Managing expenses is one of the best ways to ensure the long-term profitability of investment properties, and prudent developers know the importance of carefully monitoring and challenging property tax assessments. But student housing, as a subsector populated largely by tax-exempt educational institutions, presents unique opportunities to minimize taxes for some projects.
Excepting abatements and other local incentives, there are two principal ways to minimize property taxes: The property can be entitled to a statutory tax exemption, or the property can be deemed to have a value of zero dollars. In certain instances, creative structuring can take advantage of these options to improve the developer's cash flow and returns.
Beneficial vs. actual ownership
One of the most potent ways to minimize property taxes is a statutory exemption. For university-owned housing, exemptions will almost always eliminate the tax bill before it arrives in the mail. But what if the property is owned by a private developer, not the university?
Although private ownership by a for-profit entity often sentences real estate to a lifetime of property tax liability, some states disregard formal ownership for property tax purposes, focusing instead on who benefits from the asset. In states adopting this "beneficial ownership" doctrine, the law may treat privately owned properties the same as university-owned real estate, entitling them to exemptions otherwise limited to properties used for educational purposes.
Consider the example of a small private college that wants to develop new on-campus housing, but lacks the resources to borrow the necessary funds to construct the building. Instead, the school contracts with a private developer, which builds the student housing and leases it to the college. The school then operates and maintains the property as student housing, just as it would any other dormitory.
Even though a private developer owns the structure, the benefits of the building go to the college, which may be deemed the beneficial owner of the property. Because the college's intent is not to earn a profit, but rather to support its educational mission by providing housing for its students, the property is exempt.
This structure still allows the developer/owner the right to earn a reasonable return on its investment in the property. This result is logical when one considers that the college's intent is to finance the construction of on-campus housing. If the college financed the construction of a dormitory with a bank loan, the school would not be disqualified from claiming an exemption just because the bank earned a return on its loan.
Precluding profit in this manner would effectively prevent any educational institution from borrowing funds at market rates to finance any construction. Just as the bank is entitled to a reasonable return on its loan, the student housing developer is entitled to a reasonable return on the lease.
Of course, beneficial ownership works in both directions, potentially making an otherwise-exempt property taxable. If university-owned property is leased to a private party who uses it to make a profit, then the property would likely not be entitled to an exemption. Even though the true owner is an exempt educational entity, the beneficial owner is not exempt.
Leaseholds without market value
Even when a property lacks a statutory exemption, however, it will not incur property tax liability if it is deemed to have a negligible market value. An assessed value of zero dollars will always result in zero taxes owed.
A recent case from the West Virginia Supreme Court shows how a new student housing development – or, at least, the developer's leasehold interest in the development – could properly be assessed as having no market value.
In that case, a university leased land to a developer for the purpose of developing student housing with a retail component. The developer constructed the improvements on the leased land at its own expense and transferred title of the new building to the university, which executed a sublease to use the student housing. As the subtenant, the university offered the on-campus housing to students, collecting rent and turning it over to the developer, who then returned 50 percent of the net cash back to the university as a payment on its lease.
The university operated the residential facilities, therefore, while the developer was compensated for constructing the improvements and retained the right to sublease the retail space. The developer's interest in the property was a leasehold.
Because university-owned property is exempt, the university's interest in the property was not taxable. But in West Virginia, leaseholds are taxable real property interests, meaning the developer's interest needed to be assessed. The county assessor concluded that the developer's interest in the property had a value independent from the university's exempt interest, and assessed that interest. The developer challenged the assessment, arguing for a zero value.
The case eventually came before the state Supreme Court, which held that the value, if any, of a leasehold interest is based on whether the leasehold is economically advantageous to the lessee and freely assignable, so that the lessee can realize the benefit of the lease in the marketplace. After all, market value is measured by what the interest could garner if sold on the open market.
If the lease could not be freely assigned to another party, it would have no value in the marketplace. Because the lease was drafted in a way that the assessor conceded was not freely assignable, the Court affirmed that the value of the developer's leasehold interest was zero.
Beware potential pitfalls
The applicability of these strategies to a particular project is fact-dependent. For example, some states, especially those with large amounts of public lands, tax possessory interests. In those states, a government-owned property leased to a private entity can be taxed if the private entity has a "possessory interest" in the real estate. Likewise, privately owned improvements on exempt land can be taxable because the tax is being imposed on the improvement, rather than on the whole property. And assessors eager to increase the tax base can still challenge even the best structuring.
Not all development deals will be ripe for these types of exemption-planning opportunities, nor will all student housing developers find these strategies compatible with their business objectives. Competent tax counsel can help developers weigh the myriad factors that may determine what strategy can deliver the best returns.
But property taxes are one of the largest ongoing expenses of property ownership, so opportunities to minimize their impact on a project's financial results deserve full consideration. With some creativity, developers can improve their own profitability while also helping their academic partners achieve their goals.