35 Years Can Be Taxing on A Landlord: The California Property Tax Implications of Leases of 35 Years Or Longer

By: Jeremy Gruber

Introduction

Under California law, real property is taxed annually at a maximum of 1% of its assessed value.  Unless and until a “change in ownership” occurs, annual increases on a property’s assessed value are capped at 2%.  However, when a “change in ownership” occurs[1], except in the case of certain excluded transactions, the property is reassessed, and its assessed value for tax purposes is adjusted to reflect the property’s current market value.[2]  While one might think that a “change in ownership” only includes a conveyance of the fee interest in a property, California law provides that certain leasing transactions (including, among other things, the entering into of a lease with a term of 35 years or more including options) constitute a “change in ownership” for property tax purposes.  Accordingly, in addition to the host of other economic factors considered by landlords in evaluating the economics of a potential lease transaction, California landlords should be aware of potential property tax implications and include them in the analysis. 

Certain Lease Transactions Can Trigger Reassessment

Section 60 of the California Revenue and Taxation Code 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 the fee interest.”  In the leasing context, pursuant to Section 61(c) of the Revenue and Taxation Code and Property Tax Rule 462.100, unless an exemption applies, a “change in ownership” occurs upon the creation of a leasehold interest for a term of 35 years or more (including renewal options), the termination of a leasehold interest which had an original term of 35 years or more (including renewal options) and any transfer (including subleases and assignments) of a leasehold interest having a remaining term of 35 years or more (including renewal options).  Additionally, the Board of Equalization has stated that the extension of a lease with an original term (including renewal options) of less than 35 years to a term of more than 35 years would constitute a “change in ownership” triggering reassessment; however, the Board of Equalization has also stated that the extension of a lease which had an original term of more than 35 years, but has a remaining term of less than 35 years, such that the new term is greater than 35 years, does not constitute a “change in ownership”.  In the event a lease transaction triggers a reassessment, only the leased premises is reassessed, so a “change in ownership” resulting from a lease to a tenant in a shopping center will not trigger a reassessment of the entire shopping center.  California law requires that the transferee (in the leasing context, the tenant) file a change of ownership statement in the county where the property is located at the time of recording or, if the transfer is not recorded, within 90 days after the change in ownership. 

Accordingly, under California law, a lease of 35 years or more actually results in two “changes in ownership” (and triggers two reassessments) – one upon the entering into of the lease, and one upon its termination.  Additionally, in the event a landlord enters into a lease of 35 years or more and the tenant assigns its interest in the lease or subleases the leased premises at time when there are 35 years or more remaining in the lease term, that assignment or sublease constitutes a “change in ownership” and triggers a reassessment.

Managing the Property Tax Consequences of Lease Transactions

Likely the best way for a landlord to avoid triggering a reassessment in connection with a new lease is to limit the lease term (with renewal options) to less than 35 years; we are seeing many leases entered into with original terms (including renewal options) of 34 years 11 months.  As noted above, even if the original term (with renewal options) is less than 35 years, an extension of the lease term to longer than 35 years can trigger a reassessment, but such extensions are likely to happen toward the end of the lease term, meaning that the landlord will likely have avoided reassessment for a good amount of time. 

If a landlord is negotiating a lease for a term of 35 years or more (including renewal options) and there are contingencies in the lease, then the landlord should attempt to include language in the lease providing that the tenant may not file a change of ownership report until the contingencies are satisfied (provided that the contingency period is within the statutory period for filing a change of ownership report), such that, in the event the lease is terminated, the property is not reassessed.  However, if a memorandum of lease is being recorded in connection with the lease, the assessor is likely to find out that a change of ownership has occurred shortly after the memorandum is recorded.

As noted above, a change in ownership occurs when a tenant assigns its interest in a lease or subleases the leased premises at a time when the lease has a remaining term of 35 years or more.  If a tenant proposes to assign its lease or sublease the leased premises under such circumstances, a landlord should analyze whether consequences of a reassessment would outweigh any benefits the landlord may reap as a result of the assignment or sublease, and if so, the landlord should refuse consent to the proposed assignment or sublease (to the extent the landlord has the right to refuse consent under the lease).

Regardless of whether they may be able to avoid reassessment, landlords should be aware of the lease transactions that trigger reassessment and take the consequences of reassessment (and the benefits of avoiding reassessment) into account when they evaluate the economics of a potential lease or extension. 

Avoiding unintended property tax reassessments like those discussed above can be difficult and typically require careful planning at the early stages of lease transactions.  For advice on the foregoing or other issues, please feel free to contact us.