What is an Ad Valorem Tax?

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Definition:

An ad valorem tax is a tax you pay based on the value of major property you own or items you buy.

🤔 Understanding ad valorem tax

An ad valorem tax is a tax you pay based on the value of an item you own or buy. Ad valorem is a Latin phrase that roughly translates to “according to value,” and typically you pay the tax as a percentage amount of the item’s value. Property taxes are one type of ad valorem tax - you are paying a tax that the government determines based on the value of your home or other personal property. Sales taxes are another ad valorem tax; when you buy an item, you pay an added amount in taxes based on a percentage of the purchase price.

Example

Imagine Tim goes to the store to buy a new shirt. When he goes to pay, he pays both the price of the shirt itself and an additional amount, a sales tax based on a percentage of the price - an ad valorem tax. When he goes home to the house he owns, he pays his property tax bill, based on a percentage of the home’s value levied by his town’s government. The percentage of the value he has to pay in taxes varies depending on where he lives and what tax rate the state or local government has decided to impose.

Takeaway

Ad valorem taxes are kind of like credit card charges…

When you carry a balance on your credit card, that’s the result of purchases you’ve made. In addition to paying off the balance, you also have to pay a finance charge, an additional amount based on a percentage of your balance - similar to an ad valorem tax. That amount goes not to the retailers where you bought the items, but to the credit card company, just as an ad valorem tax goes to the town or state that imposes it.

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What are the different types of ad valorem taxes?

We pay ad valorem taxes on items we own or items we are purchasing. Some are levied on an ongoing basis, for as long as we own an item. Others are levied only once, when we originally purchase the item.

Property taxes

A property tax is a tax that a property owner pays on the assessed value of the property they own. You don’t just pay property taxes at the time of sale; you continue to pay them, usually every year, as long as you own your property. Property taxes are typically imposed on real estate - your land and house, and any other buildings on your property (like a garage) or improvements you’ve made to it. Some states also impose property taxes on big items you own like cars or boats. (Smaller possessions like your appliances, clothing and personal items usually aren’t subject to property taxes.). Often the government will send someone to your home to assess its value. The property-tax rate set by the government is then applied to that value to determine how much tax you should pay.

Sales taxes

A sales tax is a tax you pay based on an item’s price when you purchase it. A seller might choose to add on the sales tax when you pay for the item, or they might include it in the price. Sellers collect sales taxes and send them to the government that imposes them, usually state and local governments. Sales taxes are based on a percentage of the price of goods or services –- they change as the price of the item changes. Let’s say you’re laptop shopping and are looking at one priced at $500. Tomorrow you return to the store and see the laptop is now selling for $525. The sales tax you would pay has increased, even though it’s the same computer. But you pay it only once, when you buy the laptop - you don’t have to keep paying during the period you own it.

Excise taxes

An excise tax is a tax that the government levies on certain goods and services, like the federal 7.5% tax imposed on airline tickets. It is often businesses that have to pay excise taxes, but the businesses may then pass those taxes along to the consumer in the form of price increases.

Not all excise taxes are ad valorem taxes. Some excise taxes are set at a specific rate. For example, the excise tax for cigarettes is levied per pack of cigarettes, not based on the price of the cigarettes.

Value-added taxes

A value-added tax (VAT) is a tax that is applied when a company adds value to a product. It is similar to a sales tax, but VAT is charged every step of the away, as a product moves down the supply chain and companies add value to that product. Say a company makes a product out of raw materials - the VAT is imposed on the next buyer to tax the amount of the value the manufacturer added to those raw materials. A sales tax does not apply until the very end when the consumer purchases the product, and it applies to the whole value of the item.

The United States does not currently have any value-added taxes, though 160 other countries do. Those countries that do use VAT often exempt certain products and services like medical care and insurance.

Import duties

Some import duties - taxes that are imposed when goods are brought into the country from abroad - are ad valorem taxes. The 25% tariff that President Trump imposed on imported steel in 2018 is an ad valorem tax, for instance. Other import duties are imposed based on the number or weight or volume of an item imported, and thus are not ad valorem taxes.

How are ad valorem taxes levied?

In the United States, it is state and local governments that levy most of the ad valorem taxes in the form of sales taxes and property taxes. In some cases, local and state governments both levy an ad valorem tax on the same item, as is sometimes the case with property taxes. The federal government also levies ad valorem taxes in the form of excise taxes when they are based on the value of the product or service, as with firearms, airline tickets, and heavy trucks. Governments in more than 160 countries levy value-added taxes, though the United States doesn’t.

How are ad valorem taxes calculated?

Ad valorem taxes are set as a percentage of the value of the item you’re paying taxes on. That means the rate you’ll pay in taxes varies widely based on the item in question and where you live.

Forty-five states charge sales tax, but their rates range from as low as 2.9% in Colorado to as high as 7.25% in California. Many states allow their local governments to levy sales taxes as well, so the sales taxes that consumers pay could be even higher than those numbers. For example, if you go shopping in Chicago, you’ll find yourself paying a grand total of 10.25% in sales tax.

Property tax rates also vary widely across the country, so homeowners’ tax bills can differ by thousands of dollars even when their homes are the same value. The lowest state property tax is Hawaii’s at 0.27%, while the highest is 2.35% in New Jersey. On a house with a value of $250,000, you would pay $5,875 in property tax in New Jersey but only $675 in Hawaii. Home prices also vary widely from state to state, which plays a role in the variance of property tax bills.

What are the exemptions to ad valorem taxes?

As with some other types of taxes, there are exemptions to ad valorem taxes that can help taxpayers lower their tax burden. Many states exempt food and prescription medications from sales taxes, for instance. Nonprofit organizations like charities, schools and religious organizations may be exempt from paying sales tax on items related to the organization. There are also sales tax exemptions for companies who buy wholesale products. A company that manufactures products may not have to pay sales tax on the wholesale materials they purchase to produce their product. Retail businesses may not have to pay sales tax on the wholesale items they buy to sell to consumers. The expectation is that sales tax is only required for an item once — if the consumer pays it, it isn’t necessary for everyone else in the sales chain to do also.

There are also exemptions for property taxes. Many states have a homestead exemption, which allows homeowners to avoid paying taxes on a certain portion of their home’s value. Many states also have property tax exemptions for seniors, disabled people, military members on active duty, and veterans. For example, Colorado exempts 50% of the first $200,000 of the value of a home for seniors and military veterans.

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