Commercial property owners can maximize returns by minimizing property taxes, writes J. Kieran Jennings of Siegel Jennings Co. LPA.

Investing should be straightforward—and so should managing investments. Yet real estate, often labeled a "passive" investment, is anything but. Real estate investment done right may not be thrilling, but it requires active management, particularly in controlling one of the largest ongoing expenses, property taxes.

In recent years, the real estate industry has faced numerous challenges that harbored opportunities for savvy investors. From the COVID-19 pandemic and interest rate spikes to the work-from-home trend and increased vacancies, these disruptions were not just problems to solve—they were openings to reassess strategies, particularly regarding property taxes. Investors who seized these moments to reduce their tax burdens likely reaped significant benefits.

Consider the advice of the late judicial philosopher, writer and judge Learned Hand, who famously said: "Anyone may so arrange their affairs that their taxes shall be as low as possible; they are not bound to choose that pattern which will best pay the Treasury. There is not even a patriotic duty to increase one's taxes."

For real estate investors, this principle underscores the importance of addressing their largest tax expense: annual property taxes. These taxes not only erode returns year after year but can also negatively affect refinancing terms and eventual sales prices.

The best time to act? Now

Opportunities to reduce property taxes arise from shifting markets, new tax laws, court decisions, and even turnover among local assessors and prosecutors. Staying proactive means regularly reviewing these factors to determine whether each new assessment warrants a challenge.

To illustrate how market conditions and legal frameworks create opportunities, consider the following scenarios. Although these are hypothetical, they derive from true situations and case histories.

Tax is for tangibles: Soon after an investor purchased a hotel in Florida four years ago, the local assessor valued the property at 80 percent of its purchase price—a reasonable valuation for tax purposes at the time. Recent case law casts that value in a different light, however. Assessors must now exclude intangible business value, which can constitute up to 50 percent of a hotel's total value, from property tax liability. Ensuring the assessor valued their property correctly under the new directive enabled the subject property's owner to achieve a substantial reduction in the hotel's taxable valuation, saving tens of thousands of dollars annually.

Interest rates reconsidered: A multifamily complex acquired in 2021 was assessed at 90 percent of its purchase price. Although the owners had secured favorable interest rates at the time of acquisition, the taxpayer was still able to obtain a 30 percent assessment reduction in 2023. How? By citing the impact of rising interest rates on market conditions, which had suppressed property values due to buyers' increasing cost for debt financing. This assessment reduction helped improve the owners' cash flow and property valuation during refinancing negotiations.

Advanced to obsolescence. A newly constructed industrial facility in Ohio built to serve a rapidly developing industry faced obsolescence challenges as the needs of its intended tenant base changed in the evolving subsector. Under Ohio law, such properties are classified as special-use and must be assessed based on value to the user. The owners demonstrated significant economic obsolescence, effectively reducing the property's valuation. Additionally, the owners showed that many fixtures the assessor had initially included in the valuation were personal property. With strict adherence to legal definitions in revisiting the assessment, the assessor excluded the personal property from taxation. Understanding the legal definitions of assessable property and providing evidence of obsolescence enabled the owners to achieve meaningful tax savings.

These three examples highlight how market shifts and legal precedents create opportunities to lower tax burdens, even when the immediate need for action isn't obvious.

How to recognize a fair assessment

The methods for determining whether a property is fairly assessed depend on local and state laws, which vary widely and change frequently. Staying informed requires continuous monitoring of tax laws and local tax authority practices.

A taxpayer or tax advisor determined to stay current on local tax conditions should be sure to follow three key steps as part of their inquiries:

1. Understand local laws and definitions. Assessors calculate fair market value based on jurisdiction-specific guidelines.
2. Identify potential exemptions. Elements such as business fixtures might be reclassified as personal property and excluded from taxation.
3. Evaluate risks. Be aware that challenging an assessment involves risks, which can range from minimal to significant, depending on local laws and circumstances.

Combining a thorough understanding of jurisdictional laws with an analysis of property-specific facts is critical. This approach ensures taxpayers know what evidence to produce and will know when they're being fairly assessed.

The bottom line is that commercial property owners must exercise vigilance, expertise and a proactive mindset to manage their property taxes effectively. By viewing challenges as opportunities, property owners can minimize expenses, maximize returns, and protect the long-term value of their assets. Regardless of whether an assessment appeal requires an attorney, thinking like a lawyer will yield dividends.

Highest and best use analysis can be a key to reduced property tax valuations, observes Timothy A. Rye of Larkin Hoffman.

Ad valorem property taxes reflect real estate value, and in most states, assessors value a subject property at market value based on its highest and best use. Although assessors often assume the current use is highest and best, taxpayers who analyze their property's usage may discover an opportunity to reduce their assessment by showing its optimal use has changed.

What is highest and best use?

Highest and best use is the "reasonably probable use of property that results in the highest value," according to the Dictionary of Real Estate Appraisal, 6th Edition. Along with that definition the publication includes four criteria the highest and best use must meet, requiring that the use be legally permissible, physically possible, financially feasible, and maximally productive.

For property tax valuation, assessors, appraisers and property tax attorneys need to consider each factor in a highest-and-best-use analysis. For most properties, determining whether the current use is legally permissible or physically possible is easily ascertained by answering the question, "Can the property do what it is doing?"

Determining whether a use is financially feasible or maximally productive is trickier. Financial feasibility of the current use may be as simple as identifying whether the property generates a positive net operating income, or if it would be cost prohibitive for the user to replace the space with an alternative property.

The analysis gets more complicated when trying to determine whether the use is maximally productive.

Take the example of an aging office building with declining occupancy. Should the owner invest money in building improvements with the goal of attracting more tenants, or is it better to vacate the building and convert it to multifamily use?

In this example, the first option would require a discounted cash flow analysis that considers an extended period of renovations, tenant improvements, vacancy loss during lease-up, and leasing commissions. In other words, the building would be valued as though it were stabilized at some point in the future, the costs associated with achieving stabilization would be deducted, and the future value and investment costs would be present valued to the valuation date.

Alternatively, the property could be valued like a new development with the projected use as multifamily. Whichever use has a greater value in today's dollars is the winner, or maximally productive use, and therefore the highest and best use.

The tipping point

When does a property's current use stop being its highest and best use? It could be when new development is in high demand and buyers will pay more for the land alone than they will for the property with existing structures.

It could be when the property is losing tenants and accumulating significant vacancy. The market sees the building as less appealing, and the remaining tenants start looking for more vibrant properties. Or it could be when the building is simply worn out and the cost to fix or restore it is greater than its value would be after repairs.

Every property will have its own unique set of circumstances to signal the practical end of its current use, but once a usage starts to tip, it seldom comes back. When the tipping point arrives, the highest and best use changes, and can have a profound impact on valuation.

Usage drives taxable valuation

When a property's current use is no longer highest and best, the property tax valuation likely should change too. While property tax assessments are generally based on the highest and best use, the mass appraisal techniques assessors employ to value properties are unlikely to incorporate highest and best use changes. The volume of properties assessors must value is simply too large to include individual highest and best use analyses.

As a result, it is up to taxpayers and their property tax counsel to identify when the highest and best use has changed and bring it to the assessor's attention, either informally or through a property tax appeal. In preparing arguments for such a meeting, remember that valuations based on highest and best use require data reflecting the highest and best use.

For example, if an office building is no longer viable as an office, but rather its highest and best use is conversion for multifamily residences, then the comparable sales should comprise sales of buildings that are also facing a change to multifamily. Using sales of stabilized office buildings as comparable sales would result in improper valuation of the subject property hypothetically stabilized with office tenants, rather than pursuant to its actual highest and best use.

Commercial real estate markets are experiencing significant changes, straining many property operations and owner cash flows. As a result, it is critical to carefully analyze highest and best use when reviewing property tax assessments.

Jaye Calhoun and Divya Jeswant of Kean Miller LLP on an assessment strategy that may help you trim your property tax bill.

Few states impose property tax on intangible assets such as a trade name, franchise, goodwill and the like. Indeed, some office buildings, industrial properties and big-box stores don't derive significant value from intangibles in the first place.

Intangibles are a significant income generator for many hotels, casinos, restaurants and other properties, however. For these assets, assessors are required to identify and exclude the value attributable to those nontaxable intangibles. The proper method to do so has been the subject of much debate.

Fortunately for taxpayers, recent case law is helping to clarify best practices for isolating and removing value attributable to intangibles from commercial assessments. By following the examples of taxpayers who have successfully applied alternative approaches, property owners across the country may be able to exclude a larger portion of overall property value as intangible and, in turn, lower the property taxes on their business real estate.

Scaling Rushmore

Although some assessors persist in applying the cost approach, most valuation professionals consider the income approach most appropriate for valuing income-producing properties. That is because a property's past, present and future or projected income inevitably impact its valuation.

Many assessors have traditionally applied the "Rushmore Approach" to exclude the value of intangibles from an income-based valuation. This essentially deducts management and franchise fees from a property's net income, treating those amounts as a proxy for the value of intangibles.

Many taxpayers reject the notion that the Rushmore Approach can account for the full value of intangibles. Some of these property owners and their appraisers have countered with the "Business Enterprise Approach," which seeks to remove the often significantly higher revenue generated by intangible assets. This approach is sometimes called the "Income-Parsing Approach" because it requires going-concern income attributable to intangibles to be parsed and stripped from taxable property income.

A spate of decisions over the last few years, particularly concerning hotel valuation, has created a growing momentum favoring the Business Enterprise Approach. Taxpayers should be aware of the potential for significant tax savings with this approach.

Business enterprise successes

The most significant recent cases in which taxpayers successfully argued for using the Business Enterprise Approach are in two states known for high property taxes: Florida and California.

The first is Singh vs. Walt Disney Parks and Resorts U.S. Inc., a 2020 case dealing with the valuation of the Disney Yacht & Beach Club Resort adjacent to Epcot. A Florida appellate court categorically ruled that the Rushmore Approach fails to remove all intangible business value from an assessment. The court was simply unconvinced by the assessor's arguments that deductions for franchise and management fees can remove the entire intangible business value.

Another encouraging decision occurred in 2023, SHR St. Francis LLC vs. City and County of San Francisco. A California appeals court considered various income streams of the Westin St. Francis hotel, including its management agreement, income from cancellations, no-shows and attritions, in-room movies, and guest laundry services.

The court held that it was insufficient to simply deduct the management fees because income from a nontaxable, intangible asset like a management agreement should include both a "return of" and a "return on" that asset. In other words, the owner would expect to generate a profit, or income-based value over and above the cost of the management agreement. The court found that the assessor failed to present evidence that the management agreement's value did not exceed management fees.

In dealing with the remaining items, the court drew a dividing line between "intangible attributes of real property" that merely allow the taxable property to generate income (cancellations/no shows/attritions) and are therefore includible vs. "intangible assets and rights of the business operation" utilizing the real property. These latter assets and rights, including in-room movies and guest laundry services, relate to the intangible business operation and are, therefore ,excludible from income-based, taxable property value.

Another widely reported decision from 2023 is Olympic and Georgia Partners LLC vs. County of Los Angeles. The appellate court in this case pointed out a key flaw in the Rushmore Approach. That it is unlikely the deduction of franchise and management fees could fully account for the value of intangibles because no owner would normally agree to fees "so high as to account completely for all intangible benefits to a hotel owner."

Half Moon Bay legacy

Several recent decisions cite SHC Half Moon Bay LLC vs. County of San Mateo, a 2014 California case involving the Ritz Carlton Half Moon Bay Hotel's workforce, leasehold interest in the employee parking lot, and agreement with a golf course operator. The appellate court explicitly acknowledged that the deduction of management and franchise fees from the hotel's projected revenue stream did not properly identify and exclude intangible assets.

Taxpayers throughout the country have successfully made these same arguments. In 1300 Nicollet LLC vs. County of Hennepin, a Minnesota court in 2023 took stock of case law across the country and observed that although the two methods have been competing for 20 years, there is an emerging preference for the Business Enterprise Approach and increasing skepticism of the Rushmore Approach.

Some states such as New Jersey continue to rigidly administer the Rushmore Approach, while other states consistently uphold the Business Enterprise Approach, at least in recent years. Yet other states view both methods as potentially reasonable for an assessor to apply; some of those cases may have more to do with the standard of proof during appellate review. There are also states such as Louisiana in which the issue is yet to be dealt with judicially, arguably giving taxpayers an opportunity to get ahead of the curve.

Clearly, taxpayers and their commercial appraisers should determine whether the assessor has properly excluded maximal value for intangibles in valuing their income-producing properties for property tax purposes. In particular, appropriately applying the Business Enterprise Approach can generate significant property tax savings on commercial real estate and may be worth pursuing.

Spencer Fane's Michael Miller on the critical steps for finding tax relief.

This is a challenging time in the property tax world. Pandemic-era federal assistance programs have dried up, increasing communities' appetite for tax dollars to deal with crime, homelessness, transportation and other issues. Recognizing that inflation has put taxpayers under pressure, governments may offer tax relief to homeowners, their voters, but not to the commercial property owner.

In Colorado, a November ballot issue would reduce the valuation of a residential property by $40,000 and of a commercial property by $50,000. This will be little help to an owner of a $2 million commercial property.

Relief for the commercial property owner must instead come from a deep dive into the assessor's valuation, best performed by the property owner and an experienced property tax professional working as a team. What follows are key stages for preparing an appeal.

1. Understand and observe all filing deadlines.

Every state has a deadline for starting the appeal process. If a taxpayer misses that deadline, they lose the right to appeal. In some states, after paying their tax, a taxpayer might be allowed to file for an abatement sometime later.

It is important to provide the property tax professional with relevant information in sufficient time to analyze it before filing the appeal. This is a challenge in many cases, such as when the taxpayer receiving tax notices is out of state and their advisor is local. Contacting the advisor before tax notices go out can provide a head start, often enabling the advisor to find the property's taxable value before the notice arrives.

2. Critically analyze the assessment basis.

By itself, a substantial value increase does not qualify as a reason to appeal. Often, the assessor will justify the increase based on the general market strength shown in substantially rising prices. The taxpayer must ask, is this for the entire county, or for this specific type of property in this specific location?

A recent example illustrates how assessors' generalizations can overstate an individual property's value change. As our firm appealed a client's assessment in an expensive resort area, the local newspaper quoted the assessor stating that prices had increased 50% or even more. Available sales of comparable properties all occurred at least a year prior to the valuation period, while one was near the valuation period.

The assessor trended the earlier sales to the valuation period by making a 50% adjustment to each sales price. However, our team compared the most recent year-ago sale with the current sale of a comparable property in the same location, showing that the price per square foot only went up 14%. It was clear the 50% increase was a mass appraisal number covering the entire county, while prices in the subject property's submarket increased at a much slower pace. This deep dive yielded results in the appeal.

3. Analyze the assessor's comparable sales.

Most jurisdictions require assessors to value the fee simple estate, the real estate alone. Assessors have attempted to debate what this means, but what it clearly does not mean is a sale price based upon the income generated by a lease. Nor can the taxable value be based on the success of the business operated from the property.

Simply stated, fee simple value must be limited to the real estate, not the business. When applying this to an owner-occupied property, this means a fee-simple buyer would be purchasing a vacant property. Value is based on the price at which a willing buyer would buy, and a willing seller would sell, the property. And in the sale of an owner-occupied property, there is no lease.

Often in this situation, the assessor will nevertheless use the sale of a leased property as a comparable. It is not comparable, because the buyer is buying the income stream from the lease, not just the bricks and mortar. Moreover, the rent seldom reflects current market rent. Possibly the lease was signed when rents were higher than today, the lease escalated rents automatically, or the landlord agreed to build the property according to the tenant's specifications and increased the rent by the amortized cost. Every lease is unique. The sale of a leased property is simply not the same as the sale of a property without a lease.

While examining income properties within the assessor's comparable sales, be sure to analyze the income's source. Taxable values of income-producing properties are based on income derived from the real estate and not income derived from other sources.

A hotel buyer, for example, is buying not only the bricks and mortar, but also the flag or brand, and the hotel's reputation. These are intangibles included in the acquisition price. However, intangible value is not subject to a property tax.

Another example of this concept is seniors housing. Seniors housing has numerous profit centers beyond rent for the room. It may have a beauty shop, a physical therapy center, a recreation facility such as a bowling alley, special medical services and many other offerings. The resident pays rent, but also pays extra for the many services. For property tax purposes, the income used to determine value must be separated between business cashflow and income generated from the real estate.

Property tax in the current environment can indeed present a challenge, but it need not be overwhelming. The taxpayer must analyze the assessor's value in depth to find factors that would result in a successful appeal. It may start with sticker shock over the assessor's notice, but an experienced tax professional's analysis can level the playing field between the assessor aggressively pursuing increased funding and the property tax owner looking for tax relief.

Attorney Molly Phelan on how to reduce property tax liability.

Office property owners may feel they are getting squeezed from all sides in 2022, but the right strategy can help them turn lemons into lemonade by reducing property tax liability.

The Bad News: Inflation was up 7.1 percent year over year in December, its highest rate since 1982.

The Culprits: Supply chain issues (raw material shortages, seaport congestion and logistic limitations), labor shortages (general wages up 5 percent, retail wages up 15 percent), and a housing shortage (national apartment vacancy at 2 percent and average rent growth above 15 percent year over year).

The Response: The Federal Reserve signals a shift to tightening monetary policy, indicating future interest rate increases.

The office market is facing headwinds of its own. Numerous corporations have announced permanent shifts to hybrid in-person/work-from-home operations for office staff, significantly decreasing demand for office space. Rental rates have dropped anywhere from 5 percent to 33 percent during the pandemic, depending on market and class. Although Manhattan rents for Class A space have increased 2 percent in the past year, the net operating income for these properties is down 7 percent due to increased costs and lease concessions.

In the Midwest, office landlords previously expected to provide one month of free rent per year to woo tenants. Now brokers are reporting a free rent ratio of 1.6 months per year, with leases over 10 years pushing two months per year. Tenant improvement costs have increased approximately 44 percent since the beginning of the pandemic, and turnaround time for occupancy has increased from 30 days to 60 days.

Farther down the balance sheet, things aren't much better. Energy prices tracked in the S&P Goldman Sachs Commodity Index ended 2021 59 percent higher than in the beginning of the year. Labor costs, from janitorial staff to property managers, have increased as well.

The Good News: Although the market has handed office landlords a bucket of lemons that are putting downward pressure on average net incomes, landlords can make lemonade from this data to significantly reduce their real property tax liabilities, even if their NOI has not yet taken a hit.

The Strategy: Pivoting from a direct capitalization value analysis to a discounted cash flow approach can capture the effects of investor outlook data on a property's market value. Appraisers and assessors who value office properties typically figure direct capitalization in their income analysis to estimate fee simple market values. This is standard practice in stabilized markets but is a poor fit to current conditions.

With the dramatic changes and uncertainty in the office market, appraisers should be conducting discounted cash flow analyses, which identify the market conditions investors are anticipating as of the valuation date. The DCF analysis examines the market like an investor would, considering trends such as rental rate reductions and increases in operation costs and vacancy. These factors are then built into pricing models.

Savvy investors are aware of a sleeping giant that few assessors or taxpayers are identifying, and that is shadow vacancy. While landlords are still collecting income on current leases, there is no reflection of the market's precarious situation in their income. A DCF, however, identifies upcoming vacancy and reductions in market rents, which may have a significant effect on NOI.

Methods Compared

Let's compare the two approaches, beginning with a look at direct capitalization applied to a 500,000-square-foot office complex. As of Jan. 1, 2022, its tenants are paying $25 per square foot in net rent, or a maximum $12.5 million in annual attainable rent. Stabilized vacancy is 8 percent and operating expenses are 20 percent, or $2.3 million annually. A capitalization rate of 6.5 percent indicates a market value of $141,538,462. In Illinois, outside of Cook County, an assessment level of 33.33 percent and a tax rate of 5 percent equates to a tax liability of $2,358,738.

Paired with the estimated increases in interest rates as indicated by the Federal Reserve, the cap rate could easily increase to 7.5 percent for the specific property. The DCF analysis using these factors indicates the market value is $102,120,000 and the taxes are reduced to $1,701,830. The difference in tax liability is $656,909, or a reduction to the tenants of $1.31 per square foot in tax pass throughs.

Commercial real estate investors across the board rely on the discounted cash flow model, but few taxpayers or their advisors use the strategy in contesting property assessments. Given the additional information and analysis required to perform the analysis, not all appraisers can properly construct a credible discounted cash flow model.

For success, it is critical that both the taxpayer's advisor and appraiser be able to knowledgeably discuss the differences between the two models, and in an assessment appeal, be able to explain why the discounted cash flow model is a more reliable methodology in this market.

To remain competitive, landlords must reduce occupancy costs for tenants and their own holding costs as they take back more vacant space. Even if an assessment has been lowered or remained stable over the past few years, having a credible team provide an alternative view can offer a competitive advantage moving forward.