For Californians, Proposition 13 has placed a limit on assessed increases in taxes on real estate since its passage in 1978. To oversimplify, no increases in taxes of more than 2% per annum are allowed unless the real estate is sold or materially improved. While resulting in serious underfunding of the state’s public education system, Prop 13 has been a boon to commercial property owners. For example, a property owner who purchased a building in downtown San Francisco and held it for 20 years, is still paying taxes on that building based on the 2000 purchase price (with the modest increases noted above).
Commercial tenants benefit from this tax regime as well until a property is sold – at which point, the re-assessment based on the purchase price of the property is passed through to the commercial tenant. Triple net leases allow landlords to pass through real estate taxes to tenants on a pro rata basis. Thus, the sale of the property can result in a very painful shock for commercial tenants with a tax bill increasing as much as 100% or more in a single year. I had a client operating a small restaurant in a shopping center fast food court whose tax bill was about $1,000 per year (i.e., Tenant’s pro rata share of taxes on its triple net lease).
After the shopping center was sold, my client received a tax bill from the landlord for $12,000. Pursuant to the lease, the tenant was required to pay this new tax amount within 30 days of receipt. (Ultimately, we were able to negotiate with the new landlord to pay such amount in monthly installments over a period of a few years). A similar impact will be felt by commercial tenants on a “gross” lease who are required to pay increases in taxes over a base year. If the property is sold after the base year, then such tenant pays all increases in taxes resulting from the sale of the property.
In order to avoid such unexpected tax bills, commercial tenants have sometimes been able to negotiate for “Prop 13 protection”. This basically means that in the event the property is sold, the increase in taxes will not be passed through to the tenant. Other variations include limiting such increases by a percentage (i.e., no more than 5% increase in a single year or no increase during the first 5 years of the lease). Prop 13 protection creates a chilling effect on the sale price of commercial property and so Prop 13 protection is typically only available in a very pro-tenant market (e.g., during the Great Recession of 2008).
However, a new proposition, Proposition 15, is on the November ballot in California. Prop 15 will repeal Prop 13 with respect to commercial properties (Prop 13 protection will remain for residential properties and thus this proposed rule is often referred to as the “split roll”). Initially, Prop 15 would be limited to properties valued at more than 3 million dollars. Prop 15 would be phased-in beginning in the fiscal year 2022-2023. There are also some exceptions to Prop 15 for small businesses.
While the passage of Prop 15 would be a boon for California’s schools, it will have a dramatic impact on commercial leases as properties will be assessed based on market value (so the triggering event of a sale of the property as required by Prop 13 will no longer be necessary). If Prop 15 is passed, commercial landlords and tenants will need to determine how the imminent re-assessment will need to be allocated between the parties to the lease. If Prop 15 is not passed, commercial tenants may wish to consider including protections against such re-assessments in their leases.
A complete description of Prop 15 can be found here.
Jo Ann is available to work with commercial landlords and tenants in determining strategies for determining the impact of Prop 15, if passed, on commercial leases.
I am an attorney, but unless I am already your attorney, then I am not your attorney and this update does not create an attorney-client relationship. I am licensed to practice law in California and Nevada and have based the information presented on US laws. This blog post is legal information and should not be seen as legal advice. You should consult with an attorney before you rely on this information. Woodsum Law Offices provides guidance to landlords and tenants in navigating the effects of the COVID-19 global pandemic on commercial leases.
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