An unprecedented national debate is raging as vocal proponents of additional government revenue seek significant property tax changes that will be costly to taxpayers.

A recent Michigan Court of Appeals decision in Menard Inc. v. Escanaba (the “Menard decision”), which involved a Menards hardware store in the Michigan Upper Peninsula City of Escanaba, confirms that proponents of greater taxation are masking their true goals with claims that they merely seek equitable taxation. Consequently, it is important for property owners to understand the issues involved.

Typically, property taxes reflect market value rather than a property’s value-in-use, which is the value to the owner. The market value standard bases taxes on the amount the property probably would fetch, after reasonable market exposure, in a sale between two knowledgeable, unrelated parties.

With the exception of the right to appeal under due process, no property tax component is more essential to taxpayers than basing taxation on market value, and not on value-in-use. The market value standard provides a framework for equitable and uniform property taxation.

Market value bases taxes on what is achievable in a market sale, determined through objective information such as comparable sales, rental income, operating expenses, capitalization rates and other market information.

Important distinctions

With market value taxation, a property’s value is unaffected by who owns the property, or whether the owner is able to use the property to operate a successful business. For example, a retailer, manufacturer, or cloud data storage provider may use intangible and tangible property, including real estate, in a way that achieves extraordinary income from business operations. This does not change the market value of the real property used.

In contrast, value-in-use taxation is inequitable and non-uniform. Consider two identical, neighboring residential properties that have the same market value. Their value-in-use would most likely differ, and the differences could be dramatic. The disparity could be because one house has more occupants, or because one property is used only part of the year.

Alternatively, one house could have greater value-in-use because a resident generates significant income from work done while in the home, such as in a home office or studio. Also, when one of these identical properties sells, the property’s value-in-use could substantially increase or decrease.

Those who seek value-in-use taxation might argue that such taxation is equitable because owners who obtain more value from using their properties should pay higher property taxes. But consider some of this position’s enormous failings:

• Most people would readily agree that the most equitable system is one in which all properties are uniformly valued based on their usual selling price, rather than their differing values in use.
• Value-in-use taxation is highly subjective and inherently inequitable. Imagine the problems and disputes if properties were valued based on the value each owner experienced.
• Value-in-use assessment would result in duplicative taxation. If a property is used in conjunction with a business, whether the property is a residence or otherwise, value-in-use property taxation will reflect the business’s income and success. Yet, there will be duplicative taxation where other taxes are imposed on the business, such as income taxes, gross receipts taxes and value-added taxes.

Given the enormous problems with value-in-use taxation, taxpayers could understandably think there is little risk that such taxation would be adopted.

Unfortunately, those seeking value-in-use taxation have shrewdly focused on the taxation of large big-box retail properties, which they claim have been unfairly valued based on sales of vacant properties that allegedly had value-depressing deed restrictions.

The proponents of greater taxation have even tried to divide taxpayers by suggesting that some taxpayers will pay higher taxes because big-box taxpayers are not paying their fair share.

Keys to the truth

Developers build big-box retail properties to the owner’s specific needs, typically with a layout matching the owner’s other stores. Buyers of such properties invariably pay far less than the cost to construct such properties. They do so because they will spend large sums for renovations the new owner desires, in particular to fit a business image.

Also, there is reduced demand for these properties. It’s what appraisers call external obsolescence – especially with growing industry disruption from Internet sales. There are numerous sales of big-box properties without deed restrictions that confirm the selling prices for these properties are low compared with their construction costs.

Notwithstanding these irrefutable truths, the Menard decision held that an assessor could value the property under a cost approach, as if the property had no functional obsolescence. According to the Michigan Court of Appeals decision, a buyer would consider a property suitable for its own needs, merely because the property satisfied the needs of its original owner.

Such reasoning obviously values the property based on its value to the original owner – i.e., value-in-use, not its market value. These principles are the same whether dealing with a non-residential property or a home that has been custom built to an owner’s unusual tastes.

Significantly, the Menard decision specified that value-in-use taxation also could apply to a large industrial property. And a prior Michigan Court of Appeals decision endorsed value-in-use for the headquarters of a financial institution. Once the value–in-use genie is out of the bottle, it can cause above-market valuations and increased taxes for virtually any type of property.

Notably, the pro-government briefs that oppose Menards appeal to the Michigan Supreme Court deny that the decision endorses value-in-use taxation. These denials, like those in the press made by advocates of greater taxation, disregard that the Menard decision itself uses the very words “value-in-use" in endorsing such taxation. It remains to be seen if the Michigan Supreme Court will review the Menard decision, and it could be a year or more before the case’s ultimate outcome is known.

High stakes game

Some in the business community are responding to today’s property tax debate as they would to any intense effort to broadly raise property taxes. Such groups understand what is at stake and are defending market value-based property taxation for all properties.

Yet those who seek higher taxes appear to be strongly united. Whether they succeed in imposing value-in-use taxation may well depend on whether the business community itself will unite to oppose what eventually could become an enormous tax increase.

To paraphrase Abraham Lincoln, a business community divided against itself will inevitably succumb to the united forces that seek greater taxation.