Four Common Misconceptions About Real Estate Transactions:
Part One—Illinois Tax Proration
Real estate transactions have many complicated components. In our more than 23 years of experience, four issues commonly come up for our clients:
- The Illinois property tax prorating policy.
- The difference between appraisals and inspections.
- The difference between warranties and insurance.
- How earnest money works.
Understanding these four concepts helps you make wise decisions whether as a buyer, seller or homeowner. This month, we cover the state of Illinois’ policy of prorating property taxes.
If you are a homeowner, you know only too well that property taxes are a major expense. However, they seem almost a hidden expense for many because they are frequently paid by escrow and folded into your monthly mortgage payment. Homeowners appreciate this convenience, but it can create confusion because of the state of Illinois’ rather unusual policy of charging property taxes in arrears. That is, property taxes for one year are not paid until the following year. Each year the tax bill for the previous year comes out in May, and the two payments are due in June and September. For example, as an Illinois homeowner, the property tax bill for the taxes incurred while you lived in your home in 2015 arrived in May of 2016. The first payment was due June 1, 2016, and the second payment will be due September 1, 2016.
Typically, this does not cause issues for homeowners. You pay taxes personally or through your escrow every year, so which year they cover does not have a significant impact on you year to year. However, in a year that you buy or sell a home, the prorating of your property taxes creates a complicated adjustment to the real estate transaction, one that can be somewhat confusing for many homeowners.
Imagine if this were true: you purchase your first home in May of 2016. You receive a property tax bill that month for the property taxes incurred during 2015, and you are expected to make payments in June and September. Since you did not live in the home during 2015, it does not make sense for you to be responsible for those payments. The correction for this occurs during the closing, ensuring that the property taxes are covered by the people who lived in the home when the taxes were incurred. Because those taxes are the responsibility of the seller, the seller credits the buyer for those property taxes at the closing.
Consider this example: The Jones lived in their home from 2012 to 2016. They sold their home this summer to the Smiths, closing in June of 2016. This means the Jones property tax responsibility for that home would cover all of 2015 and the first half of 2016, which is three installments. The Jones’ paid their first property tax installment on June 1, 2016, which means at closing they owe the Smiths for the second installment due in 2016 and the first installment due in 2017.
The calculation gets a bit more complicated when you consider that taxes increase each year, and you cannot accurately predict the property taxes for the following year. Using our example, while we know what the Jones’ tax bill is for the second installment due in 2016, we do not know what the tax bill will be for the first installment of 2017, the one that covers the first half of 2016. To account for the increase in property taxes, the seller typically credits the buyer for an amount over the previous year’s tax bill, usually around 105%.
Closing timing impacts the amount credited to the buyer. If closing occurs before the first installment has been paid, then the seller owes one year plus the time up to the day of closing. As you may remember, the seller needs to cover the amount of time that they incurred taxes while living in the home. For example, if the closing was in March of 2016, then the seller credits the buyer for the two installments that cover 2015 and are due in 2016 and a prorated and adjusted amount to cover January through March of 2016.
The seller does not need to bring cash to cover the property tax payments. Instead, the amount is covered in the form of a credit that comes out of the proceeds from the sale of the home. It then reduces the amount of cash the buyer needs to bring to closing. While this may seem like a burden for the seller, it typically becomes almost a wash if the seller is then buying a new home because then they will receive a credit from their seller for the property taxes that will come due on their new home.
Look for a continuation of our series on four common misconceptions about real estate transactions in upcoming issues. Next month: the difference between an appraisal and an inspection. To learn more, contact us today. We would love to help. To keep up with important housing market updates, follow us on Facebook and LinkedIn.