Real Estate Law

Commercial Landlords and Long-Term Leases

As a commercial landlord, the idea of entering into a long-term lease with a stable client can be a dream come true. For the buyer of commercial real estate, the existence of a tenant with a long-term commitment to the property is a significant factor in determining whether to make an offer to purchase this property and at what price. While an owner and a potential buyer may assume that an existing long-term lease is an ideal situation for both, in setting the seller’s price and determining the buyer’s offer, both parties need to take into account whether such transaction is considered a “change in ownership” with reference to Proposition 13 and whether a property tax reassessment will occur as a result of the transaction. 

As a result of the 1978 voter initiative commonly known as Proposition 13, the government can reassess the value of real property for taxation purposes after a “change in ownership” of the property. Under the statutes implementing Proposition 13, whether the transfer of a lessor’s interest in taxable real property results in a change in ownership generally depends on the length of the remaining lease term at the time of the transfer. If the remaining term of the lease is less than 35 years, then for purposes of Proposition 13 there’s a change in ownership. If the remaining term of the lease at the time of the transfer is 35 years or more, then for Proposition 13 purposes, there’s no change in ownership because of the lessee’s long-term interest in the property. 

Unfortunately, Proposition 13 skipped the vital step of defining the term “change of ownership” and as such, the California Legislature was called upon to fill this void, which it did by passing California Revenue & Tax Code Sections 60, 61, and 62.

Revenue & Tax Code Section 60 sets forth a general test with reference to whether a change of ownership has occurred: “A ‘change in ownership’ means 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.” Revenue & Tax Code Section 61 identifies several specific transactions deemed to be a “change in ownership,” while conversely, Revenue & Tax Code Section 62 identifies several specific situations deemed not to be a “change in ownership.” Believing that lay assessors and taxpayers would otherwise have difficulty applying legal concepts such as “beneficial use” and “substantially equivalent,” the “statutory examples” in Revenue & Tax Code Sections 61 and 62 were designed to elaborate on common transactions. Thus, common types of transfers were identified and concrete rules for them were set forth in Sections 61 and 62.

So how does the existence of a long-term lease play into whether a change of ownership has occurred for the purpose of reassessing the tax basis for the property?

Under Revenue & Tax Code Section 61(c)(1)(A), “[T]he creation of a leasehold interest in taxable real property for a term of 35 years or more” effects a change in ownership. As explained by the California Supreme Court, “The Legislature decided, following the task force’s recommendation, that the creation of a 35-year lease would achieve a change in ownership (Section 61, subd. (c)(1)) because the length of the lease would give the lessee’s interest some of the practical attributes of a conveyance of fee simple.” (Pacific Southwest Realty Co., supra, 1 Cal.4th at p. 165, 2 Cal.Rptr.2d 536, 820 P.2d 1046.) 

The termination of a leasehold interest with an original term of 35 years or more is also a change in ownership, as is a “transfer of a leasehold interest having a remaining term of 35 years or more.” (Revenue & Tax Code Section 61(c)(1)(B)&(C).)

Under Revenue & Tax Code Section 61(c)(1)(D), “[A]ny transfer of a lessor’s interest in taxable real property subject to a lease with a remaining term … of less than 35 years” is a “change in ownership, as defined in [S]ection 60.” Conversely, under Revenue & Tax Code Section 62(g), “[A]ny transfer of a lessor’s interest in taxable real property subject to a lease with a remaining term … of 35 years or more” is not a “change in ownership.”

While the standard commercial lease requires the tenant to reimburse the landlord for all or a representative position of the property taxes incurred by the landlord through the common area maintenance fee, hitting a long-term existing tenant with a sudden and unknown increase in the dollar amount of the reimbursement can lead to uncomfortable results and issued between the landlord and the tenant.