August 2011 Archives

August 16, 2011

Why San Diego Tenants Should Seek Property Tax Protection in Commercial Leases

Most San Diego business owners know that commercial landlords typically pass on real estate taxes, including property taxes, to their tenants. Whether it's a triple net lease requiring commercial tenants to pay their pro rata share of all property taxes due including property tax reassessments or a base year lease (common for office buildings) where tenants are responsible for property tax increases only, property tax reassessments can have a devastating effect on unsuspecting San Diego tenants. The problem stems from California's Proposition 13 which limits property tax reassessments to 2% annually, but allows for full tax reassessments upon the transfer of ownership. Unwary prospective tenants may not realize that an attractive property has not been reassessed under Proposition 13 for years, if not decades. If the property is sold, or ownership is transferred in any number of ways, the property tax reassessment can be significant.

139045_shopping_centred_4.jpgFor example, consider a property that has not changed ownership in ten years (meaning it has not been reassessed for Proposition 13 purposes in ten years). In 1994, at the time the property last changed ownership, its value was assessed at $10,000.000.00. Assuming maximum Proposition 13 increases annually of 2%, in 2003 the Proposition 13 tax basis for the property would be $12,189,944. At a tax rate of 1.5%, the tax on the property in 2003 would be $182,849.00 (12,189,944 X .015). A new tenant in 2003 with a 10% pro rat share of property expenses under a triple net lease would owe $18,285 in taxes for 2003. Typically, these taxes are anticipated and paid by tenants as part their monthly Common Area Maintenance (CAM) expenses. However, in 2004, if the property is sold to an investor for $20,000,000.00, it triggers a Proposition 13 reassessment. The Proposition 13 reassessment is based on the new $20,000,000 price tag resulting in a property tax of $3,000,000.00 (20,000,000 X .15%). The new tenant's pro rata share for 2004 is virtually doubled to $30,000.00. In most cases, the tenant will continue to pay the same monthly CAM payment for 2004 and will be billed for the difference upon reconciliation in early 2005 (approximately $11,350 assuming the 2004 CAM calculations accounted for an anticipated 2% Prop 13 tax increase). This can place a significant burden on a new or growing business especially when the business owners do not see it coming. In some cases, the amount owed can be staggering. This is a highly simplified example, but the outcomes are similar in just about any scenario so long as property values are appreciating faster than the 2% maximum allowed under Proposition 13. Of course, the problem is less common in San Diego's current down market, but it is a climate where large appreciations can be expected in the future.

The simple solution for tenants is to seek Prop 13 protection (a clause in the lease that excludes from tenant's expenses any increase in property taxes resulting from reassessments or at least those increases directly attributed to a transfer of ownership). This is not always a practical solution, especially for tenants with less leverage. Nonetheless, it should always be the subject of negotiation. The potential harm can devastate a business. If complete Proposition 13 protection is not possible, tenants should consider seeking a cap (say 5%) on annual property tax increases or an advance agreement to spread out the lump sum tax payment that would be due upon reconciliation. If these concessions prove impossible which is often the case, a new tenant needs to know when the property was last reassessed for Proposition 13 purposes, what its assessed value was at the time and what its assessed value is today in order to forecast the potential losses due to a transfer of ownership. The longer it's been since the last reassessment, the greater the tenant's exposure to extreme property tax increases.

The property tax increase isn't a one-time burden. The new tax basis remains until the property is again reassessed and will not decrease unless property values decrease. It's understandable then that landlords seek to pass the burden onto tenants. In fact, a commercial property is harder to sell (has less value) if its tenants have Proposition 13 protection. Either way, blindly entering into a commercial lease without understanding how property taxes are apportioned is unwise for tenants and landlords alike. Consultation with a San Diego Commercial Lease Lawyer is the best way to avoid pitfalls like this.