We all expect to pay our fair share for local public services, but in practice, how fair and equitable is our property taxation system?

Nationally, low-tier homes are assessed at a higher value, relative to their actual market value than are high-tier properties. In fact, properties in the bottom 10% of homes pay an effective tax rate that is more than double that paid by a property in the top 10% of homes within the same jurisdiction, on average, according to research from the University of Chicago.

As a result, those homeowners of less valuable homes and with lower incomes carry a disproportionate tax burden.

A regressive tax, by definition, imposes a harsher burden on lower-income households than households with higher incomes. For example, the most common type of regressive tax is sales tax, as everyone pays the same amount of tax for the same goods, regardless of their income level. Regressive taxes reduce the tax burden of the people who have a higher ability to pay and shift the relative burden increasingly to those with a lower ability to pay.

Homes across the county in multiple jurisdictions are over-assessed relative to their actual market prices in low-income neighborhoods, while those in wealthy neighborhoods are under-assessed.

Notably, the University of Chicago study excludes homes assessed in California, due to our state’s unique tax system. Here, Proposition (Prop) 13 ensures property taxes are reassessed at the time of sale rather than at regular intervals, as the rest of the nation experiences. Here, Prop 13 is its own type of regressive tax, with the tax burden disproportionately impacting new homeowners.

First step to a more equitable tax system – amending Prop 13

On top of the regressive nature of property taxes seen in America today, where high-tier properties are assessed at a lower ratio than their low-tier counterparts, California has its own burdens which allow some to reap the benefits of property taxation limits, while others are left to do the heavy lifting on the taxes needed.

Prop 13, or the People’s Initiative to Limit Property Taxation, passed in 1978, limits property taxes to 1% of the property’s assessed value at the time of purchase, plus an annual inflation factor. Reassessments occur upon a transfer of title, even when a property’s fair market value (FMV) is substantially higher than its assessed value.

Prop 13 is itself a regressive tax. In this system, property taxes place the greatest tax burden on new homebuyers and current renters, those who are the least likely to be able to afford it.

The original motive behind Prop 13 was to create a system that protects homeowners who are retired and living on fixed incomes from potentially dramatic increases in property taxes. However, this system brought with it several dynamics unfavorable for maintaining turnover and home sales volume.

For example, long-term homeowners are often hesitant to sell their home since any new home they purchase will bring with it a significantly higher tax rate, thus reducing their purchasing power.

Further, some owners have found ways to take advantage of Prop 13, avoiding reassessment. For example, the change of ownership of a limited liability company (LLC) (or other legal entity) does not constitute a change of ownership, unless an individual or entity acquires more than 50% of the membership interest in the LLC. [Calif. Rev & T C §64]

As long as this Prop 13 loophole exists, an entity vested in title to real estate may divide the sale of its membership interests while avoiding reassessment. The result is that investors who cunningly divide their interests under 50% of the total share avoid paying their fair share of local public services, while first-time homebuyers disproportionately shoulder the burden. Prop 13 can be amended to continue protections for retired and disabled homeowners, while removing the loopholes that allow LLCs to unfairly take advantage of the system.

While LLC ownerships avoid reassessment, new homebuyers and renters are left picking up the tab on public services. Throughout the nation and in the state of California, regressive taxation persists. Here in California, reforming our taxation process starts with fixing Prop 13.

Related article:

Brokerage Reminder: Prop 13 – transactions excluded from reassessment