Most Arizona cities and towns impose taxes on the privilege of transacting business within city or town limits. These taxes are known as transaction or business privilege taxes. In many cities and towns, such privilege taxes are a primary source of revenue. Commonly known transaction privilege taxes include the retail sales tax, the bed tax and the construction contracting tax. Unfortunately, many real estate developers do not realize that real estate development may also be subject to a municipal transaction privilege tax if a developer sells real estate he has improved. This tax is known as the “speculative builder tax,” and it is assessed against the sales price of improved real property. It applies even when the developer hires a general contractor to construct the improvements. Fortunately, a developer can reduce the speculative builder tax by the amount of the construction contracting tax charged by the general contractor. Still, the speculative builder tax can be substantial where the sales price of the improved real property greatly exceeds the cost of the improvements.
Here is how it works. If an owner of real property improves it himself or through others by building a structure, making improvements to land without a structure by adding roads or landscaping or bringing water, power, and other utilities to the property line, the owner can be liable for the speculative builder tax if he sells the property after making the improvements. If the improvements consist of custom, model or inventory homes, or improved residential or commercial lots without a structure, then the property is subject to the speculative builder tax regardless of how long the developer holds the improved property before selling it. On the other hand, if the improvements are made on commercial property with a structure, the tax only applies if the property is sold within 24 months after the improvements are substantially completed.
Not all improvements trigger imposition of the speculative builder tax. For example, mass grading may not be considered to be an “improvement” nor are improvements to a development such as the construction of a main road that does not touch the individual platted parcels of land.
The speculative builder tax rate varies by jurisdiction. In Tucson, the tax rate is 2 percent of the sales price, while Oro Valley and Marana both charge 4 percent. In southern Arizona, Sahuarita’s tax rate is 4 percent, Sierra Vista’s tax rate is 2.45 percent, Benson’s tax rate is 4 percent and Nogales’ tax rate is 2 percent. In the greater Phoenix area, Phoenix charges a speculative builder tax of 2 percent, Glendale recently raised its tax rate to 2.2 percent, Scottsdale’s tax rate is 1.65 percent, Mesa’s tax rate is 1.75 percent, Tempe’s tax rate is 1.8 percent, Buckeye’s tax rate is 3.1 percent, and Queen Creek tops out at 4.25 percent.
In Tucson, the owner can deduct the cost of land from the gross proceeds from sale, and the speculative builder tax is then imposed on the net amount. However, in most Arizona cities and towns, including Phoenix and Scottsdale, the owner cannot deduct the land cost from the gross sales proceeds; the entire sales price of the development is subject to tax. In January 2010, Tucson’s city council voted to continue allowing this “cost of land” deduction.
Larger cities like Tucson and Phoenix collect and administer their own privilege taxes. Both Tucson and Phoenix have municipal auditors who audit developers to see whether they have paid the speculative builder tax by comparing recent sales records to permits that have been pulled to improve the property. Using this audit technique, it is remarkably easy for auditors to find sales of improved real property where taxes have not been paid. Smaller cities and towns rely on the state revenue department for collection and distribution, so are less likely to be able to audit payment of the speculative builder tax. In either case, developers often do not realize that the speculative builder tax applies, so they never file tax returns. If a return is not filed, the statute of limitations never begins to run, so an auditor can assess speculative builder taxes based on sales that occurred several years ago.
The speculative builder tax can also entangle someone who buys improved real property. Municipal ordinances allow the city or town to collect the speculative builder tax from a purchaser if the buyer fails to pay the tax. For example, to remind developers of their obligation to pay the speculative builder tax, the City of Tucson files a notice of prospective tax lien against improved real property to advise both buyers and sellers that sale of the property triggers the tax, although the enforceability of such a notice is questionable because it is recorded before the sale occurs and the tax is owed. Likewise, foreclosure or a sale in lieu of foreclosure of recently improved real property may cause the lender to become liable for unpaid speculative builder taxes once the lender sells the foreclosed property.
A commercial developer can avoid the speculative builder tax entirely by waiting at least 24 months to sell improved commercial property. A residential developer can pass the tax on to another developer or a homebuilder who completes the project if that subsequent developer/ builder agrees to take on the tax liability. But, because each person who improves and then sells real property may be liable for the speculative builder tax, without careful planning the same project could be subjected to multiple layers of taxation as it is bought and sold during development.
By ordinance, a city or town can agree to waive the speculative builder tax on newly annexed areas for a specified number of years. This moratorium must apply city wide, and cannot apply to some new developments and not others. Few, if any, city or towns currently have adopted such moratoriums for newly annexed areas.
The bottom line is that developers need to be aware of the speculative builder tax on the sale of improved real property when they decide to develop within a city or town, especially when evaluating the relative costs and benefits associated with annexation into a municipality. Developers should account for this (and other privilege taxes) so that they are not caught unaware when the local tax auditor comes calling.