Ad Valorem Tax

What is Ad Valorem Tax?

The term “ad valorem” is Latin for “according to value,” which means that it is flexible and depends on the assessed value of an asset, product, or service. An ad valorem tax is charged by state and municipal governments and is based on the assessed value of a product or property. The most common ad valorem tax is the property tax, which is charged on real estate and personal property.

An ad valorem tax is not limited to property alone and may extend to other taxes such as value-added tax and the sales tax on goods and services. It is charged at the time of the transaction, as is the case with Value Added Tax (VAT), which is deducted at the point of purchase. Ad valorem tax may also be charged as an annual fee, such as inheritance tax.

Determining Ad Valorem Tax values

Fair market value of the property

Tax assessments for determining ad valorem taxes are calculated as of January 1st. The tax is levied as a percentage of the assessed property value, which is also known as the fair market value. The concept of fair market value refers to the estimated price of the property that a willing buyer and a willing seller, who both possess a reasonable knowledge of all facts about the property, would accept without being under any compulsion to buy or sell. The price should be a reasonable one for both parties.

Valuation process

Tax authorities often hire professional appraisers to determine the value of a property. They conduct a routine inspection of the property under consideration as part of the valuation process to calculate the fair market value. Some of the determining factors of fair market value include the cost of the property, comparable market data, property use, projected income from the property, and estimated depreciation of the property. If property owners are unsatisfied with the valuation given by the tax authorities, they may file an appeal at the local level, higher agency, or at the tax court.

Paying levied tax

Once the fair value of the property has been determined and the ad valorem tax has been charged, the tax authority sends a notification to the property owner. The amount that a property owner pays is dependent on the classification of the property. Properties may be classified as residential, commercial, agricultural, industrial, etc. The amount of tax charged is also dependent on the state and municipal laws since each government unit enacts its own tax laws.

Examples of Ad Valorem Tax

Ad valorem taxes often form the main sources of revenues for state and municipal governments. The government unit may require any business or individual owning an asset or doing business within its jurisdiction to pay ad valorem tax. The most common ad valorem taxes are:

Property tax

Property tax is an ad valorem tax that the owner of real estate or other commercial and residential properties pays on the value of their property. The term “property” refers to land, personal property (such as a car or aircraft), and improvements to land (immovable man-made improvements). Tax authorities may hire evaluators to determine the value of the property on a regular basis before arriving at the final tax assessment value. The items taxed under property taxes vary by jurisdiction, and most government units exempt household goods, inventories, and intangible properties such as bonds.

How property tax is determined

In many states, there exists a central appraisal authority that values all properties and shares the data with the local government units or tax authorities. The authorities then use the valuations to set a tax rate and impose an ad valorem tax on the property owners. This tax is computed by multiplying the assessed value of the property by the millage rate applicable to each property. The millage rate is expressed as a multiple of 1/1000 of a dollar.

Sales tax

Sales tax is a tax charged at the point of purchase of certain goods and services. The tax may be included in the price of the product or added at the point of sale. Sales tax is charged as a percentage by tax authorities. The seller of the product is authorized to collect the tax at the point of purchase from the final consumer and forward the levies to the relevant tax authority. Goods sold to businesses for resale are excluded from sales tax, as long as the purchaser produces a resale certificate and a statement that the goods are for resale. Different types of sales tax include seller taxes, consumer excise taxes, and retail transaction taxes.

Sales tax rates around the world

Sales tax is charged at the national, state, and municipal levels and the rate varies by country. Countries in Western Europe such as Norway, Sweden, and Denmark charge higher sales tax, as much as 25% – more than most countries around the world. In most states in the US, sales tax comprises the tax for the national, state, county, and city tax. For example, Chicago charges a sales tax of 10.25%, which includes 6.25% state tax, 1.25% city tax, 1.75% county tax, and 1% for the regional transportation authority. Los Angeles charges a 9.5% sales tax, which comprises 7.25% state tax, 2% county tax, and 0.25% city tax.

Value Added Tax (VAT)

VAT tax is sometimes referred to as a goods and services tax (GST) in some countries. It is charged on the value added by a business on the goods and services it purchases from the market. VAT differs from sales tax because the latter is charged on the total value of the goods or services. It is an indirect tax that is collected from a different party than the one who bears the cost of the tax. For example, when a consumer purchases a cup of coffee, they are essentially paying VAT for the entire production process from the cultivation, purchase of coffee beans, processing, and the final product, since coffee becomes valuable at each stage.

Summary

An ad valorem tax is a tax that is based on the assessed value of a property, product, or service. The most common ad valorem tax examples include property taxes on real estate, sales tax on consumer goods, and VAT on the value added to a final product or service. Ad valorem taxes comprise one of the primary sources of revenue for state, county, and municipal governments.

Other resources

CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep learning and advancing your career, the additional CFI resources below will be useful:

• Progressive Tax System
• Permanent/Temporary Differences in Tax Accounting
• Deferred Tax Liability/Asset
• Accounting for Income Taxes
• See all accounting resources