In a nutshell:

• The Michigan Supreme Court recently ruled that a state law allowing county treasurers to keep surplus proceeds from tax foreclosure sales is unconstitutional. Until now, some counties have used money from these sales to finance a number of services, including blight remediation and general budget balancing. 
• The state legislature will have to replace the current law with one that passes constitutional muster; the extent to which a new law will change the current tax foreclosure system remains to be seen.
• This ruling does nothing to address issues related to over-assessment or the high interest and penalties charged to delinquent taxpayers. These issues have contributed to the tax foreclosure crisis in many communities, notably in Detroit.

The Michigan Supreme Court recently ruled that local governments cannot keep the surplus proceeds from property sales resulting from tax foreclosures. The ruling has been described as a “bombshell,” and for good reason: It cuts off what is, in some counties, a major revenue stream.

The ruling stems from the cases of Uri Rafaeli and Andre Ohanessian. Rafaeli, who underpaid his 2014 property tax bill by $8.41 ended up owing $285 with interest and penalties. The property was ultimately foreclosed and sold at auction to recoup the unpaid taxes, interest, and penalties with the proceeds from the $24,500 sale going to Oakland County. Ohanessian owed approximately $6,000 in unpaid taxes, interest, penalties, and fees from 2011.  As was the case for Rafaeli, Oakland County foreclosed on Ohanessian’s property for the delinquency, sold his property at auction for $82,000, and retained all the proceeds in excess of Ohanessian’s tax debt. 

The issues around property tax foreclosure and counties’ use of delinquent tax revolving funds are statewide problems, but they have been particularly difficult in Detroit, where one-third of properties have gone through tax foreclosure since 2008. The city has been charged with overtaxing homeowners by an estimated $600 million by over-assessing property during this time period.

Tax foreclosure and the Delinquent Tax Revolving Fund

The General Property Tax Act, as amended in 1999, requires counties to act as delinquent tax collectors for their constituent local units of government and to deposit the proceeds from delinquent taxes and fees, as well as from the sale of tax foreclosed property, into their delinquent tax revolving fund. After one year unpaid, local governments hand over their overdue accounts to the county. The counties forward money from the fund to local governments to cover the unpaid taxes and try to collect the delinquent taxes to recoup the unpaid amounts. 

If needed, counties use short-term borrowing to cover the costs of the delinquent tax revolving fund, but they charge much more interest on overdue taxes than they pay for borrowing, leading to excess dollars in the fund from both interest and fees and tax foreclosure sales. State law allows county boards of commissioners to transfer any excess funds into counties’ general funds. This has led to claims of counties balancing their budgets on property owners’ misfortunes. For example, Wayne County had a balance of $127.8 million in its delinquent tax revolving fund in 2019.

The Michigan Supreme Court found the section of the law allowing the county to keep the surplus proceeds from tax foreclosure sales to be an unconstitutional taking under Article X, Section 2 of the 1963 Constitution. The Takings Clause, found in both the U.S. and Michigan Constitutions, prohibits government from taking private property without providing just compensation. In this instance, it protects the former owner’s property right to collect the surplus proceeds following a tax foreclosure sale. According to the court, these surpluses belong to the property owner.

What will this cost counties?

This is the big question. The recent court decision does not provide a clear picture of the financial implications.

Counties and the state had argued that current state law and practice did not violate the Takings Clause because delinquent taxpayers get more than two years’ worth of notices before the government forecloses, during which time they can sell the property, pay back taxes, and keep the proceeds. Governments argued that after the process is exhausted, it isn’t an example of taking property, but rather of a taxpayer giving it up. This argument held up with the lower courts, but not with the Michigan Supreme Court.

The financial impact of the ruling is unknown. The case at hand applied to one county and two former property owners, but the ramifications extend much further. Hundreds of thousands of properties have been foreclosed on since the law was amended in 1999. It is not known how much in surplus proceeds was collected by counties over this time. Homeowners who have already been through tax foreclosure would need to sue to recover any money and it is possible that class-action lawsuits could address past losses. There is a six-year statute of limitations on takings claims, but lawsuits have been filed that date further back than this. During court arguments, Oakland County claimed that an unfavorable ruling would put more than $2 billion in surplus proceeds at stake statewide. 

State and local officials argued that the current system provides counties with resources to deal with blighted and abandoned properties. For some counties, operation of the delinquent tax revolving fund is a break even endeavor. While county treasurers may sell some properties for more than the amount of unpaid taxes, others will sell for less. Surpluses in one year may be offset by deficits in another year. Without the ability to at least break even, county treasurers lack the ability to pay cities, villages, townships, and other taxing jurisdictions shorted by delinquent taxpayers. 

While this is certainly true in some instances, other counties have had surpluses in their delinquent tax revolving funds and used the money for purposes other than foreclosure costs and blight remediation. The law allows excess funds to be used by counties to balance their budgets. The Detroit Free Press found that at least nine counties across the state have used these monies over the last few years to cover regular county expenses.

What happens next?

The case will now be sent back to Oakland County Circuit Court to determine a remedy, but beyond crafting monetary relief for Rafaeli and Ohanessian, it will have to involve changing state law since the current law was ruled unconstitutional. 

It will be important for the legislature to quickly replace the old law with one that passes constitutional muster. Tax foreclosure is an ongoing process. If cities and townships will remit their delinquent taxes to the counties, where will the money come from to pay the bills? Counties use short-term borrowing to cover costs, but will the interest and fees from delinquent taxes provide sufficient funds to pay the county back for these costs, including the added costs associated with borrowing? Or do counties rely on the surplus funds from properties sold to cover some of these costs? Counties will soon have to determine policies for properties with only minimal outstanding tax liabilities. 

Only part of the story

According to some, this lawsuit only addresses part of the problem with Michigan’s tax foreclosure process. According to Jerry Paffendorf, CEO of Loveland Technologies, the real problem with the current law is that counties make a lot of money when homeowners pay their taxes late, much more so than the excess profit on tax foreclosed properties that are sold. This is because when counties collect back taxes, the law allows them to tack on a hefty interest rate of up to 18 percent plus fees.

The tax foreclosure crisis in Detroit, coupled with the findings of property being over-assessed in the city, have led to programs to help low-income homeowners struggling to pay back taxes, including the recently passed Pay as You Stay program, which allows foreclosing governments to reduce delinquent property taxes to no more than 10 percent of a home’s value and eliminate all associated interests, penalties and fees.

What will happen next is unknown, but the current system is broken. The COVID-19 recession is likely to lead to a new increase in tax foreclosure, hopefully not on a scale equal to the Great Recession 10 years ago. It is up to the state and counties working together to develop a law that passes constitutional muster and protects both taxpayers and local governments alike.