The Problems that Exist with Appraised Value Caps

In an effort to provide "property tax relief" in the State of Texas, the Legislature is considering various proposals that would establish annual caps on appraised value.

Some of these proposals relate merely to residential homesteads, which already enjoy an appraised value limit of 10 percent per year. Other proposals (including HJR 35, the version to be considered in the House of Representatives) would extend the value limitation to all real property whether residential or commercial. Other proposals would just extend the limit to other forms of residential property, such as owner-occupied multifamily structures and any leased single-family dwellings. Yet other proposals would continue to apply the appraisal limitation only to residential homesteads, but would reduce the annual limit.

Various proposals would cap the appraised value increase at 3 percent or 5 percent per year.

If passed by the Legislature, any proposed value limit would have to be submitted to and approved by voters in the state. A constitutional amendment would be required to make the limits effective since currently the Constitution requires that property be appraised at its fair market value, except for the residential homestead limitation.

As currently structured, the new value limitation would commence with the 2006 tax year utilizing 2005 as the base year for valuation. In other words, a 2006 appraised value normally could not exceed the 2005 appraised value by more than the percentage limitation. Thus, if the property was valued at $100,000 in 2005, the maximum 2006 value would be $103,000 with a 3 percent limit or $105,000 with a 5 percent limit.

There are certain exceptions to the general limitation rule - exceptions that already exist with residential homesteads. For example, the appraisal district would be allowed to increase the appraised value beyond the limit to take into consideration "the market value of all new improvements to the property." New improvements are defined as improvements that increase the market value of the property. New improvements are not to include ordinary upkeep, repair, or maintenance of the property.

Also, the limitation terminates with the first tax year after the transfer of title to the property (except for transfers between spouses of residential homesteads). A new limitation period begins with the tax year following the first full calendar year that a new taxpayer owns the property.

Furthermore, the cap would not apply to mineral interests or to special use land valuations allowed under Chapter 23, such as agricultural land, timber land, and recreational land.

Several elected officials and interest groups have seized upon the annual cap methodology as a method of achieving "property tax relief."

But do caps or limits on appraised value really achieve fair and equitable tax relief? The reality is that caps are more of a smoke-and-mirror procedure to claim tax relief where none in fact occurs. Over time, caps on appraisals result in greater and greater inequity and often limit a taxpayer's ability to obtain individual relief.

The following are some of the potential problems associated with appraisal caps.

Lost Revenue

Appraisal caps rarely result in an actual reduction in property taxes. While the caps are successful to some extent in holding down the taxable value of properties, this also serves to hold down the growth of a taxing unit's taxable base. With more and more properties subject to a cap limitation, a taxing unit will be faced with having to find sources to make up the lost revenue resulting from the limits. Most often, this will take the form of increased property tax rates if allowed. Though the Legislature is proposing placing further limits on the tax rate that school districts may assess, no such limits exist or are currently proposed for the thousands of other taxing units in the state. Thus, to make up for tax revenues lost due to the cap, taxing units will increase their property tax rates in an effort to achieve the same rate of revenue growth as in the past.

Additionally, in a further effort to make up lost revenue, taxing units might turn to new or increased user and service fees. Such fees normally will hit hardest in the commercial sector, but depending on the fee could also impact residential taxpayers.

Shifting the Tax Burden

An appraisal cap primarily benefits long-term holders of property. A person or entity that retains ownership of a property for an extended period of time is most likely to enjoy the "relief" granted by the limitations. Conversely, persons who acquire property or who build or improve property receive no benefit from the limitations until they have held the property for more than a year.

This results in a greater share of the overall tax burden being borne by new taxpayers or property purchasers. For example, imagine two similar office buildings on the appraisal roll at $500,000 each due to the cap. One of the properties sells for $1 million. The purchaser will now have to pay taxes on a $1 million value, while the owner of the other building will have to pay taxes only on a $525,000 value (assuming a 5 percent cap). Thus, for the same type of property, one owner will have to pay almost double the amount of taxes.

Additionally, because of the different base year values, the disparity could increase in subsequent years. For example, the new owner could face $1,050,000 in appraised value in the second year (a $50,000 value increase), while the old owner would only face a $551,250 value (about $26,000 in increase). As the years pass, the newer owner could find the value spread between his property and the similar property steadily widening.

Limiting Improvements

The disparity between a new owner and an old owner is not the only problem with caps. An owner that chooses to improve his property could face the same inequity. Because an appraisal district is allowed to add value associated with any value-enhancing improvements to the property on top of the cap, a property owner that chooses to improve his property will find himself paying a much greater proportion of taxes than a property owner that allows his property to decline.

Essentially, appraisal caps encourage the stagnation of property improvement and a decline in real estate development. Such market declines bleed over into other industries, such as construction, remodeling, lending, and related businesses.

Tenant Uncertainties

In many lease situations, tenants assume the obligation of paying property taxes associated with the leased space. The leased property may consist of an entire building (for which the tenant must pay all the taxes) or merely a portion of a building (for which the tenant's share of taxes is often apportioned). With appraisal caps and the possibility of such a cap terminating due to the landlord's actions, tenants will face uncertainty as to their future expenses.

If the landlord chooses to sell the property with tenants in place, the value cap would disappear with the acquisition and tax assessments could spike. The tenants would then be compelled to pay property taxes based upon a newly determined higher market value, instead of the capped value for which they might have budgeted.

Additionally, if the property owner makes improvements to a portion of a building to benefit a new tenant, prior tenants may find their taxes driven up by the increased property value attributed to the improvements even if the prior tenants receive no actual benefits from the improvements.

Furthermore, landlords may find themselves at a competitive disadvantage in obtaining or retaining tenants. If the landlord acquires or remodels a property, he could increase his appraised value and thus the property taxes associated with the property. The landlord will then have greater tax expenses to pass through to a tenant, while his competitor might be able to keep a lower taxable value that his prospective tenants can enjoy.

Similarly, the owners of newly constructed income-producing property (whether apartments, offices, warehouses, etc.) will face a greater appraised value than owners of pre-existing competitive properties. Tenants might thus be faced with the choice of newer space with a considerably higher tax pass-through (or lease rate to compensate for the increased taxes) or older space with significant cost savings due to the appraisal cap.

Equal and Uniform?

The first provision of the Texas Constitution in Article VIII relating to "Taxation and Revenue" states: "Taxation shall be equal and uniform." Because appraisal caps are by their very nature not "equal and uniform," a constitutional amendment will be required to impose the limitations. However, applying appraisal caps to all real property could effectively terminate any claims of unequal appraisal by forcing a comparison against excessive market values.

Currently, a property owner may protest the value of his property by claiming that the property is either appraised at greater than market value or appraised unequally in comparison to similar properties. When considering unequal appraisal of a residential homestead, a property owner is required to consider the market values assigned to the comparable properties and not the capped value. A similar provision will apply to other types of properties subject to a cap.

However, with the institution of caps, many property owners may choose to forego a protest of the market value assigned to their property. Because the property owner does not pay taxes on the market value (instead paying only on the capped value), there is no incentive for him to protest unless he can achieve a market value less than the existing capped value.

With the absence of market value protests, market values could be subject to appraisal creep where appraisal districts assign higher and higher values to property. (In fact, the appraisal districts will have no incentive to truly consider and value most properties because they will be subject to a cap.) Because the appraisal district is not forced to lower the market value, properties may actually be listed at market values that exceed true market. The property owners will not care because they only need to worry about the capped value on which their taxes are determined.

However, these high-market-value properties will then become comparables for other properties. Because the unchallenged values become the measure by which "equal and uniform" is determined, claims of unequal appraisal will become extinct.

Appraisal District Entrenchment

With the introduction of annual appraisal caps, the concerns of appraisal districts will focus on two criteria: the base year value and the improvement value.

The base year for implementation of a cap is the first tax year after acquisition or construction of a property. Because the value determined in this year will set the cap for values in future years, appraisal districts may be more unwilling to reach a resolution of value in the base year of a property. The district fear is settlement on a value that is too low and that their taxing units must then live with for years to come. An appraisal district may not have the ability to correct an erroneous value in a future year, as the property might be capped until the next change of ownership.

Additionally, when a new base year arrives due to an ownership transfer, the appraisal district may become entrenched in a determination of higher value in an effort to "catch up" with lower taxable values imposed in prior years due to the existence of caps in those years.

Furthermore, in a declining market, the appraisal district may be unwilling to reduce values. This reluctance may result from a desire to recapture lost taxes due to prior year caps or from the concern of establishing a new base year value. If an appraised value falls below the capped value, it essentially creates a new base year since the value the following year would be capped based on the new value.

The only other way for an appraisal district to bust a cap is to consider improvements and add the value of such improvements to the capped value to establish a new base year value. Thus, appraisal districts may overstate the actual value increase associated with an improvement. Also, though the proposed statute as written indicates that improvements do not include ordinary repair and maintenance items, appraisal districts might choose to fight property owners on whether an expenditure is merely a repair or an improvement. It is possible that any capitalized expenditure (new roof, tenant finish-out, etc.) will be seized upon as a mechanism to increase property value above the capped amount.

The Cap as a Base

Appraisal caps are supposed to be structured to hold down taxable value. In other words, under a cap system, a property should be valued at the lower of market value or capped value. Over an extended period of time with real estate market cycles, market value will rise and decline as the market fluctuates.

However, with the existence of caps, a property's taxable value no longer follows the market. As the property increases in market value, the taxable value remains down due to the caps. But, as the property decreases in market value, the taxable value should theoretically decline when market value falls below the capped value. In reality, the declines in value may be limited by the cap. Appraisal districts, and their constituent taxing jurisdictions, may decide against lowering values in the early stages of a market decline because of a desire to recapture revenues lost during years of market improvement or a fear of setting a base year valuation at the bottom of the market.

In effect, in some situations, the cap may become the base for determination of taxable value.

Inequality for All

Over time, a cap system leads to greater and greater inequality. Because new base years are set with each property transfer or improvement, similar properties in the same neighborhood may have drastically different taxable values. Ten properties of a similar type, age and size located in the same area may have 10 different base years due to years of ownership transfer or years of improvements.

Taxpayers with a later applicable base year are likely to find they are bearing a larger share of the tax burden. Similarly, business owners will find their share of the tax burden increased as the caps only apply to real property and not to personal property.

More Information For more information and analysis of the effect of appraisal caps, GPD suggests the following documents.

"The Myth of Property Value Caps: Do They Really Control Taxes"
by Foy Mitchell, former chief appraiser of the Dallas Central Appraisal District

Interim Report 2004
House Committee on Local Government Ways & Means
Texas House of Representatives

If you have any questions about the contents of this article, please contact the GPD Property Tax Section at propertytax@gpd.com.