2008 Texas Land Title Institute – Rollback and Proration of Taxes

St. Mary's University School of Law and Texas Land Title Association Present: The 18th Annual Robert C. Sneed

TEXAS LAND TITLE INSTITUTE

December 4-5, 2008 San Antonio, TX

A Primer on Tax Proration and Rollback Taxes

Labry Welty

Author contact information: Labry Welty Munsch Hardt Kopf & Harr, P.C. Dallas, TX lwelty@munsch.com 214-855-7500

MHDocs 1618926_1 980693.2

Labry Welty MUNSCH HARDT KOPF & HARR, P.C.

DALLAS | HOUSTON | AUSTIN

3800 Lincoln Plaza 500 North Akard

Dallas, Texas 75201-6659 Direct: (214) 855-7531 Fax: (214) 978-4373 lwelty@munsch.com

munsch.com Labry Welty is shareholder in the Dallas office of Munsch Hardt Kopf & Harr, PC. He represents taxpayers in federal, state and local tax transactional, planning, and controversy matters. He has over seventeen years of tax-specific experience with federal, state and local tax planning for the formation, acquisition, reorganization and disposition of businesses; and tax minimization planning for public and privately-owned businesses in a large number of industries, including real estate and finance. Prior to practicing law, Labry earned his B.B.A. in Accounting from West Texas A&M University and a J.D. from the Southern Methodist University Dedman School of Law. Labry has authored and spoken on various tax-related topics for numerous industry groups, professional associations and continuing education seminars.

Tax Proration and Rollback TaxesSt. Mary’s University School of Law and Texas Land Title Association Present:

The 18th Annual Robert C. Sneed

TEXAS LAND TITLE INSTITUTE

December 4-5, 2008San Antonio, Texas

Labry Welty

Tax Proration: Who Pays?

Goals typically based upon economic benefit of property

Sellers = preclosingBuyers = postclosing

Negotiated terms control

Property taxes generally prorated based upon the number of days

Tax Proration: Who Pays?

Federal income tax deductibility – can only deduct taxes owed as determined under the Code

Tax filing responsibility

BUT what about Rollback Taxes?

Rollback Taxes

Texas pays tribute to Agriculture

Texas Constitution, Article VIII, section 1-dTexas Constitution, Article VIII, section 1-d-1

PENALTY imposed for taking land out of agricultural production or use

Special appraisal NOT exemption from tax

Agricultural Use ValueMarket Value

Section 1-d

“Agricultural Use” Provisions -

Continuously devoted to agricultural for 3 previous yearsOwned by an individual whose primary occupation is agriculture

Time measurementGross income measurement

Apply annually

Section 1-d

Tax/penalty triggered

SaleNonagricultural use - as determined by Chief Appraiser

Tax lien attaches to land

Date of SaleDate change of use occurs

Section 1-d-1

“Open Space” Provisions – most common

“Qualified Open-Space Land”Principally devoted to agriculture to degree of intensity generally accepted in the area5 of preceding 7 years OR ecological lab used by university

Primary purpose controls

Section 1-d-1

Agricultural Use

Cultivating soilCrop productionFloriculture, viticulture, and horticultureExotic Animals for Commercial Value (not recreation)TimberWildlife ManagementIdle use in conjunction with governmental programs

Section 1-d-1

Tax/penalty triggered

Change of Use - as determined by Chief Appraiser

Tax lien attaches to land

Date change of use occurs

Section 1-d-1

No penalty if Change of Use occurs as a result of:

Sale for a right-of wayCondemnationTransfer of property to the StateTransfer of property from the state for economic development purposes if use of land will generate revenue in excess of 20 times the Rollback tax (including interest)

Section 1-d-1

Ineligible landLocated within city limits unless

No public services provided ORDevoted to agricultural use for previous 5 years

Owned by nonresident alien or foreign government if required to register ownership or acquisition of property – Is this Constitutional?

Owned by a corporation, partnership, trust, or other legal entity if required to register ownership or acquisition of property AND nonresident alien or foreign government owns majority interest - Is this Constitutional?

Section 1-d-1

Change of Use

Physical change required

Agricultural use drops below “degree of intensity generally accepted for the area” – NO rollback taxes triggered but lose special valuation privilege

Cessation of agricultural use – TAX IMPOSED

Penalties Imposed

Market Value less Agricultural Use Value

Ex: Pizzitola v. Galveston County Central Appraisal District

$7,302 per acre Market Value v. $90 per acre Ag Value

Section 1-d: 3 years plus interest

Section 1-d-1: 5 years plus interest

May not protest market valuations for previous years!

New tax! As such proration clauses do not adequately address

Penalties Imposed

Required disclosure by seller of vacant land

Failure to provide disclosure allows buyer to recover rollback taxes from seller for change in use that occur as late as the 5th anniversary of the date of transfer

CHECK PROPERTY TAX CERTIFICATE FOR SPECIAL APPRAISAL METHOD

Labry Welty214.855.7531

lwelty@munsch.com

2008 Texas Land Title Institute – Rollback and Proration of Taxes Page 1

A PRIMER ON TAX PRORATION AND ROLLBACK TAXES

BY: LABRY WELTY

I. Introduction

A. Negotiating and drafting tax provisions in an acquisition agreement requires an understanding of the effect of rollback taxes on tax liability.

B. A rollback tax, in Texas, is triggered by a change in the use of land that has qualified as "agricultural" or "open air" for tax purposes under the Texas Tax Code.

C. The amount assessed to the owner of the land is equal to the difference between the taxes paid under the agricultural or open-air tax exemption and the taxes that would have been paid if the land had been taxed at market value. Rollback taxes also include interest charges.

D. A rollback tax extends back either three (3) or five (5) years depending upon the type of exemption for which the land qualified.

E. Most importantly, a rollback tax is considered a new, additional tax imposed by law that attaches on the date the change in use occurs.1 As such, a buyer could be assessed with rollback taxes upon taking ownership of property and changing its use—despite including a provision in the acquisition agreement that prorates tax liability between the buyer and seller.

II. Prorated Tax Liability

A. Generally, unless the buyer is assuming all past, present, and future tax liabilities of the target property, provisions are included in an acquisition agreement to allocate responsibility for the payment of taxes incurred by the property between the pre-closing and post-closing periods.

B. Sellers are usually liable for taxes on the property up to and including the date of the execution of the acquisition agreement.

C. Buyers are usually liable for taxes on the property after closing.

D. Responsibility for the payment of taxes for the period between the date the agreement is signed and closing will usually be allocated to the party who receives the economic benefit of the property for such period.

E. The acquisition agreement should include language that allocates the taxes between the seller and the buyer very specifically.

1 Tex. Tax Code Ann. § 23.55(a); Compass Bank v. Bent Creek Investments, Inc., 52 S.W.3d 419 (Tex. App. Fort

Worth 2001).

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1. The allocation of annual periodic taxes (e.g., real and personal property taxes) may be done on a per day basis. (i.e., the number of days in the applicable tax period divided between the number of days pre-closing and the number of days post-closing).

2. The allocation of taxes should be done in connection with indemnity provisions and should take into account any taxes for which the seller is already being held accountable.

a) For example, taxes might be accrued on a closing balance sheet that is being used to adjust the purchase price.

b) If so, seller should not also be charged for the accrued taxes when these taxes are actually paid.

3. The responsibility for filing tax returns should be addressed in the acquisition agreement.

F. Deduction of Prorated Taxes

1. For federal income tax purposes, the prorated portion of the taxes owed, not necessarily paid, by the buyer/seller is deductible for the year the property was sold (if the buyer/seller itemizes deductions).

2. Deductions are available regardless of the amount actually paid by the buyer or the seller.

III. Rollback Taxes

A. A land owner triggers a rollback tax by taking land that has met the qualifications for one of the two types of agricultural appraisal authorized by the Texas Constitution out of agricultural production or use.

1. Texas Constitution, Article VIII, section 1-d:

a) Eligibility requirements for land to be designated for agricultural use under 1-d:

(1) The land has been devoted exclusively to or developed continuously for agriculture for the three years preceding the current year.2

(2) The individual using the land intends to do so for agriculture as an occupation or a business venture for profit during the current year.3

2 Tex. Tax Code Ann. § 23.42(a)(1). 3 Tex. Tax Code Ann. § 23.42(a)(2).

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(3) Agriculture is the individual's primary occupation and primary source of income.4

(a) Agriculture is an individual's primary occupation if he or she devotes a greater portion of time to agriculture than any other occupation.5

(b) Agriculture is an individual's primary source of income if he or she derives a greater portion of his or her gross income from agriculture than from any other occupation.6

(4) In addition, an individual claiming the right to have his land designated for agricultural use must apply for the designation each year he or she claims it.7

b) Rollback tax: If the 1-d land is sold or diverted to nonagricultural use as defined in the eligibility requirements, the total amount of additional taxes for the three years preceding the year in which the land is sold or diverted plus interest at the rate provided for delinquent taxes becomes due.8

c) The determination that the land has been diverted to a nonagricultural use is made by the chief appraiser.

d) A tax lien attaches to the land on the date the sale or change of use occurs to secure payment.9

2. Texas Constitution, Article VIII, section 1-d-1:

a) Most property owners apply for 1-d-1 appraisal as opposed to 1-d appraisal.

b) Eligibility requirements for land to be designated as "qualified open-space land" under section 1-d-1: 10

(1) The land is currently devoted principally to agricultural use to the degree of intensity generally accepted in the area.

(2) The land has been devoted principally to agriculture use or to the production of timber or forest products for five(5) of the

4 Tex. Tax Code Ann. § 23.42 (a)(3). 5 Tex. Tax Code Ann. § 23.42 (c). 6 Tex. Tax Code Ann. § 23.42(c). 7 Tex. Tax Code Ann. § 23.43. 8 Tex. Tax Code Ann. § 23.46(c). 9 Tex. Tax Code Ann. § 23.46(d). 10 Tex. Tax Code Ann. § 23.51(1).

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preceding seven (7) years OR is land that is used principally as an ecological laboratory by a public or private college or university.

c) The term "agricultural use" includes but is not limited to:11

(1) Cultivating the soil

(2) Producing crops for human food, animal feed, planting seed, or the production of fibers

(3) Floriculture, viticulture, and horticulture

(4) Raising or keeping exotic animals for the production of human food or of fiber, leather, pelts, or other tangible products having a commercial value

(5) Planting cover crops or leaving land idle for the purpose of a governmental program, provided the land is not used for residential purposes or a purpose inconsistent with agricultural use

(6) Planting cover crops or leaving land idle in conjunction with normal crop or livestock rotation procedure

(7) The use of land to produce or harvest logs and posts for the use in constructing or repairing fences, pens, barns, or other agricultural improvements

(8) Wildlife management

d) When the land is used for several purposes, the primary or most important use must be agricultural.12

e) Rollback tax: If the use of the land that has qualified for a 1-d-1 tax appraisal changes, a tax is imposed on the land equal to the difference between the taxes imposed on the land for each of the five years preceding the year in which the change of use occurred and the tax that would have been imposed on the land based on market value.13

(1) A tax lien attaches to the land on the date the change of use occurs to secure payment.14

11 Tex. Tax Code Ann. § 23.51(2). 12 Tarrant Appraisal Dist. v. Moore, 845 S.W.2d 820, 823 (Tex. 1993). 13 Tex. Tax Code Ann. § 23.55(a). 14 Tex. Tax Code Ann. § 23.55(b).

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(a) The rollback tax penalty does not apply if the change of use occurs as a result of:15

(i) A sale for right-of way

(ii) A condemnation

(iii)A transfer of the property to the state.

(iv) A transfer of the property from the state to an individual or business for the purposes of economic development if the economic development is likely to generate enough revenue to exceed 20 times the amount of additional taxes and interest that would have been imposed

(b) There are also certain types of land ineligible for appraisal as open-space land16

(i) Land that is located inside the corporate limits of an incorporated city or town unless:

(a) The city or town is not providing government/proprietary services OR

(b) The land has been devoted to agricultural use continuously for the preceding five years

(ii) Land that is owned by a nonresident alien or foreign government who is required to register ownership or acquisition of that property (Constitutional?)

(iii)Land that is owned by a corporation, partnership, trust, or legal entity if the entity is required to register its ownership or acquisition of that land AND a nonresident alien or foreign government owns a majority interest in the entity (Constitutional?)

f) What constitutes a "change in use" for the purposes of triggering a rollback tax under section 1-d-1?

15 Tex. Tax Code Ann. § 23.55(f). 16 Tex. Tax Code Ann. § 23.56.

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(1) The Agricultural Appraisal Manual explains that a change in use is a physical change—the owner must stop using the land for agricultural purposes.

(a) No change in use occurs if the land continues to be used for agricultural purposes even though the land may no longer qualify for an open-space land appraisal.17

(i) Example: A ranching operation has one animal unit for every 10 acres of pasture. A landowner who has an agricultural appraisal sells off his entire heard. Since he has stopped all agricultural activity, he will lose his agricultural appraisal and incur a rollback tax. However, if the rancher simply reduces his heard to include only a few animals (which is not considered to be "the degree of intensity generally accepted in the area"), he will lose his eligibility for agricultural appraisal without suffering a rollback tax penalty.

(2) Texas courts have also confirmed that "cessation of agricultural use constitutes a change of use for rollback tax purposes."18

3. A landowner's right to notice and protest

a) An owner of land that has qualified for agricultural appraisal under section 1-d or section 1-d-1 is entitled to notice from the chief appraiser "as soon as possible" following a determination that there has been a change in use or a diversion to non-agricultural use. The notice must also include information about the owner's right to protest the determination.19

b) A property owner is entitled to protest before the appraisal review board following a determination that there has been a change in the use of the land.20

c) The property owner must file a written notice of his or her intent to protest with the appraisal review board having authority to hear the matter protested not later than the 30th day after the date the notice of the determination is delivered to the property owner.21

17 See Tex. Att'y Gen. Op. No. JM-667 (1987). 18 Resolution Trust Corp. v. Tarrant County Appraisal Dist., 926 S.W. 2d 797, 800 (Tex. App.—Fort Worth 1996,

no writ). 19 Tex. Tax Code Ann. § 23.46(c); § 23.55(a). 20 Tex. Tax Code Ann. § 41.41(a)(8). 21Tex. Tax Code Ann. § 41.44(a)(4).

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IV. Avoiding liability for rollback tax penalties

A. Parties to an acquisition can always negotiate which of them will pay the taxes that have accrued at the time of closing or any taxes that will subsequently accrue.

1. The parties' agreement will generally be given effect.22

2. Rollback tax liability should be accounted for specifically in an acquisition agreement. Buyer should be aware that the inclusion of a clause that prorates property tax liability will not cover any rollback tax liability triggered by a change in use after the closing date.

B. A person who is the owner of an interest in vacant land who contracts for the transfer of that interest must include the following bold-faced notice:

If for the current ad valorem tax year the taxable value of the land that is the subject of this contract is determined by a special appraisal method that allows for appraisal of the land at less than its market value, the person to whom the land is transferred may not be allowed to qualify the land for that special appraisal in a subsequent tax year and the land may then be appraised at full market value. In addition, the transfer of the land or a subsequent change in the use of the land may result in the imposition of an additional tax plus interest as penalty for the transfer or change in the use o the land. The taxable value of the land and the applicable method of the appraisal for the current tax year is public information and may be obtained from the tax appraisal district established for the county in which the land is located.23

a) Liability for any rollback tax associated with recently-acquired vacant land can be avoided if the above notice is not included in the acquisition agreement.

b) The person to whom the land is transferred is entitled to recover from the previous owner any additional taxes that the person is required to pay as a penalty because of:

(1) The transfer of the land; or

(2) A subsequent change in the use of the land that occurs before the fifth anniversary of the date of the transfer.24

c) Buyers and sellers alike should be aware of this requirement.

22 Fender v. Moss, 629 S.W.2d 192 (Tex. App. Dallas 1982). 23 Tex. Prop. Code § 5.010(a). 24 Tex. Prop. Code § 5.010(e).

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C. Finally, buyer can always check the property's tax certificate for any special appraisal method that might trigger a rollback tax penalty.

V. Concluding Remarks