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Property Tax Resources

Feb
27

Tax Trap: Don't Overlook Occupancy in Property Assessments

Assessors too often value newly constructed apartments as fully occupied, producing excessive assessments.

Developers frequently ask how to estimate property taxes on newly constructed multifamily properties, and tax assessors often provide an easy answer by adding up the value of building permits or by projecting the project's value when fully rented. However, this seemingly simple question grows complex when the assessor's valuation date precedes full occupancy and the ramifications of a wrong answer can linger for years.

Consider these points to value a new multifamily project more accurately.

Valuation Methods

Charged with valuing hundreds or thousands of parcels, assessors often seek a quick way to value a new multifamily project.

The cost approach offers the quickest and easiest route for the assessor, who estimates the current expense to construct an identical structure. One way to do this on a new project is to add the value of the building permits to the land value.

While building costs are clearly a factor in the decision to build, the cost approach ignores the market preference to value income-producing projects based primarily on income.

The assessor's second-easiest option is to rely on an appraisal's stabilization value and ignore the time and cost required to achieve stabilization. In valuing a not-yet-built multifamily project using an income approach, appraisers preparing a financing appraisal should, but don't always, calculate two different values: the "at completion" value and the "stabilized" value.

"At completion" is the project's value when construction is complete but prior to being fully leased. The prospective market value, or "as stabilized," reflects the property's projected market worth when, and if, it achieves stabilized occupancy.

The Dictionary of Real Estate defines stabilized value in terms of the expected occupancy of a property in its particular market, considering current and forecast supply and demand, and assuming it is priced at market rent. To determine a property's fair market value prior to stabilization, one must account for the monetary loss the owner will incur prior to stabilization.

Development Issues

Improvements generally trigger reassessment. The assessor's statutorily mandated valuation date generally ignores the development calendar's key milestones, most importantly the construction commencement, completion and revenue stabilization dates.

The developer makes assumptions during the development process, calculating the cost of building and operating the improvements as well as the rents that can be achieved. This calculation serves as the basis for a pro forma of an income and expense analysis of the project when fully leased.

Construction loans reflect building costs and subsequent time and money needed to achieve full lease-out or stabilization. Banking regulations require the lender to obtain an appraisal. The completed, but not yet stabilized, project incurs costs in the form of income not received during initial leasing, until it reaches stabilization.

Permanent financing depends on the stabilized value, which, in turn, depends on the project's income. Appraisals for permanent loan commitments obtained prior to the project's completion use a prospective valuation date and must contain various assumptions as to the property's financial condition on that prospective date.

The FDIC's Interagency Appraisal and Evaluation Guidelines authorize using a prospective market value in valuing a property interest for a credit decision. The Uniform System of Professional Appraisal Practices requires disclosure of assumptions in an appraisal with a prospective market value, as of an effective date subsequent to the appraisal report's date.

Assumptions regarding the anticipated rent at stabilization and the time required to lease the property are key to calculating stabilized value. Also critical are incentives the owner may offer prospective tenants during lease-up, and the project's projected income once fully leased. The appraisal should clearly disclose these assumptions, but they can still prove incorrect.

Clear disclosure of assumptions is critical. Unfortunately, many appraisers fail to adequately disclose their assumptions, and shortcut to the project's stabilized value.

Valuation Dates

Most state statutes prohibit taxation of improvements while under construction. The project usually comes on line for tax purposes after completion but prior to stabilization.

Being mandated by statute, the valuation date often does not account for where the multifamily project is on the spectrum between completion and stabilization. Unsophisticated assessors charged with valuing these projects often employ mass-appraisal techniques and may value the asset similarly to the market's stabilized properties.

Statutory Caps

Some states cap potential increases in tax value, which may magnify impact of the initial tax valuation. Caps limit increases that would otherwise bring values up to the market. For example, South Carolina properties undergo countywide reassessment every five years, but property values ordinarily cannot increase by more than 15 percent from the previously determined value.

Assessors know that a project's value at completion will nearly always be lower than its stabilized value because stabilization takes time and costs money. Competition may lower the project's achievable income, too. This knowledge can spur assessors to reach for stabilized values regardless of whether the project is yet stabilized. This taxes the unrealized, additional value between completion and stabilized levels.

A Matter of Time

All of the above considerations involve a timing disconnect between the property's actual condition on the statutorily mandated valuation date and its estimated future value based on fallible projections by the lender, developer or assessor. Axiomatically, assumptions don't always hold true. Lease-up may take longer than expected and may require concessions that increase cost. In over-built markets, the stabilized income may be lower than originally anticipated.

Charged with calculating true or fair market value as of a statutorily mandated valuation date, the assessor should examine how the market would value the property as of that date. If the asset has not achieved stabilization, the assessor should discount appropriately for time and financial costs required to achieve stabilization.  That is what the market would do, and is what the assessor is statutorily obligated to do.

And that should be the answer to the seemingly simple question of how to value newly constructed multifamily projects for tax purposes.

Morris Ellison is a partner in the Charleston, S.C., office of the law firm Womble Bond Dickinson (US) LLP. The firm is the South Carolina member of American Property Tax Counsel, the national affiliation of property tax attorneys.
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Feb
22

Snakes In The Property Tax Woodpile

Real estate acquisitions and improvements harbor traps for the unwary taxpayer.

Estimating the costs of purchasing or improving real proper ties may seem a simple exercise. However, tax traps await owners who are unaware of the dangers to avoid or otherwise veer off the trail. Prudent investors will be alert to the hidden tax snakes inherent in real estate decisions. Missteps taken at the time of purchase can lead to substantially higher property taxes later. To avoid these snakebites, the prudent investor will carefully research a property's existing tax treatment before closing, consider whether to execute an allocation engagement and ensure that the transaction is properly documented.


In some states, statutory caps limit valuation increases that would oth­erwise rise to reflect the market. For example, California's Proposition 13 limits increases in assessed value to 2 percent per year even if the property's market value is increasing at a faster rate, so long as ownership remains unchanged. Property owners should know that acquisitions and improve­ments can dramatically impact tax values that were previously limited by statutory caps.

In most states, acquisitions trigger reassessments at the next applicable valuation date. In researching existing tax values prior to purchase, prospec­tive buyers often research the taxing authority's online tax records. Online research may fail to distinguish be­tween capped or taxable value versus fair market value, however. If the ac­quisition removes the prior cap and the buyer estimates taxes based on the capped value rather than the fair market value, the new property owner could be in for a very rude awakening come tax time.  

Acquisitions can also change dead­lines for filing tax appeals in some ju­risdictions. For example, the normal filing deadline for appeals in South Carolina is January 15, but most coun­ty assessors will mail new assessment notices during the year following an acquisition. In those circumstances, the filing deadline is 90 days after the date of the reassessment notice.

Failure to take simple but essential steps in documenting a purchase can have substantial tax ramifications. For example, South Carolina law poten­tially exempts as much as 25 percent of a commercial property's purchase price from later ad valorem taxation, but only if the purchaser files for the exemption on or before January 30 fol­lowing the closing. Failure to file can cost purchasers tens of thousands of tax dollars or more. Yet many purchas­ers are unaware of this exemption un­til after they receive the new tax bill, when it is generally too late to file for the exemption.

Closing documents can increase future property tax bills. Many asses­sors calculate taxable value based on the consideration recited in a deed. Purchasers typically acquire income­ producing properties based on existing or potential cash flow.It is the com­bination of the real property, tangible personal property and intangible per­sonal property which generates that cash flow.

The deed consideration should re­flect only the value of the real property and improvements, not the total trans­action value. Similarly, title insurance should reflect the real property's value and exclude value attributable to tan­gible or intangible personal property. A well-thought-out allocation agreement potentially simplifies later record keep­ing and yields significant savings on income, property and transfer taxes, sometimes worth millions of dollars.

For example, operating hotels are generally sold as going concerns. That distinct from the underlying real es­tate. The hotel's intangible personal property, such as its brand, reserva­tion system or on-line presence, may substantially increase cash flow but is generally exempt from ad valorem tax­ation.Using the transaction's value, rather than the value of the real estate and improvements, in the deed not only increases documentary stamps but could lead to unwarranted higher ad valorem taxes.

Pre-purchase cost segregation stud­ies are often useful in documenting these separate values, but many pur­chasers and their lenders are reluctant to engage in this component analysis. For example, large hotel loans typical­ly proceed from a lender 's corporate loan department,not the real estate de­partment, and with good reason. Loan officers can be reluctant to explain to their superiors or to regulators why title insurance values might be lower than the face amount of the note, when the loan is really underwritten on the value of the cash flow and not the in­dividual components contributing to that cash flow. That reluctance could manifest itself in reduced loans being made available for borrowers.

Similarly, loans secured by retail real estate occupied by national credit ten­ants previously garnered less scrutiny from lenders and regulators in assessing loan risk. That laissez faire attitude may be changing as e-commerce erodes sales at brick-and-mortar stores, which continue to close in large numbers.

In some jurisdictions, changes in the property's condition such as a vacancy by a major retail tenant do not trigger a reassessment, and may not be factored into tax bills. The key inquiry in those situations is whether the change in condition occurred after the applicable valuation date.

Property improvements also cre­ate taxation pitfalls. In states that cap taxable property values, the caps may come off when improvements are made. In other words, the cost of im­provements could include not only construction expenses but also a substantially greater tax burden.

The effect of improvements on prop­erty taxes varies by jurisdiction. Flor­ida has adopted a bright-line test that examines whether the completed improvement increases value by at least 25 percent. California law protects properties from reassessment so long as any work is normal maintenance or repair, or the improvement does not convert the property to a state "substantially equivalent to new." Whether new construction or improvements fall into this category is "a factual deter­mination that must be made on a case­ by-case basis," the California statute states. South Carolina law contains no such guidance.

Timing also matters. Most jurisdic­tions prohibit taxing improvements until after the improvements are com­pleted, as defined by applicable stat­ute. If the applicable valuation date is Dec. 31, 2018, an owner might consider delaying completion until after Jan. 1,2019, to delay a major tax increase. Re­gardless, careful analysis and plannirig can help property owners address the hidden cost of increased taxes.With careful planning, the prudent property owner can avoid being bit­ten by the lurking snake of increased property taxes and walk the property tax trail with confidence.

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Morris Ellison is a partner in the Charleston, S.C., office of the law firm Womble Bond Dickinson LLP. The firm is the South Carolina member of the American Property Tax Counsel, the national affiliation of property tax attorneys. He can be reached at This email address is being protected from spambots. You need JavaScript enabled to view it.
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Oct
05

Sounding the Alarm on Code Compliance Costs

Most multifamily owners are familiar with reserve requirements for items such as fire alarms and alarm replacement. Yet those owners may be surprised to learn that complying with the latest fire code changes can jeopardize statutory caps on property tax increases. In fact, recent changes to the International Fire Code (IFC) could substantially increase fire safety requirements, trigger loan defaults and escalate repair and property tax costs for apartment owners.

By their nature, apartment buildings are not, and cannot be, constructed to meet future unanticipated building code requirements. In many jurisdictions, property owners know that if their building suffers more than a 50% loss, they will be required to satisfy new code requirements during reconstruction. However, few owners expect to be saddled with retroactive application of new code requirements even if there is not a casualty.

The IFC provides a comprehensive regulatory framework of code templates setting minimum standards aimed at both safeguarding buildings from fires and protecting building occupants when fires occur. Among other things, the IFC addresses the installation and maintenance of automatic fire alarm and sprinkler systems and fire safety requirements for new and existing buildings.

States and local jurisdictions are often slow to adopt and apply the latest building codes to existing properties. So while the 2015 version of the IFC has been published, many state and local governments are still coming to grips with the 2009 version, which incorporated retroactive requirements regarding the installation of fire alarms into existing buildings. For property owners, significant concerns arise when governmental officials adopt an IFC version that retroactively imposes new requirements.

For example, the 2009 IFC included several potentially expensive retrofit requirements for existing buildings. Chapter 46 of the IFC recommended the installation of smoke detectors in each bedroom for existing structures. For buildings that are more than three stories high or contain more than 16 multifamily units, the IFC imposes retroactive requirements, including installing manual or automatic fire alarm notification systems; installing audible fire alarms in each unit; and wiring all units to ensure visual fire alarms may be installed for the hearing impaired.

Retroactive application of new requirements creates issues for owners of existing properties. Modifications to meet new regulations for existing buildings can cost thousands of dollars per unit, and failure to make required upgrades can have serious consequences, including fines, possible insurance and liability problems not to mention that violation of local building codes generally constitutes an event of default under standard loan documents such as the Freddie Mac form loan agreement.

Moreover, the capital reserves that most permanent lenders require borrowers to maintain for building maintenance are seldom adequate to fund fire-safety retrofits, since borrowers and lenders could not reasonably anticipate the nature and cost of these improvements when establishing reserves. Most apartment complexes are owned by single purpose entities. Their loan documents strictly limit obtaining new loans. If cash flow is tight, these owners face financial challenges in funding retroactive code-mandated improvements.

Increases in property taxes represent an additional hidden risk to property owners in jurisdictions where statutory caps limit property tax increases, such as Florida and South Carolina. Caps limit increases in taxable value for properties subject to reassessment that would otherwise rise to reflect the market. Florida, for example, generally limits annual increases in taxable value to 10% of the prior year's assessment. South Carolina limits increases to 15% of the property's prior assessed value unless there has been a property improvement, ownership change, or assessable transfer of interest.

Caps can be removed if an existing project undergoes renovations, adding a substantially heavier tax burden atop the renovation expense. For that reason, property owners who are required to make IFC-mandated improvements must determine whether the renovated properties will run afoul of the statutory cap limitations, and prepare accordingly.

There is no problem in California where the law protects properties from reassessment unless renovations make the property "substantially equivalent to new."

IFC compliance measures are more likely to jeopardize assessment caps in states such as South Carolina where state law requires taxing authorities to include the value of new construction when valuing properties. South Carolina excludes minor construction or repairs from taxation, but does not define these terms and interpretation is often left to local taxing authorities.

No one advocates ignoring fire safety, but multifamily owners must investigate all potential costs – both obvious and hidden – of bringing their properties into compliance.

Morris Ellison Photo Current july 2015Morris Ellison is a partner in the Charleston, S.C., office of the law firm Womble Carlyle Sandridge & Rice LLP. The firm is the South Carolina member of American Property Tax Counsel, the national affiliation of property tax attorneys. Morris Ellison can be reached at This email address is being protected from spambots. You need JavaScript enabled to view it..

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May
17

Smartphones, Showrooming Impact Cost

Smartphones lead the way in making mobile a key player in consumer purchases in-store and online.

The battle between physical stores and online retail rages on, but the recent explosion in smartphone usage is blurring the battle lines. Using smartphones, consumers in a store now can simultaneously shop and compare pricing and product availability at competing stores or online. The practice is sometimes referred to as “showrooming.” Increasingly, retailers must simultaneously invest in the problem. a combination of brick-and-mortar stores, websites, digital marketing and merchandise delivery to sell goods.

Only the real estate component of that infrastructure is subject to property tax. If property owners identify the portion of store sales attributable at least partially to online shopping, they can argue for taxable property values more accurately based on the remaining sales volume attributable to a store’s physical location and condition.

Retailers that think mobile is a channel use the wrong metrics to measure the smartphone’s impact on retail. Smart retailers focus on the impact on overall business rather than trying to measure only app downloads or channel sales.

Extrapolating a retail property’s value from base rent is relatively easy, but what happens when rent is based on sales? How do sales that take place in the store via smartphone, or online transactions that stem from a store visit, affect percentage rent?

Assessors and appraisers don’t yet have satisfactory answers to these questions and developing appropriate metrics is challenging. Taxpayers can help shape the debate, and their own tax liability, by understanding the problem.

Digital Influence Spreads

The lion’s share of U.S. retail sales continues to revolve around physical stores. Forrester Research reports that in 2015, e-commerce sales totaled approximately $334 billion, while off-line sales totaled $2.9 trillion, more than eight times more. However, many offline sales were digitally influenced, meaning shoppers connected with digital touch points, particularly mobile phones.

Forrester estimates that $1.2 trillion of U.S. retail sales in 2015 were web-influenced, and that by 2020, $1.6 trillion of all off-line retail sales will be web-influenced. The penetration of online buyers using smartphones increased to 86 percent in 2015, up from 54 percent in 2011, Forrester found.

Shoppers want to receive products quicker and cheaper than ever before, but still prefer to shop in physical stores in order to touch merchandise and obtain products immediately. Successful physical retailers combine physical stores and digital tools, enabling customers to touch and receive goods in a more cost-effective way than ever before.

Physical retailers must realize the key role smartphones play in unlocking sales. American adults use smartphones to locate stores and to check store hours, requiring retailers to keep websites current. Forrester estimates that in the first quarter of 2016, more than one-quarter of U.S. online mobile phone users ages 18 to 34 used their phones to compare prices online for products they were considering buying.

Shoppers also research product information on smartphones, often while in a store. Retailers, therefore, must monitor price variances and adjust prices in real time, against both physical and virtual competition.

Physical retailers also need to address perceived problems with off-line shopping, such as long lines and out-of-stock merchandise. Some sophisticated retailers have addressed these issues by developing store-specific data. Forrester reports that companies such as Target and The Home Depot now direct shoppers, via smartphones, to look for items in specific locations within stores, thereby reducing wait time and frustration. Nike store employees can look up inventory and make sales immediately with their smartphones. Shipping continues to pose a problem for both physical and virtual retailers. When the product is in stock, the physical retailer does not have a problem. However, maintaining inventory in stores potentially imposes the added costs of the inventory itself, additional rent and associated property taxes.

In January 2016, The Wall Street Journal reported that Gap, Inc., which includes retailers Banana Republic and Old Navy, was narrowing its free shipping window to 5 to 7 business days, down from 7 to 9 business days. Is this enough to satisfy the demands of consumers who expect immediate delivery of products, particularly from physical retailers?

Challenge to Retailers

Physical retailers face three very expensive budget items: associates, real estate occupancy costs (including taxes) and inventory. They must create a more pleasurable, yet competitive, shopping experience in order to beat digital competitors. Stores must become increasingly immersive and engaging experiences that enable customers to do everything from trying on wearable goods to playing with and testing products, or attending cooking classes and food demonstrations. The importance of enhancing the shopping experience in physical stores often means creating easy availability to other amenities such as restaurants and coffee bars.

While it may seem counterintuitive, the quality of a retailer’s online presence will influence sales, and hence the underlying value of the retailer as a tenant in a shopping center. Developers need to attract retailers who simultaneously focus on brick-and-mortar store sales, websites, digital marketing and merchandise delivery to sell goods. Percentage rent clauses in leases must appropriately capture sales.

All of this takes money and increases the complexity of measuring costs. Costs, such as property taxes, play a key role as retailers compete for sales and profits. Online retailers generally pay property taxes for distribution centers but can often reduce this cost by obtaining tax incentives, such as fee in lieu of tax agreements. Physical retailers, which often have a greater impact on the local economy, have less leverage to control property taxes. They face the challenge of showing assessors how mobile technology and e-commerce, not location alone, impact sales.

In January 2016, Forrester reported that “too often, companies measure what they can, rather than what they should, because they lack the analytics to generate the insights they need. Retailers track mobile sales rather than influenced sales because they can, and, more often than not, do treat mobile as a [separate] sales channel.”

This is precisely the problem tax assessors and physical retailers face in measuring mobile technology’s impact on a retail property. The assessor’s job is to value the real estate, not the business, which is increasingly affected by mobile innovation. Theoretically, one can use only in-store sales volume in the valuation but to what degree is a store-front simply an advertising medium — like a billboard. Stores can encourage customers to order while browsing at the store but have it shipped to their house and/or pickup at a nearby location that has lower property tax, possibly a warehouse on a side street.

Increasingly, retailers must balance between the physical and the virtual, with the smartphone serving as the key touchpoint. Retail success is still about location — location of the actual shopper inside or outside the store, at home, at work, at a competitor’s store or on a website or smartphone  — it’s just not about physical storefronts anymore.

Morris Ellison Photo Current july 2015Morris Ellison is a partner in the Charleston, S.C., office of the law firm Womble Carlyle Sandridge & Rice LLP. The firm is the South Carolina member of American Property Tax Counsel, the national affiliation of property tax attorneys. Morris Ellison can be reached at This email address is being protected from spambots. You need JavaScript enabled to view it..

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Dec
31

Beware The Costs Of Hidden Capital

Owners Must Examine The Tax Consequences Of Making Capital Improvements Before Breaking Ground

For nearly 40 years, states have attempted to protect property owners from rapidly escalating property tax bills by limiting increases in the taxable value of real estate.  Often referred to as “caps,” these limitations are myriad and complicated, but share a tendency to distort the market for developers of new space and for property owners seeking to improve existing commercial properties.

How so?  Laws are state-specific, but taxpayers purchasing or improving real estate may lose the benefit of the cap on their property’s value, and incur a substantial tax increase on top of the acquisition or improvement cost.  In other words, caps discourage property owners from improving their properties, while owners who know how caps apply can access tremendous savings.

Caps in Action

Caps apply by limiting increases in taxable value for properties subject to reassessment that would otherwise rise to reflect the market.  For example:  California’s Proposition 13 generally limits annual valuation increases to 2 percent, even if the property’s market value is rising at a faster rate.  Common triggers for reassessment are an ownership change, countywide reassessment and improvements to the property.

Some states exempt a fixed percentage of any increased assessed value following an ownership change.  Ownership changes can include not only title transfers but also internal transfers of interests in the entity that owns the property.  To access this exemption, the taxpayer may need to take some timely action, such as filing a claim or meeting other state requirements.  Miss the deadline, and the exemption disappears.

Consequences of an oversight can be dramatic.  For example, an apartment complex previously assessed, capped or otherwise, at $20 million sells for $30 million.  Rather than incur taxes reflecting the full $10 million increase in value included in the sale price, the buyer qualifies for a 25 percent tax exemption, or $7.5 million.  Yet, failure to file a timely exemption application could result in taxation of that otherwise exempt $7.5 million of the total value.

Many jurisdictions cap value increases during periodic reassessment.  Florida generally limits annual increases to 10 percent of assessed value for the prior year.  South Carolina, which theoretically reassesses every five years, limits increases to 15 percent of the property’s prior assessed value unless there has been a property improvement or a change in ownership.

Some limits disappear if there has been an ownership change.  Florida generally defines an ownership change as any sale or transfer of title or control of more than 50 percent of the entity that previously owned the property.  South Carolina has adopted a much more complicated system of assessable transfers of interest (ATI’s).  The definition of an ATI runs for four full pages in the South Carolina Code.

Impaired by Improvements

With tax caps, taxpayers who improve their properties face even greater potential tax consequences, because states generally remove artificial caps on new construction and major renovations.  In other words, the total cost of improvements can include not only construction expenses but also a substantially heavier tax burden.  The result places an improved income-producing property at a serious disadvantage in competing with unimproved properties.

What constitutes an improved property? Florida has adopted a bright line test by examining whether the improvements increase value by at least 25 percent.  California law protects properties from reassessment so long as any work is normal maintenance or repair, or the improvement does not make the property “substantially equivalent to new.”

South Carolina is much more complicated and unclear.  The state requires assessors to include the value of new construction in valuing properties, but its statutes fail to define “improvements,” leaving interpretation to local taxing authorities.

The result is a patchwork quilt of inconsistency.  In order to circumvent South Carolina’s 15 percent cap on periodic reassessment, some counties have adopted a stepped approach to increases in value, although such a procedure is clearly unauthorized by statute.  Other counties simply add the value stated in building permits to existing assessed value in order to derive a new value, though the market would never see a sale on that basis.  Still other counties assume stabilization in valuing a new or improved income-producing property such as a hotel rather than accurately valuing the property before stabilization.  Clearly, a property owner improving a property faces a potential hidden cost in the form of increased taxes by loss of the statutory cap.

Reimplementation of tax caps on an improved income-producing property further complicates an owner’s prediction of costs.  Whatever the method of valuing the improvements, how does South Carolina’s 15 percent general cap apply to future valuations when the property value may be much greater?

If the taxing authority simply adds the cost of the increased value set forth in building permits, has the taxing authority fully captured an increase in value which, in turn, may be subject to re-imposed caps?  To state the obvious, an owner will not improve a property merely to re-cover the cost of improvements, but rather sees the potential of income gains exceeding improvement costs.

Most income-producing properties will generally require some period of time for lease up or stabilization.  Should the taxing authority be allowed to make assumptions of future income that the market would not make if the property sold prior to stabilization?  These questions have no easy answers.

Regardless of the system used for valuing new improvements, caps give a competitive advantage to owners of unimproved property in the form of lower costs.  Property owners must examine the obvious – and hidden – tax consequences of improvements to determine whether potential income from improvements justifies the costs.

Morris Ellison Photo Current july 2015Morris Ellison is a partner in the Charleston, S.C., office of the law firm Womble Carlyle Sandridge & Rice LLP. The firm is the South Carolina member of American Property Tax Counsel, the national affiliation of property tax attorneys. Morris Ellison can be reached at This email address is being protected from spambots. You need JavaScript enabled to view it..

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Jul
08

Custom-Built Carrots: Attracting Growth Firms Calls for Smart Incentives

In the wake of the Great Recession, government initiatives to promote economic growth have varied widely across the nation. Some states targeted manufacturers, while others focused on technology companies and other high-impact, knowledge-based firms. A spirited debate has emerged on the role of economic incentives in these efforts.

Historically, Southern states have targeted manufacturers rather than knowledge-based companies as the engines of economic growth by offering tax incentives aimed at reducing costs. Manufacturers typically make substantial upfront capital investments and create large numbers of jobs. These companies quickly generate property tax revenue for the public coffers.

Knowledge-based technology companies and startups, however, seldom make hefty initial capital investments, nor do they create large numbers of jobs right away. Rather, these employers tend to offer fewer, but higher-paying, jobs that have a greater impact on the economy than an equivalent number of manufacturing positions. As a result, traditional tax breaks linked to job numbers and capital investment don’t appeal to knowledge-based companies, particularly startups that are not yet generating revenue.

The real target should be a category that is best characterized as "growth" companies. Regardless of sector, these companies include startups as well as more established companies that are increasing revenue at a high rate.

Most companies measure success by revenue and profit growth, not by numbers of employees, capital investment outlays or numbers of patents. One study notes that growth firms tend to be eight years old or less and most economists agree that startups will create the vast majority of future U.S. jobs.

Recent statistics suggest a one-size-fits-all approach to economic incentives may not be best. In May, the nation’s unemployment rate fell to a seven-year low of 5.4 percent; however, job growth during the past few years has been remarkably uneven. Fourteen states have rebounded strongly, with employment increasing 10 percent or more from Great Recession lows. Top performers include Texas and Utah, where unemployment has risen more than 15 percent, and California and Colorado, where employment is up more than 13 percent. Knowledge-based jobs are a critical component to employment growth in these states.

In contrast, total employment in 10 primarily industrial states has grown just 5 percent or less from Great Recession lows.

Cutting Costs, Growing Jobs

Nevertheless, manufacturing jobs have been an important component of the recovery. Some states that have enticed manufacturers by offering lower production costs have been among the leaders in the comeback. For example, employment increased about 11 percent in South Carolina, 10.5 percent in Georgia, and 9.9 percent in North Carolina. These states all created an attractive business environment in part by taking steps to cut costs, such as taxes on capital investment.

One of South Carolina’s main incentives has been a fee-in-lieu-of-taxes agreement (FILOT), which targets property taxes. A participating company negotiates the agreement with the county where the company is locating or expanding its facility.

Generally, a FILOT agreement enables companies investing at least $2.5 million in a new facility or an expansion over a five-year period to cut their property taxes by about 40 percent annually. A FILOT typically lasts for a set term of 20 to 30 years.

To calculate property taxes, South Carolina calculates uses according to the following formula: property value x assessment ratio x millage (or tax rate) = tax. A FILOT can reduce the assessment ratio of a manufacturing facility from 10.5 percent to 6 percent, and sometimes to as low as 4 percent.

FILOTs may also set the millage rate for the duration of the agreement or modify millage every five years. Any personal property subject to the FILOT depreciates. The approach to assessment is similarly variable. The FILOT agreement either sets the property’s value at cost for the agreement’s entire term or permits an appraisal every five years. That provision offers an opportunity to revisit the property’s value even during the life of the FILOT.

While clearly attractive to a manufacturer, a FILOT is less appealing to knowledge-based and technology firms, since these companies are unlikely to make substantial initial capital investments.

Structuring incentives for knowledge-based firms poses unique challenges. These employers invest significantly in non-tangible intellectual property and hire highly skilled, highly paid employees. Income tax credits can be attractive if those companies are making a profit, but those credits have little appeal for a startup that is losing money while the market determines whether the company’s product is attractive.

Economic development cannot focus on manufacturing to the exclusion of knowledge based jobs. In his book The New Geography of Jobs, Enrico Moretti notes that each new high-tech job creates five additional jobs out-side the high-tech sector. He argues that the “innovation” sector has a disproportionately larger multiplier effect than manufacturing. That means one of the best ways for a state to generate jobs for less-skilled workers is to attract technology companies that hire highly skilled employees.

Attracting knowledge-based companies requires creation of the critical mass of firms and workers needed to sustain a truly competitive, often self-sustaining, high-tech ecosystem. That ecosystem, in turn, re-quires a landscape that is culturally vibrant, economically robust and entrepreneurial. These qualities are essential to attracting, engaging and retaining the young talent that contributes so heavily to the knowledge-based economy.

Innovative Manufacturing

In the 21st century, innovation isn’t restricted to knowledge-based companies. Manufacturers must also innovate to expand revenues and profits and to respond to changing opportunities. The recovery from the Great Recession has shown that states must look beyond conventional incentives and tailor their strategies to the competitive needs of the companies that are investing capital and creating jobs.

Smart companies, economic development officials and policymakers should focus on growing revenues and profits, not incentives. Despite the differences between the manufacturing and knowledge-based sectors, their workforces are central to both. With that in mind, employers should strive to build the innovative, flexible and adaptable workforce that is a key to growth.

All too often, however, conventional incentives and development strategies fail to address these concerns. Physical infrastructure does not attract and retain employees; opportunity does. Smart economic development is about increasing income for both companies and workers and encouraging innovation. Smart incentives should do the same.

ellison mMorris Ellison is a partner in the Charleston, S.C., office of the law firm Womble Carlyle Sandridge & Rice LLP. The firm is the South Carolina member of American Property Tax Counsel, the national affiliation of property tax attorneys. Morris Ellison can be reached at This email address is being protected from spambots. You need JavaScript enabled to view it..

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Jan
16

Reducing Hotel Property Taxes By Properly Valuing Intangible Assets

Most, but not all, taxing authorities acknowledge that hotels include intangible and tangible assets. Reducing property tax costs by removing intangible value has long been controversial due to the challenging task of valuing intangible assets. Intangibles include items such as the assembled workforce, service contracts, reservations systems, web presence and hotel management and franchise agreements.

Most, but not all, taxing authorities acknowledge that hotels include intangible and tangible assets. Reducing property tax costs by removing intangible value has long been controversial due to the challenging task of valuing intangible assets. Intangibles include items such as the assembled workforce, service contracts, reservations systems, web presence and hotel management and franchise agreements.

Fortunately for hotel owners, a recent decision by the California Court of Appeals makes clear that measuring a hotel’s intangible value solely by deducting franchise fees and management fees understates a hotel’s intangible value. Assessors must exclude all intangible value to tax the hotel’s real property properly. Proper exclusion of intangible value will necessarily result in lower taxes.

The debate
It is axiomatic that investors buy operating hotels based on the income generated by the hotel’s business. The income is generated by the combination of the property’s real estate, tangible personal property, and intangible personal property. All of these components are essential and the absence of any of these elements severely compromises a hotel’s ability to generate revenue.

Ad valorem taxing authorities are not investors or lenders. They are charged with valuing only the real estate component of a hotel for tax purposes. Isolating a hotel’s taxable value requires that the assessor remove from the hotel’s overall value both the value of tangible personal property and the value of the intangible personal property used in conjunction with the operating business.

Valuing the hotel’s tangible personal property, such as beds, furniture and the like, is relatively easy. Valuing intangible assets poses a far greater challenge. How should the assessor separate the value of intangible assets from the hotel’s overall value? The answer to that question has been the subject of heated debate.

Evolving methodology
The Appraisal Institute’s current curriculum recognizes the presence of intangible value in hotels but avoids the issue of how to calculate this value. This omission implicitly acknowledges that the value of an operating hotel lies at the intersection of real property appraisal and business valuation, and both skill sets are required to value a hotel property appropriately.

Stephen Rushmore developed the initial approach to the problem over 30 years ago. To account for a hotel property’s intangible value, the Rushmore Approach simply subtracts management fees and franchise fees from the hotel’s revenue and capitalizes the remaining revenue to determine real estate value.

The debate about valuing intangible property in a hotel has been long, loud and heated. While revolutionary at the time, the Rushmore Approach has been criticized for years. Rushmore’s defenders have responded to the criticism on several fronts.

Critics argue the Rushmore Approach offers the attraction of simplicity at the expense of understating the contribution made by intangible personal property to the hotel’s revenue. Critics further argue that the Rushmore Approach’s assumption that the deduction of management and franchise fees effectively accounts for a hotel’s entire intangible value is contrary to the experience of market participants in owning and operating a hotel. Rushmore’s detractors often advocate an alternative method known as the business enterprise approach, which casts a wider net to account for intangibles.

Rushmore’s supporters note the absence of hard data to quantify sales of a hotel’s individual components. The absence of this data, however, is unsurprising, considering investors buy and sell hotels based on income generated rather than on the value of individual components.

Rushmore’s advocates also suggest that alternative approaches overstate intangible value, thereby reducing the mortgage-asset-secured value lenders rely upon for hotel financing.

Courts weigh in
The Rushmore Approach certainly accounts for some intangible value, but, does it reveal the full intangible value associated with a hotel such as licenses to use software and websites?

Until recently, Glen Pointe Associates vs. Township of Teaneck, a 1989 New Jersey opinion, was the seminal hotel property tax decision that adopted the Rushmore Approach to extract the real estate value of an operating hotel. A May 2014 California Court of Appeals opinion, however, suggests the tide may be turning against the Rushmore Approach and in favor of the business enterprise approach.

In SHC Half Moon Bay vs. County of San Mateo, the California Court of Appeals held that “the deduction of the management and franchise fee from the hotel’s projected revenue stream pursuant to the income approach did not - as required by California Law - identify and exclude intangible assets” such as an assembled workforce and other intangibles.

In overturning the taxing authority’s methodology as a matter of law, the appellate court held that the taxing authority had failed to explain how the deduction of the management and franchise fee, i.e. the Rushmore Approach, captures the value of all of the hotel’s intangible property. Considering that consumers increasingly make hotel reservations online instead of using a flag’s reservation system, it is increasingly difficult to argue that the Rushmore Approach sufficiently captures the value of the hotel’s website or its relationship to on-line providers outside of the flags.

The arrival of Airbnb in the market also provides food for thought. Airbnb is a controversial web platform where an apartment owner advertises an apartment online for overnight paying guests. The platform boasts over 800,000 listings in 33,000 cities in 192 countries. Many local governments argue Airbnb allows apartment owners to avoid hospitality taxes or other hotel regulations.

Airbnb’s success demonstrates the difficulty of isolating a hotel’s real estate value by only excluding management and franchise fees. Airbnb doesn’t charge management or franchise fees, yet the service allows owners to increase the income potential of their apartments far beyond market rent.

The debate between advocates and critics of the Rushmore Approach rages on. The challenge for valuing hotel real estate remains. The beauty of the Rushmore Approach is its simplicity, but in the days of the Internet and Airbnb, simplicity may not equate to accuracy. In the wake of the decision from California, the tide may be running out on the Rushmore Approach.

ellison mMorris Ellison is a partner in the Charleston, S.C., office of the law firm Womble Carlyle Sandridge & Rice LLP. The firm is the South Carolina member of American Property Tax Counsel, the national affiliation of property tax attorneys. Morris Ellison can be reached at This email address is being protected from spambots. You need JavaScript enabled to view it..

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Jun
16

Accounting For E-commerce In Retail Property Values

"Computing value can get complicated if stores are required to mix online sales with physical sales."

Shopping via smartphones and tablets is here to stay, but the new-found convenience has introduced new uncertainties and complexities to shopping center owners, developers and investors.

The uncertainty stems from the ways e-commerce complicates shopping center valuations and development. Appraisers, assessors and property investors are forced to reconsider previously accepted answers to fundamental questions: What is the relative value of in-line stores and anchors? How should stores on contiguous parcels comprising a regional mall be valued? How fundamental is location? In an e-commerce world, the answers to these questions are increasingly uncertain and complex.

For example, the existing ad valorem tax system taxes a property's real estate value rather than its profitability. The current system assumes rents, which form the basis of commercial property values, relate directly to profitability. Rents in a regional mall are based upon profitability. For example, a jewelry store in a mall's center court may pay $75 per square foot while a family apparel store pays $20 per square foot. What really matters is occupancy cost. When occupancy costs (the total costs paid to the landlord including rent and reimbursable items such as CAM) exceed 12 percent of sales, the tenant may be headed for trouble. Higher sales permit higher occupancy costs. Indeed, appraisers often incorrectly equate real property value to the profitability of the property's business operation when the real property should be valued in fee simple in a tax appeal.

Conventional wisdom suggests strong anchors improve a center's real estate value, stabilize a property's financial statement, reduce an owner's risk and increase the price a buyer would pay for the center. For example, a Nordstrom will often bring inline tenants that would otherwise not go to the mall. A recent variant on this theme is the proliferation of mixed-use centers, which often include office, apartments and other life style uses designed to draw potential shoppers for the retail tenants. Put simply, retail sales historically relate to the center's location, trade area population, trade area household income and foot traffic, not to factors such as web presence. Additional uses also theoretically provide more stability to the project's value.

E-commerce is challenging conventional wisdom about the effect of anchors on overall value as online sales increase pressure on bricks and mortar retailers and diminish their role in overall retail sales. In February 2014, the U.S. Census Bureau reported that 2013 fourth quarter retail e-commerce sales, adjusted for seasonal variation but not for price changes, increased 16 percent from the fourth quarter of 2012, as compared to a 3.9 percent increase in total retail sales for the same period in 2013. E-commerce accounted for 5.8 percent of total sales in 2013 compared to 5.2 percent for the same period in 2012.

On a non-adjusted basis — that is, excluding sales in categories not commonly purchased online — Internet Retailer magazine estimated e-commerce accounted for 7.6 percent of total retail sales during 2013, a 6.8 percent increase from the same period in 2012. Forrester Research projects that by 2017, direct online purchases will account for approximately 10 percent of all U.S. retail sales, representing a nearly 10 percent compound annual growth rate from 2012. Looking beyond purely online purchases, Internet Retailer estimates that by 2017, 60 percent of U.S. retail sales will involve the web.

In some ways, these figures understate e-commerce's impact on bricks and mortar retailers. For example, the figures do not account for lost profitability and price pressure created by consumers who price shop online and visit a center to make a purchase. Further, how many consumers now shop on-line for groceries and either have those groceries delivered to their homes via a provider such as Amazon.com, or collect them from a drive-through checkout line?

Forrester Research predicts U.S. e-commerce spending will increase because larger retail chains will invest in omnichannel" efforts — tying together stores with the web and mobile — along with more consumers using smartphones and tablets, and what the report calls "increased comfort with web shopping."

Onmichannel marketing will likely decrease inherent real estate values and lower ad valorem taxes since e-commerce decreases the importance of bricks and mortar stores and foot traffic. If 60 percent of retail sales will involve the web by 2017, how important is location? How important are anchors?

The answers may be, "Not very much." E-commerce's impact is already evident in store closings by retailers once considered national credit or anchor tenants. In 2013, a major South Carolina grocery chain that anchored many small shopping centers closed most of its stores. Nationally, in early March 2014, RadioShack announced the closure of approximately 1,100 stores while Staples announced plans to close 225 stores. Is it coincidental that Staples is now the number 2 e-tailer behind Amazon?

Historically, the risk in leasing to a large anchor was much lower than leasing to smaller tenants. Different uses generally involve different capitalization rates, or expected rates of return relative to the purchase price. The risk involved with office leases differs from the risk of renting to national retailers. Historically, inline stores arguably should have had a higher capitalization rate than the anchor stores did, since there was more risk. This was never the case as all the department stores have credit ratings below investment grade and are larger stores and therefore have a greater risk than smaller inline stores with better credit. Most malls trade on cap rates in the 6 to 8 percent range, whereas the few department stores that were leased when sold traded in the 10 to 12 percent range. Taxing authorities traditionally only paid lip service to these risk differences in calculating one overall capitalization rate, and tended to gravitate to a lower rate thought to be inherent in the anchor. But in an increasingly online world, is the riskier tenant the inline store, or is it the anchor?

The evolving significance of anchors also raises questions about the inter-relationship between separate parcels. Unsophisticated assessors tend to ignore state laws requiring parcels be individually valued. Instead, taxing authorities value the project by grouping multiple parcels together and applying one blended capitalization rate, regardless of the multiplicity of uses and tenants. Unquestionably, inline stores and anchors have a symbiotic relationship, but how does one measure that relationship value particularly when the anchor is on a different parcel from the mall itself?

The physical location of a closed anchor in a mixed-use center can exacerbate the problem. For example, what happens when a failed anchor, located in the middle of the mall, creates parking or access issues for patients visiting medical offices? How is this impact measured?

While the solutions are still unclear, a few basic issues confronting the industry are coming into focus through the cyber static:

  • Appraisers and tax authorities need to recognize most power centers and malls are complex businesses, where anchors and inline stores depend on each other (and internet presence) for profitability.
  • The historic relationship of the capitalization rates applied to inline stores versus anchors needs to be scrutinized more closely.
  • Some jurisdictions specifically require parcels be valued individually for tax purposes. If so, how does one measure the interdependency of the tenants that comprise the center?
  • How does an owner address increased vacancies within mixed-use centers for both profitability and tax purposes?
  • How does one calculate a property's real estate value when it is part of the retailer's onmichannel sales effort?

The challenges posed to owners by e-commerce spans the gamut from development to taxes. Valuing regional malls, power centers and even local shopping centers for property tax purposes is increasingly difficult in the e-commerce era. An owner who appropriately quantifies the different and increasingly complex risks associated with these businesses is far more likely to adapt successfully to the e-commerce world, and simultaneously reduce property tax bills. Recognizing the questions and challenges posed by e-commerce is the first step in obtaining the answers.

ellison mMorris A. Ellison is a partner in the Charleston, S.C. office of the law firm Womble Carlyle Sandridge & Rice L.L.P., and is the South Carolina member of American Property Tax Counsel, the national affiliation of property tax attorneys. He can be reached at This email address is being protected from spambots. You need JavaScript enabled to view it..

 

 

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Dec
18

South Carolina Taxpayers Play 'Dating Game'

Inconsistencies and confusion reign in determining effective date for valuing commercial properties.

"The practical implementation of the mandated five-year county-wide reassessment program further compounds the dating confusion. Many counties delay county-wide reassessment for one year, as authorized by statute, and in some cases, two years..."

Commercial property owners in South Carolina already faced an unsettled and confusing issue in trying to determine he valuation date for ad valorem taxes. Now, the South Carolina Court of Appeals has further complicated the issue.

Determining the valuation date should be simple: South Carolina law states the pertinent date of value for a given tax year is Dec. 31 of the preceding year. For example, logic suggests the valuation date for 2013 property taxes hould be Dec. 31, 2012. But that logic is often mistaken. South Carolina statutes require local assessors to engage in a countywide reassessment every five years. The process is referred to as an "equalization and reassessment program," and is intended to equalize the tax burden on property owners. Logic suggests the equalization program will equalize values, but that logic is also mistaken.

Act No. 388 and its Wake

Approximately seven years ago, the South Carolina General Assembly passed Act No. 388 which, among other things, capped value increases resulting from a county-wide equalization and reassessment to 15 percent of the property's prior assessed value, so long as the property had not changed hands in the past five years. However well-intentioned, the effort to lower property tax burdens wrought havoc with the concept of equalization.

The legislature also created the concept of an assessable transfer of interest, which eliminated the cap in some situations, such as in certain transfers of interest within the ownership entity, or following construction of improvements. In a sense, the legislation penalizes a landowner from a tax standpoint for improving a property's economic performance with new construction.

By their nature, caps erode the principal of uniformity since taxes for some properties go uncapped. Competing properties may have identical uses and financial performance, but taxes may be capped on one property, but not on the other. Under Act No. 388, two economically identical properties could be taxed using different valuation dates.
In fact, Act No. 388 promulgates a potential for four alternative valuation dates.

In an effort to address some of the outcry over the inequality engendered by Act No. 388, the legislature in 2012 provided an exemption of up to 25 percent of the purchase price of commercial properties. Unfortunately, this provision adds yet another little-known filing deadline, since the application for the exemption is due on or before Jan. 31 of the applicable tax year. In other words, a property purchaser must file for this exemption prior to the first Jan. 31 after acquisition. Failure to do so likely invalidates the exemption.

The practical implementation of the mandated five-year county-wide reassessment program further compounds the dating confusion. Many counties delay county-wide reassessment for one year, as authorized by statute, and in some cases, two years. For example, after delaying a scheduled 2004 reassessment to 2005, Charleston County delayed its next scheduled county-wide reassessment from 2010 to 2011 and decided to use a Dec. 31, 2008 valuation date rather than Dec. 31, 2010. The question is what date to use for valuation in the county-wide reassessment. Should it be the date on which reassessment was scheduled to occur or Dec. 31 of the year prior to implementation?
The correct answer is unclear.

Interim Appeals Defy Logic

So, what happens if a property owner wants to appeal the value of a property in the middle of the fiveyear period because of a change in economic performance? For example, is it fair to tax a property based on its economic status as of the valuation date used in the last county-wide reassessment, when it may have lost its anchor tenants since then? Logic and the clear language of state statutes suggest the valuation date should be the lien date, or Dec. 31 of the year prior to the year in which taxes are due, in order to treat properties equally based on economic performance.

According to the South Carolina Attorney General, however, that logic again would be wrong. In 2010, the attorney general opined that county assessors should ignore the unambiguous statutory language regarding valuation date and use the effective date of the last county-wide reassessment. County assessors are implementing this opinion regardless of logic.

In the 2013 case of Charleston County Assessor vs. LMP Properties, the South Carolina Court of Appeals further complicated the dating problem. In this case, the parties agreed to a Dec. 31, 2003, value date because 2004 was the date of the county's last county-wide reassessment. However, the Court determined Dec. 31, 2007, was the proper date for determining the property's highest and best use. In other words, the Court held an appraiser should use one date to determine the property's value and a different date to determine the property's highest and best use. How licensed appraisers meet these requirements and satisfy professional standards under the Uniform Systems of Professional Appraisal Practice defies logic. Logic suggests that assessors should use a uniform date, the lien date, for valuing real property. Logic also suggests the property's economic performance as of the lien date should control for interim appeals. But, then again, whoever said that dating — in love or taxes — had to
be logical?

ellison mMorris A. Ellison is a partner in the Charleston, S.C., office of the law firm Womble Carlyle Sandridge & Rice LLP. The firm is the South Carolina member of American Property Tax Counsel, the national affiliation of property tax attorneys. Morris A. Ellison can be reached at This email address is being protected from spambots. You need JavaScript enabled to view it..

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Dec
13

Building Value

How to Save Money by Allocating Prices in Real Estate Transactions

"Federal regulators recognize operations account for a significant component of hotel income and value..."

By Morris A. Ellison, Esq., as published by Commercial Property Executive, December 2012

Commercial real estate investors generally acquire properties based on total cash flow, rather than on the perceived value of the property's individual components generating that cash flow. Increasingly, however, lenders are attempting to underwrite real estate loans through component analyses by breaking down a property into income-generating elements under the theory that separately valuing components reduces risk.

Taxing authorities already generate separate tax bills, often at different rates, for real property, personal property and business licensing fees. A similar approach from lenders, which are under increasing regulatory pressure to reduce risk, may impinge on commercial real estate financing and slow the industry's recovery.

A purchaser often analyzes components of cash flow when evaluating how to improve a property's operational performance and the impact of taxes on potential returns. Common considerations include real estate transfer taxes, allocation of basis for income tax purposes, real and personal property tax assessments, and segregation of readily depreciable or amortizable assets from non-depreciable or non-amortizable assets. Allocation generally involves four components: (i) land (non-depreciable); (ii) buildings or improvements (generally depreciable); (iii) tangible personal property (generally depreciable); and (iv) goodwill or ongoing business value represented by intangible personal property or business enterprise value (BEV).

Hotel properties are prime examples of component analysis, as the analysis is often a major negotiating point. Hotels are generally sold as going concerns—that is, operating businesses with a value distinct the underlying real estate. Integrating a well thought- out allocation into a purchase agreement potentially simplifies recordkeeping yields significant savings on income, property and transfer taxes, sometimes worth tens millions of dollars. The federal Internal Revenue Code applies different depreciation rates and tax calculations to different property types. Commercial businesses with substantial goodwill associated with operations (such as hotels, shopping centers, healthcare facilities and marinas) can significantly benefit from a comprehensive allocation analysis.

For example, much of the value of healthcare facilities rests in operating licenses. These and other intangible assets are generally not subject to ad valorem taxation, and accurately reflecting value will prevent overpaying property taxes due to an incorrect allocation of value. In states where the federal income tax basis is used to calculate property taxes for purchased assets, an allocation analysis is critical. For federal income tax purposes, the tax basis of purchased assets is allocated according to the residual method, which generally allocates a purchase price into classes of assets. Except for land, certain tangible assets are depreciable for federal income tax purposes.

Valuing such assets typically involves obtaining a real estate appraisal, extracting improvement values from land value and valuing tangible personal property such as furniture using the most appropriate methodology for that asset type. Because the federal income tax basis of property is determined at the time of acquisition, allocating the purchase price should be part of due diligence and not put off until after closing. Closing is a great opportunity to establish the various business assets' tax basis, and separate conveyance documents should be prepared for each major asset to document allocated value.

Property Tax Implications

After closing, governments generally separately assess taxes against the real property, tangible personal property and intangible personal property (usually in the form of a business licensing fee).

Tangible personal property, which is subject to a faster depreciation schedule, includes furniture, fixtures, equipment and supplies. Business enterprise value might include startup costs, an assembled workforce, a reservation system and residual intangible assets. The Uniform Standards of Professional Appraisal Practice (USPAP), promulgated by the Appraisal Standards Board of the Appraisal Foundation, require separation of a hotel's business value from other components. However, there is no consensus on the method for calculating BEV.

Some taxing authorities contend BEV is an illusion conjured by disreputable appraisers and property owners seeking to reduce ad valorem taxes, but the Appraisal Institute and federal regulators recognize that the operating business of a hotel, for example, accounts for a significant component of its income and overall value.

Since Oct. 1, 2011, the Small Business Administration has required affiliated lenders to obtain a going-concern appraisal for any real estate involving an ongoing business. Affected property types include hospitality, healthcare facilities, restaurants and nightclubs, entertainment venues, manufacturing firms, office buildings, shopping centers and apartment complexes. SBA lenders must obtain an appraisal valuing the separate components from an appraiser who has taken specified courses in valuing going concerns.

The Office of the Comptroller of the Currency, which regulates commercial banks, simply requires lenders to use a competent appraiser and does not specify course requirements for the appraiser. While OCC appraisals need only comply with USPAP, stricter standards may apply if required by what the OCC calls "principles of safe and sound banking."

USPAP does not specifically require appraisers to value component elements when appraising going-concern properties. Although USPAP Rule 1-4(g) states, "(w)hen personal property, trade fixtures or intangible items are included in the appraisal, the appraiser must analyze the effect on value of such non-real property items," the Appraisal Foundation has made it clear that this standard does not mandate an appraisal of the property's individual components of value. However, "the appraiser may be required to value the individual components because of what the analysis produces and/or the manner in which the analysis was applied." Thus, USPAP implicitly require an appraiser to allocate values under certain circumstances.

The OCC appears to be seeking to require more. The Federal Deposit Insurance Corp. Improvement Act of 1991 imposed additional requirements on institutions subject to OCC regulations, which require each institution to adopt and maintain written real estate lending policies "consistent with principles of safety and soundness and that reflect consideration of the real estate lending guidelines." Exactly what this means is unclear.

A recent article published by the Appraisal Institute contends that appraisals of going concern properties must allocate values. Although not attributable to USPAP requirements, the FDIC, as well as the Financial Institutions Reform, Recovery and Enforcement Act of 1989, may require allocation in order to ensure "safety and soundness." Whether these principles require different interest rates for different components of value remains an open question.

Component analysis makes sense in analyzing operations and in calculating taxes. The ongoing debate over how to calculate BEV, however, illustrates the difficulty of transporting component analysis into transactions and real estate lending. For example, large hotel loans are typically made by a lender's corporate loan department, not the real estate department, and with good reason. Furthermore, incorporating the concept of component analysis into real estate lending seems likely to increase interest rates at a time when available credit is already scarce. That debate is just beginning.

ellison mMorris A. Ellison is a member of the Charleston, S.C., office of the law firm Womble Carlyle Sandridge & Rice L.L.P., and is the South Carolina member of American Property Tax Counsel, the national affiliation of property tax attorneys. He can be reached at This email address is being protected from spambots. You need JavaScript enabled to view it..

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