Prop 15 is Ready to Rock Commercial Properties with the Split-Roll

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On November 3, 2020, California voters will decide on Proposition 15, the citizen-initiated proposition that seeks to create a split-roll tax system in California. Also known as “The California Schools and Local Communities Funding Act of 2020,” Proposition 15 would require most commercial and industrial properties to be reassessed at their market value as early as the 2022-23 lien date and for those subject to reassessment, at least every three years thereafter. Residential properties, agricultural land and properties valued at less than $3 million would continue to enjoy the protections afforded by Proposition 13 and its progeny, which limits increases in property taxes.

This article provides background on the current law, details of the proposed law and discusses a number of potential resulting impacts and considerations that owners, investors and tenants of commercial and industrial properties in California might consider in light of Proposition 15, referred to herein as “Prop 15.”

Background on California’s Property Tax Laws

Prior to the passage of Proposition 13, each local government in California could set its property tax rate annually, resulting in an average property tax rate of 2.67% of assessed value (the average rate of the property tax levied by local governments on a single property), according to the California Legislative Analyst’s Office (the “LAO”).[1] Since its passage in 1978, Proposition 13 and its progeny, commonly referred to as “Prop 13,” have capped real property tax rates at 1% of the “full cash value” at the time of the acquisition generally, with increases to the assessed values capped at no more than 2% each year until the property’s ownership is changed. Prop 13 also curtailed the ability of local governments to levy other taxes, by requiring two-thirds of voters to approve any special taxes.

The effects of the passage of Prop 13 were immediate, with a roughly 60% drop in property tax collections in 1979 according to the California LAO. [2] The landmark ballot measure made no distinction among residential, commercial, industrial, agricultural or other property types and under current California law, all real properties are taxed at the same tax rate. Prop 13 has received praise for preventing rapid tax increases and ensuring those on a fixed income are able to continuing affording their homes. On the other hand, Prop 13 has faced criticism for reducing funds for cities, school districts and other municipal operations, as well as discouraging transfers of properties with a favorable tax basis and disincentivizing upgrades and reinvestment because any additional rent would not be worth the increase in taxes and cost of the improvements. Of particular scorn by some opponents is the tax advantage enjoyed by companies owning real property for commercial purposes, especially where the property has been held long term and has a lower tax basis than other comparable properties.

Proposal for a Split-Roll

Proponents of Prop 15 argue that the split-roll would create a fairer tax system, narrow state and local budget shortfalls and raise needed revenue for schools and community services. If passed, California would no longer have a uniform property tax system, but would instead move to a classification system. The local assessor offices statewide would be charged with classifying a property as “commercial” (e.g., commercial or industrial) or “non-commercial” (e.g., residential or agricultural). This has resulted in Prop 15 often being referred to as the “split-roll” ballot initiative, because it would “split” the assessment rolls for commercial properties from non-commercial properties.

Opponents of Prop 15 argue that the increased tax costs will be passed through to small businesses and among other things, will disproportionately affect minority owned business and minority communities. In addition, while agricultural land would not be subject to reassessment, Prop 15 would trigger reassessment at market value for agricultural related facilities and improvements, causing an adverse impact on members of the farming community.

Under the proposed law, “commercial” properties, as identified below, would be subject to Prop 15 reassessment at least every three years beginning in 2022. Given the number of properties potentially subject to reassessment, the Legislature may phase in this requirement over three years. By capturing the current market value for these properties, the increased property taxes are expected to raise between $8 billion to $12.5 billion dollars in most years[3] which would be used to fund local city and county governments, certain special districts, community colleges, public school districts, charter schools and county offices of education.

The properties considered “commercial” under Prop 15 would include:

  • Real property used as commercial or industrial property;
  • Vacant land not zoned for residential use and not used for commercial agricultural production.

“Non-commercial” properties, as that term is used in this article, would remain protected under Prop 13, and include:

  • All residential properties, including those with home offices, home-based businesses or short-term rentals (including vacation rentals), as well as multi-unit residential buildings;
  • Commercial agricultural land used for producing commercial agricultural commodities;
  • Vacant land used or protected for open space, a park or equivalent designation.

Properties with both residential and commercial uses will be reassessed pro-rata based on the proportion of commercial use and taxed accordingly. Please note, under Prop 15 a mixed use property with 75% or more residential use (based on its square footage), would be excluded from Prop 15 reassessment.

Small Property Exclusion

Commercial properties that are owned by a single person or entity will be excluded if the aggregate fair market value of commercial and industrial property holdings in the State by that person or entity are less than $3 million, which amount is subject to adjustment for inflation every 2 years commencing January 1, 2025. This exclusion, referred to in this article as the “small property exclusion”, takes into consideration direct and indirect ownership interests, such that if any of the direct or indirect ownership interests of any beneficial owner is in excess of $3 million in the aggregate statewide, that would void the exclusion for the entire property.

Deferral for Qualifying Small Businesses Through 2025

Prop 15 includes several measures designed to protect small businesses from reassessment. As mentioned above, owners of properties valued at less than $3 million in the aggregate may remain protected under Prop 13 if the property qualifies for the small property exclusion. In addition, for properties occupied by small businesses, Prop 15 would defer reassessment until the 2025-26 lien date. These properties must be at least 50% occupied by small businesses. To qualify as a small business, the business must: (i) have fewer than 50-full time equivalent employees, (ii) be independently owned and operated, such that the business ownership interests, management and operation are not subject to control, restriction, modification or limitation by an outside source, individual or another business and (iii) own real property in California. For this last requirement, Prop 15 does not specify that the real property be commercial, but is nonetheless a peculiar requirement, as most small businesses rent rather than own.

Impact on Commercial Leases

For anyone that owns or rents a commercial property, the passage of Prop 15 may mean an increase in taxes possibly as soon as 2022. Depending on how long it has been since the property “changed ownership”, that increase can be significant and have considerable impacts on the parties involved. In order to explore the potential impacts, and items for the parties to consider, outlined below are two hypothetical commercial lease scenarios. Generally, landlords pass through taxes in a triple-net lease and do not pass through taxes under a gross lease, thus making taxes a tenant responsibility in a triple net lease. The numbers used below are hypothetical and used to illustrate the concepts discussed.

Scenario One – Single Tenant Triple-Net MOB Lease

Suppose there is a single-tenant medical office building (“MOB”) in a growing Southern California market. The single-story property contains approximately 12,000 square feet, has been under the same family ownership since the 1980’s and is currently leased to a nonprofit hospital under a 10-year triple-net lease, with 7 years remaining and two 5-year options to renew. Because property taxes are passed through to the tenant under a triple-net lease, this tenant is concerned about a potentially large tax bill being passed through, beginning as early as 2022.

When the parties entered the lease, the owner was able to push for a slightly higher base rental rate since the pass-through costs were relatively low when compared with other comparable properties in the area. While the rent is within the fair market range, it is at the higher end of that range. As such, the tenant pushed for Prop 13 protection so that if the property changed ownership during the lease term, any increase in the property taxes due to the change in ownership would not be tenant’s responsibility. The owner had no plans to sell and was agreeable to the arrangement.

If Prop 15 passes, this property would be reassessed at its current fair market value, a value that has increased substantially due to the value brought to the property by a high credit nonprofit hospital and base rent payments in the higher range, as described above. The bargained-for Prop 13 protection in the lease is narrowly tailored to the instance of a “change in ownership as defined in Section 60 of the California Revenue and Taxation Code” and is unlikely to prevent pass-through of the Prop 15 tax increases. The parties are aware of a similar single-tenant MOB in the vicinity of this property that sold about 6-months ago for roughly $5 million. While the other property was newer and slightly larger, the market is continuing to grow in the area and the parties anticipate that by the time any reassessment is issued, the MOB would be valued at approximately $5 million. Since the property was acquired for approximately $450,000, this would cause the annual property tax bill to increase from roughly $4,500 per year to roughly $50,000 per year, with a steady increase and reassessment every 3-years. If the reassessment occurred in 2022, there would be 5 years remaining on the initial term and this would cost the tenant roughly $250,000 or more than it had planned.

Given the anticipated valuation of approximately $5 million, this property would not qualify for the “small property” exception. In addition, the nonprofit has greater than 50 annual full-time employees, and therefore, it would also not qualify for the small business deferral.

Scenario Two – Multi-Tenant Gross Office Building

For our second scenario, imagine a 60,000 square foot 5-story multi-tenant office building in downtown Los Angeles. The property is subject to 8 leases and there is one vacant unit on the third floor that contains 4,000 square feet. All 8 leases are full service gross and have anywhere from 18 months to 8 years left on the current terms. The landlord acquired the property 3 years ago and has worked to lease up the vacancies, update the space and build a good relationship with the tenants. When the landlord acquired the building, there were a couple long-term tenants with rental rates that were slightly lower than what the landlord knew it could get with new tenants, but it viewed these tenants as assets to the building and renewed those leases slightly below market since the lower rents were a trade-off for the benefits and stability that come with long standing tenants that would remain with the building for some time. Several of these tenants were small, independently owned businesses.

The owner is a limited liability company comprised of six individuals that invested their own capital to acquire the building. The owners used a bank to finance the purchase of the building and two of the members personally guaranteed the loan.

Since all of the leases are “gross”, the landlord is responsible for any increase in the property taxes as a result of Prop 15. The owners are currently working with two of their tenants to address rent payment deferrals in light of the COVID-19 pandemic and government stay at home orders. The reduction in cash flow and increased security costs for the mostly vacant downtown office building have already caused them to have conversations with their lender regarding potential refinancing and possible extensions of time to make certain payments on their loan. At this time, the loan remains current, but they are considering requiring a capital contribution by the members to maintain a minimum cash balance in the company account.

Even though the property was reassessed when the owners acquired it 3-years ago, the ownership is concerned that a reassessment in 2022 or thereafter will cause an increase in the property taxes. Since several tenants are considered small businesses under Prop 15, the owner has determined that leasing the vacant 4,000 sf unit to another small businesses (and maintaining the current tenant mix) would allow it to defer any reassessment until the 2025-26 lien date. However, this would mean passing on a credit tenant that is interested in the vacant space.

Considerations for Owners, Investors and Tenants

As evidenced by these scenarios, there are a number of things for owners, tenants and investors to consider. Regardless of whether Prop 15 passes on November 3rd, challenges to Prop 13 and California’s current property tax scheme will likely continue in California.

We recommend that parties take a look at their commercial leases and consider the following items:

  • Will property tax increases be passed through to the tenant(s) or borne by the landlord; and if so, under what circumstances?
  • Are there any caps or limits on the pass-through of property tax increases?In particular, is any Prop 13 protection narrowly tailored to a “change in ownership” and therefore, not applicable to a Prop 15 reassessment?
  • For health care landlords and tenants, particularly those leasing to or from an actual or potential referral source, it is important to determine whether a tax increase causes the total “rent” payable to exceed the fair market threshold and whether there is a potential compliance issue to review under Stark/Anti-Kick Back laws.
  • For agricultural properties, parties might look to their use and improvements provisions to see if changes can be made to bring the property under the “agricultural” exception, to the extent it does not qualify in its current condition. As drafted, Prop 15’s exception for “real property used for commercial agricultural production” is narrowly tailored to the land, and does not apply to agricultural improvements such as barns, dairies, wineries, processing plants, vineyards and orchards, which would be subject to reassessment.

    Persons involved in commercial real estate might also keep the following items in mind:

  • Owners and/or tenants might retain an appraiser to provide an estimate of the market value and future tax costs.
  • Owners of “unique” properties that will be subject to reassessment might start a dialogue with the County to assist in working through valuation issues and scheduling site visits for the valuation process.
  • Owners of commercial properties that qualify for Prop 15 exclusion because the aggregate value of its properties is less than $3 million, must file a claim for the exemption annually. Failure to make the claim will be deemed a waiver of the exclusion for that tax year.
  • Small businesses that qualify for Prop 15 deferment must file a claim for the deferment annually. Failure to make the claim will be deemed a waiver of the exclusion for that tax year.
  • Owners that rent to small businesses, may be incentivized to continue leasing to start-ups or small-businesses. They might also consider caps on the number of employees, prohibitions on business growth and changes to ownership (e.g., prohibition on mergers, acquisitions and other transfers of ownership interests) to preserve the small business status (at least through the deferment period). Owners might also include obligations for tenants to furnish the necessary documentation supporting a small business qualification.
  • Investors in properties valued at $3 million or less may be incentivized to: (i) avoid capital improvements or upgrades which may increase the property’s value above the “small property” exclusion cap or (ii) invest any additional capital over the $3 million cap into non-real estate vehicles to avoid triggering a Prop 15 reassessment.
  • For investors in properties that would qualify for the $3 million “small property” exclusion, Prop 15 states that if any direct or indirect interest is held by a person owning a direct or indirect interest in any other property in California which causes the aggregate ownership interest to exceed the $3 million threshold, then that property will not qualify for exclusion. Investors in small properties might structure their organizational documents to prohibit the owners/members from investing or owning other properties in California to avoid Prop 15 reassessment of the company’s real property asset.
  • Properties currently excluded from reassessment through a new construction exclusion, such as active solar energy systems and work related to seismic retrofitting, life safety and ADA compliance, will become subject to reassessment under Prop 15.
  • Loss of the property tax exclusion could disrupt the economic viability of many of California’s solar projects. New legislation (AB 105)[4] has already been introduced in an effort to rescue eligible solar projects from the fallout of Prop 15.
  • From a land use perspective, municipalities may be incentivized to zone for commercial and industrial to capture additional property tax revenue. In addition, in zones where multiple uses are permitted, the municipality may be more likely to scrutinize or delay a residential development, but might expedite and entitle a commercial project.

The foregoing are just a few of the many ripple-effects that might be felt if Prop 15 passes. Like Prop 13, the passage of Prop 15 would likely result in some unintended and/or unanticipated consequences, new mechanisms to protect property values and new strategies to account for the increased tax obligations on commercial properties.

The full text of the bill can be found here.

[1] Legislative Analysts’ Office Report, Common Claims About Proposition 13, September 19, 2016, (Available from: https://lao.ca.gov/Publications/Report/3497)

[2] Id.

[3] Legislative Analyst’s Office Letter to Attorney General Hon. Xavier Becerra, October 2, 2019 (Available from: https://lao.ca.gov/ballot/2019/190523.pdf )

[4] CA AB105, 2019-2020, Reg. Sess. (2020, July 08) Retrieved October 27, 2020, from: https://leginfo.legislature.ca.gov/faces/billTextClient.xhtml?bill_id=201920200AB105

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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