Real estate tax timing in a purchase
February 9, 2020
A little more than a year ago, we addressed the timing/matching of real estate periods. Perhaps it was taxes reconciled for a calendar year, but taxes were paid on a fiscal year. Some landlord would take six months of one fiscal period and six months of another to match those fiscal periods to the calendar year. In other cases, another landlord would use the taxes paid during the calendar year as the taxes for that calendar year. As long as there was consistency, we could justify the methodology.
However, we have a practical application issue at this time. One client is purchasing two properties in Illinois from two separate sellers. Central to this scenario is the fact that the properties are in Illinois. Why? Because taxes are actually paid a full year in arrears in Illinois. Taxes for 2019 will be payable in the March and August of 2020.
So we have to consider the taxes from two different perspectives – the financial accounting perspective and the lease accounting perspective. Let’s say we are closing on the sale on 1/31/20, and let’s tackle the closing statement first. The seller owned the property for all of 2019. Therefore, since the buyer will be paying the taxes later in 2020, the buyer should be credited with a full year’s taxes. And, considering that the seller owned it for one month into 2020, the buyer should also be credited with another 31/365 days for 2020 taxes – that the buyer will not even pay until the 2021. A bit more of an issue than most other states, but still fairly straightforward. (Maryland is at the other extreme. Taxes are paid in advance, so in that case, it may be the seller getting a larger credit.)
But, now we move on to the tenant side of the equation. Tenants are escrowing taxes throughout the year (unless they are big boxes where they may pay as taxes are paid or have negotiated annual or semi-annual payments) for taxes applicable to their occupancy. Here we have a material divergence in methodology between the two sellers. The first matches taxes and escrows for the period to which they applied. So the tenant made monthly escrow payments during 2019. Those escrows will be used in 2020 when 2019 taxes are reconciled. Let’s say a tenant left in May 2019. In that case, the buyer will be reconciling taxes in later 2020 for a tenant that was never a tenant under their period of ownership and may have exposure if there is additional tax due and they cannot collect. In this case, at closing, the buyer should be collecting 100% of the escrows for 2019, plus one month of escrows for 2020. (Consider if you had a big box leave in May 2019, and that big box is only billed when taxes are paid. The new owner has to go back and bill the tenant 100% of taxes for its occupancy because there were no escrows!)
The second seller, however, uses taxes paid DURING the year as taxes FOR the year, and the escrows BILLED during the year as the escrows FOR the year. In this case, when the seller reconciled in 2019, it had just paid 2018 taxes, and the taxes paid were used as the taxes FOR 2019. The seller also used the escrows billed DURING 2019 as the escrows for 2019. Therefore, escrows due from the seller, technically, are just one month’s escrows for January 2020, because the 2019 escrows have already been applied.
ONE FULL YEAR’S WORTH OF ESCROWS OFF!!! It could have been two different sellers of the same exact property, and we would need to have two sets of expectations for escrows at closing.
This second method – the cash method – could create a separate issue. The seller (in the Purchase and Sale) has suggested that because taxes paid during the year are used as taxes for the year that they do not have to credit all of 2019 taxes plus one month’s of 2020 taxes. Rather they suggest that they should only be crediting one month of 2019 taxes (payable in 2020) for its one month of ownership in 2020.
I have not presented the “proper” proration to be made at closing. I am very fortunate as with every lease that we administer or calculate – the lease sets the rules for billing. The lease will state to use either taxes for the year, or taxes to be paid during the year. The lease itself must be administered in accordance with its requirements. But, from a financial perspective, there may be a full one year cost (or benefit) when a seller using one method is selling to a buyer using the other.