Guido I. Piotti
Associate, Stuart Kane LLP
In the iconic 1979 film, "The Warriors," the notorious underworld leader, Cyrus, called a meeting of New York's finest (facetiously speaking) to deliver his famous "can you dig it" speech. In front of a hoard of onlookers, Cyrus shouted from the top of a platform, "Can you count, Suckers?" Cyrus then proclaimed, "I say the future is ours... if you can count!" Who would have thought that Cyrus was actually referring to raising taxes and that simply knowing how to count can affect one's tax liability?
It is well known that a change in ownership of real property will trigger a reassessment of the real property and likely tax increase. Cal. Const. art. XIII A. It is less known, however, that a long-term lease may also trigger a reassessment even in the absence of an actual change in ownership. This is due in part to the way California defines a change in ownership: as "a transfer of a present interest in real property, including the beneficial use thereof, the value of which is substantially equal to the value of [a] fee interest." Cal. Rev. & Tax. Code Section 60; Cal. Bd. of Equal. Prop. Tax Rules, Rule 462.001 (emphasis added). In other words, the use of real property alone may be sufficient under the right circumstances to trigger a reassessment; an outcome that can be avoided in the lease context, if one knows how to count.
For a lease to be treated as a change in ownership and trigger a reassessment there must be a "creation of a leasehold interest in taxable real property for a term of 35 years or more (including renewal options)" or a "transfer of a leasehold interest having a remaining term of 35 years or more (including renewal options)." Cal. Rev. & Tax Code Section 61(c)(1)(A) and (C); Tax Rule 462.100(1)(A) and (2)(A) (emphasis added). The California Legislature selected the lease term of 35 years as the threshold to trigger a reassessment because that is "the length of term generally required for lease financing by institutional lenders and, therefore, approximately equivalent to [a] fee." Gottschalk & Co. v. County of Merced, 196 Cal. App. 3d 1378, 1385-86 (1987) (citing Pope & Ajalat, Proposition 13 Section 2(a): Base years, changes of ownership and new construction (1979) vol. 54, No. 8, State Bar J. 494, 498).
In an age of triple-net leases where a tenant pays for the real property taxes applicable to their premises, why should a real property owner care about a reassessment, if in the end a lease term of at least 35 years is secured? The following is a non-exhaustive list of practical reasons why such a lease should be carefully considered:
1. A reassessment will not only increase real property taxes to a higher level than applicable, but also increase overhead costs for the affected tenant and render the real property less competitive and marketable to future cost conscious tenants;
2. A reassessment could increase real property taxes to less than the entirety of the real property thereby creating more accounting and administrative layers (RTC Section 61(c)(2));
3. The termination of a lease with a term of at least 35 years will trigger a new reassessment (RTC Section 61(c)(1)(B)); and
4. If a lease with an initial term of less than 35 years is terminated without the tenant exercising an "unconditional" renewal option, the real property owner will suffer two reassessments -- one upon executing the lease and one upon its termination -- without having benefitted from a full lease term of 35 years or more. Ibid.
To avoid triggering a reassessment under a long-term lease, many real property owners limit their leases to a term just under the reassessment threshold, inclusive of "unconditional" renewal options. Things get trickier, however, when the lease contains a "conditional" renewal option that, or is amended to, extend the lease term to, or beyond, 35 years from the inception of the lease. Addressing the foregoing requires knowing how to count, but more importantly from where to start counting. Fortunately, the California State Board of Equalization, which county assessors look to for guidance, has addressed these scenarios.
Conditional Renewal Options and Lease Term Extensions by Amendment
An "unconditional" renewal option represents a binding creation of a leasehold interest and is counted towards the reassessment threshold from the inception of the lease because, at the time of its execution, the right to control the length of the lease term at some future date is vested. BOE Annotation 220.0350 at 2 (February 18, 1999). Conversely, a "conditional" renewal option, albeit set forth in the lease, does not represent a binding creation of a leasehold interest and is not counted towards the reassessment threshold from the inception of the lease because, at the time of its execution, no right to control the length of the lease term at some future date is vested; such right does not vest, may not be exercised by the tenant, and is not binding on the real property owner, unless and until the "condition" giving rise to that right and obligation occurs (Ibid.), if it occurs at all.
Accordingly, a "conditional" renewal option will not satisfy the first element necessary to trigger a reassessment -- the creation or transfer of a leasehold interest -- and will not be counted towards the reassessment threshold, unless and until the specified "condition" occurs. Ibid. When the "condition" for the renewal option does occur, the length of time added by that renewal option will then be counted towards the reassessment threshold (Ibid.), and at such time a reassessment may occur. For this same reason, the time added to a lease term by amendment will also not be counted towards the reassessment threshold until such time as the amendment is executed by the tenant and real property owner. RTC at Sections 61(c)(1)(A) and (C); see also Tax Rule 462.100(1)(A) and (2)(A).
How to Count
Once a "conditional" renewal option vests or a tenant and real property owner execute an amendment to extend a lease term, it becomes important to know how to count, but more importantly from where to start counting. Both the "conditional" renewal option and the amendment to extend a lease term do not per se create a new, or transfer an existing, leasehold interest. This raises the question whether the new additional time should be added to the entire lease term from the inception of the lease or to the lease term that remains to determine if the augmented lease term will reach or surpass the reassessment threshold.
For "conditional" renewal options, the BOE stated that, "the lease term should be computed by adding the term of the conditional option to the lease term remaining at the time the condition occurs, rather than to the entire original term, because, as discussed above, [conditional] options are included only when they become effective and subject to exercise by the lessee." BOE Annotation 220.0350 at 2 (emphasis added).
The BOE reached the same conclusion on lease extensions by amendment, but went even further by concluding that, "there cannot be a change in ownership as long as the remaining lease term plus any renewal or extension options which have been granted to the lessee amount to a period of less than 35 years. Thus, a lessor with property under a lease with 29 years remaining on the term may grant a new five-year extension to the lessee once every five years, indefinitely, and there will never be a change in ownership under existing rules. These conclusions are based upon the provisions of the Revenue and Taxation Code and property tax Rule 462." BOE Annotation 220.0337 at 1-2 (emphasis added).
Based on these two opinions, the BOE has made it clear that neither a "conditional" renewal option nor an amendment to extend a lease term will be counted towards the reassessment threshold respectively until the specified condition occurs and the date of the execution of the extension amendment. In both instances the BOE has further determined that the additional time will be added to the remaining lease term when determining if the augmented lease term will reach or surpass the reassessment threshold, and that in the case of an extension amendment, the process may be repeated in perpetuity without causing a reassessment of the real property, so long as the combination of the extension and remaining lease term does not exceed or surpass the reassessment threshold.
For tenants and real property owners seeking to enter into long-term leases, these opinions offer an opportunity to do so without the fear of triggering an unnecessary reassessment. An attorney should be consulted, however, to carefully structure such a lease to avoid violating the parameters laid out by the BOE.
In the words of Cyrus, "Can you dig it?!"