Importantly, the 1980 amendment also states that the LPV cannot exceed the FCV.14 As a result, in periods of deflation or low inflation (i.e., less than 10% per annum), the FCV and LPV of most properties will be the same.II. Proposition 117.Proposition 117 radically changes the formula for assessing real property taxes that has been the law in Arizona since 1980. Beginning in 2015, the LPV becomes the basis for the calculation of the entire property tax, not just the primary tax; and annual increases in the LPV are capped at 5%. The provision stating that the LPV cannot exceed the FCV was not changed under Proposition 117. Therefore, although the FCV is no longer relevant to the tax calculation, it serves as the ceiling which the LPV cannot exceed.In short, from 2015 forward, the assessment of property taxes is based entirely upon the baseline LPV for tax year 2015, subject to a maximum 5% increase per annum, not to exceed market value.III. Rule B.When the LPV was implemented in 1980, the Arizona Legislature realized that a parcel of real property could undergo a change that would necessitate a new value for tax purposes. For example, if a parcel is subdivided into smaller parcels, the assessor must derive both an FCV and LPV for the newly created parcels.Setting a new FCV is typically based on current market value. Setting a new LPV, however, is more problematic because the LPV is derived from the LPV in the prior year. A new parcel will obviously have no prior year’s LPV. Of equal concern is a parcel that has undergone a significant change, such as the construction (or demolition) of valuable improvements. In that case, the LPV prior to the change (say, as vacant land with no improvements) is not meaningful to the LPV of the changed property (say, as an office building). To deal with this issue, the Legislature enacted A.R.S. § 42-13302. That statute covers the multitude of possibilities that might trigger an adjustment to the LPV.There are two general categories of change that trigger a revaluation of the LPV under A.R.S. § 42-13302: property changes initiated by the government, and property changes initiated by the owner. The formula for adjusting the LPV based upon government-initiated changes is commonly referred to as "Rule A," and the formula for adjustments to the LPV based upon owner-initiated changes is commonly referred to as "Rule B." This discussion will focus entirely upon Rule B.Rule B is codified in A.R.S. § 42-13302(A):A. In the following circumstances the limited property value shall be established at a level or percentage of full cash value that is comparable to that of other properties of the same or similar use or classification:Property that was erroneously totally or partially omitted from the property tax rolls in the preceding tax year.Property for which a change in use has occurred since the preceding tax year.Property that has been modified by construction, destruction or demolition since the preceding valuation year.Property that has been split, subdivided or consolidated from January 1 through September 30 of the valuation year, except for cases that result from an action initiated by a governmental entity.Under this authority, if an owner initiates one of the enumerated changes to his property, the county assessor is directed to establish the LPV of that property "at a level or percentage of full cash value that is comparable to that of other properties of the same or similar use or classification." This is known as the "Rule B ratio." Each year, the assessor in each county performs a study comparing the difference between the FCV and LPV of similar properties within a particular classification. The difference between average FCV and LPV, stated as a percentage, derives the Rule B ratio for that class of property for that tax year. For example, if the average FCV of Class 3 residential property is $100,000, and the average LPV is $90,000, the Rule B ratio for Class 3 property is 90% ($100,000 ÷ $90,000 = 90%).Rule B ratios are different for every county, every class of property, and every tax year. For the 2015 tax year, the Rule B ratio in Maricopa County for Class 1 commercial property is 93%, and for Class 3 residential property is 77%. Between 2000 and 2015, the Maricopa County Rule B ratio for commercial property fluctuated from a low of 78% to a high of 100%, and for residential property from a low of 74% to a high of 100%.15In inflationary times, a Rule B adjustment to an owner’s property could have significant consequences to his tax assessment. Referring back to the example at the beginning of this article, assume two neighbors own identical homes, both valued on the 2015 tax roll at a FCV and LPV of $100,000. If the true market value (i.e., FCV) of both properties increases at a rate greater than 5% per year -- say by 15% per year -- by 2020 the FCV of each property will be $201,135, but the LPV, which lags behind at a 5% annual increase, will be $127,628. If one owner adds a room addition costing $10,000, that owner would receive an increase in FCV due to the additional improvement, say an increase to $211,135. The owner could also receive a Rule B adjustment to his LPV.16 If, at his misfortune, the applicable Rule B ratio for that year is 100%, his LPV will increase to $211,135, leaving him in the position of forever paying a tax bill approximately 65% greater than his neighbor, whose LPV is $127,628; a hefty and unexpected price to pay for a small room addition.By comparison, under the pre-Proposition 117 law, the LPV of the owner with the room addition would still be $211,135, but the LPV of his neighbor would be $162,341. A difference of only 23%. Plus, only approximately 65% of the tax would be attributable to the LPV, which mitigates even more against the difference in the tax bills paid by the two neighbors under the old law.IV. Real Examples.
In 2014, the out-of-state owner asked the assessor to consolidate the six parcels into one, so the owner could pay a single tax bill. The assessor dutifully complied, and because there was a parcel consolidation, applied Rule B to the 2014 LPV. As a result, the 2014 LPV of the apartment complex increased from $26,382,750 to $32,740,224, thereby costing the owner $28,303 in additional taxes for 2014. Beginning in 2015, the increased cost to the owner for this "self-requested" Rule B adjustment will be in the range of $70,000 per year, because the entire tax rate will apply to the LPV, not just the primary tax as was the case in 2014.
V. Planning Strategies.Strategies to mitigate the consequences of a Rule B adjustment are limited by two factors. First, the Rule B ratio changes every year. As shown on the chart in Endnote 15, the Rule B ratio for commercial property in Maricopa County changed from 78% to 98% in a span of three years (i.e., 2009-2011). It is very difficult to predict what the Rule B ratio might be from year to year.Second, the Arizona Court of Appeals has held that a Rule B adjustment is lawfully made in the year when the assessor makes changes to the tax roll, but not necessarily in the same year that the change to the property occurred.17 Thus, an owner cannot be assured that the Rule B adjustment will occur in a year with a favorable Rule B ratio. Rather, the assessor could defer the Rule B adjustment to a later year, with a higher Rule B ratio.In addition, there are uncertainties in the Rule B assessment guidelines. The Assessment Procedures Manual published by the Arizona Department of Revenue states that "Rule B must be used when any new construction equals ten percent or more of the prior valuation year’s FCV."18 But the same guideline authorizes the assessor to exercise its discretion to apply Rule B to improvements costing less than ten percent of FCV, and the statute expressly directs the assessor to apply Rule B whenever property "has been modified by construction, destruction or demolition …". Thus, it is unclear what amount and what type of improvement will trigger a Rule B adjustment.19 There is no reported case law on this subject.Beginning in 2015, Rule B must be a planning consideration in almost every real estate transaction, whether a sale, lease, mortgage or development. This is especially true in inflationary times, when the spread between FCV and LPV will increase. The following are some of the practical questions that practitioners must consider when providing legal advice regarding real estate transactions:Has the property recently undergone a change, and will the change trigger a Rule B adjustment?Will the property undergo a change in the foreseeable future, and will the change trigger a Rule B adjustment?If Rule B is triggered, what will be the effect on future tax assessments?Does the owner or agent have a disclosure obligation regarding a recent change to the property?Will the application of Rule B affect a borrower’s ability to obtain financing or avoid a future default?VI. Conclusion.Although touted as a simplification of the property tax assessment code, Rule B yields a dark side to Proposition 117, especially in inflationary times. Until legislation or judicial decisions resolve some of the open issues, owners dealing in real property will be unable to determine, with certainty, whether changes to real property will trigger a revaluation, and then when and how much. Attorneys may be held accountable for failing to advise clients regarding the potential adverse consequences of a Rule B triggering event. Sellers and their real estate agents may be held liable for failure to disclose a change in a prior year that might result in a subsequent Rule B adjustment. Buyers, appraisers, and lenders may be unable to rely on past property tax payment information when a property change has occurred or is expected to occur in the future. Only time will tell whether Proposition 117 proves to be a boon or boondoggle to Arizona property owners.ENDNOTES1 Proposition 117 amends Article IX, Section 18 of the Arizona Constitution. The Proposition was codified into law by the Arizona legislature under Laws 2013, Chapter 66, Section 9, amending A.R.S. § 42-13301.2 Apologies to William Shakespeare.3 Compiled Law of the Territory of Arizona, Chapter XXXIII, §2 (1871).4 A.R.S. § 42-17153(A). Peabody Coal Co. v. Navajo County, 117 Ariz. 335, 572 P.2d 797 (1977).5 A.R.S. § 42-17153(C)(3).6 BLACK’S LAW DICTIONARY, 1596 (rev. 9th ed. 2009).7 Property taxes are levied by the governing body of each county, city, town, community college district, school district, and often by special taxing districts (such as irrigation districts). The required property tax levy is then divided by the final assessed value of all real property in the taxing jurisdiction to compute the tax rate. The County Board of Supervisors extends that tax rate to the tax roll prepared by the County Assessor. The board assesses taxes on all property in proportion to its value. Tax amounts for real and personal property are tabulated by the board to complete the assessment. A.R.S. §§ 42-17151 and 42-17152.8 There are currently nine classifications of property for tax purposes. A.R.S. §§ 12-12001 through 12-12009. The assessment ratio for each class of property is set forth in A.R.S. §§ 42-15001 through 42-15009.9 Locally assessed property is property valued by the county assessor, as opposed to centrally assessed property valued by the Arizona Department of Revenue (such as mines, oil and gas interests, utilities, airlines, timber, pipelines and railroads.)10 A.R.S. § 42-13051.11 A.R.S. § 42-11001(6).12 A.R.S. § 42-11001(6) and (7); A.R.S. § 42-17151.13 A.R.S. § 42-13301.14 A.R.S. § 42-13301(B).15 Maricopa County Assessor Rule B Ratios from 2000 through 2015Class20152014201320122011201020092008 10.9399%99%99%98%85%78%80%20.7591%94%95%95%86%69%63%30.7793%100%100%100%100%88%74%40.7892%99%100%100%98%89%79%51.00100%98%100%96%75%70%-60.6987%99%99%100%99%80%-7B0.9696%100%99%93%74%66%-7H1.00100%100%100%100%100%100%-8B0.8077%72%60%61%100%99%-8H1.00100%100%100%100%100%100%-90.9399%100%98%100%100%100%-
Class20072006200520042003200220012000183%85%90%84%93%90%94%100%266%71%82%73%77%73%71%100%374%98%95%97%93%99%96%93%467%95%92%95%88%97%94%74%570%68%78%64%79%--95%668%87%80%86%78%-89%93%7B72%80%85%79%99%89%86%-7H100%100%100%100%100%95%91%-8B72%82%90%88%100%74%94%-8H100%100%100%100%90%100%100%-9100%100%100%76%90%100%100%93%
16 See the discussion in Section V regarding the assessor’s discretion to apply Rule B to new improvements.17 Premier RV & Mini Storage, LLC v. Maricopa County, 222 Ariz. 440, 215 P.3d 1121 (Ct.App. 2009).18 Arizona Department of Revenue Assessment Procedures Manual at 3.3.8 (March 1, 2011).19 For example, what type of improvements costing less than 10% of FCV should trigger a Rule B adjustment? Should tenant improvements or routine maintenance trigger a Rule B adjustment?