Incurable obsolescence — the stealth killer of commercial real estate value — is all too often overlooked in property tax appeals.

Any obsolescence can affect a property's value. Normal obsolescence involves curable problems, such as outdated fixtures and finishes that reduce a building's desirability. In valuation, the anticipated cost to cure the obsolescence (in this case, with a refreshed interior) is deducted from the property's taxable value.

As the name suggests, incurable obsolescence cannot be cured within the boundaries of the property. The obsolescence stems from outside circumstances, whether next door or in the larger markets, and no change to the property itself can overcome the deficiency.

Perhaps the government is going to change the traffic pattern, or a hog farm is going in next door. The market value may rise if a good thing is coming to the area. It will surely decline if a bad thing is coming, and the market value declines in relation to the predictability of such an event.

Property owners who learn the common forms and causes of incurable obsolescence will be better equipped to recognize its symptoms in their own real estate. In arguing for a reduced tax assessment value, evidence of obsolescence weighing on a property's operations will often tip the scales in convincing an assessor, review board or court to grant a reduction.

Passing or permanent?

Owners should be aware of functional obsolescence and be prepared to discuss it when appealing assessments. If it is a problem that can't be cured within the boundaries of the property, it is incurable obsolescence and reduces the property's market value.

The condition may have existed from the inception of the property's development and use, but more typically it results over time from factors relating to design, usability, markets, traffic patterns, government takings or regulation. For example, economic need or a government requirement may leave a property without adequate parking to support commercial buildings on the site, rendering those structures incurably obsolete.

Incurable obsolescence can be partial and a handicap to the property's viability without entirely preventing its continued use. For example, an office building designed for single-tenant use will not accommodate multiple users. There is a very limited market for single-tenant, high-rise buildings. The cost of retrofitting such a building into separate leasable offices is infeasible.

The loss in value due to incurable obsolescence may be anticipatory. If the market's users and investors see imminent incurable obsolescence, it may already affect market value. The negative impact of incurable obsolescence occurs when the problem cannot be cured on site at any cost.

In evaluating a property for instances of incurable obsolescence, however, it is important to remember that the source of obsolescence may be offsite.

Owners concerned with the production and marketing of a product or service from their property may not be aware of external elements of incurable obsolescence affecting their property's value. Or they may simply regard the circumstance as a non-priority item — at least until they get their property tax bill.

Instances of the incurable

Incurable obsolescence takes many forms, but taxpayers are most likely to encounter it in one of a few common scenarios. Those include:

Property access changes. Typically imposed by a highway or street authority, moving or removing access points can reduce a commercial property's appeal to users and lower its market value.

Altered traffic patterns. Changes to surrounding roads or highways can reduce commercial value. Limiting the property's visibility and accessibility, for example, may reduce customer traffic and brand exposure for operators on the property.

Size modifications. The property may fail to meet the required property size in relation to improvements. Possible causes include changed government requirements or the physical loss of a portion of the property due to government taking. A simple change in setback lines may have a dramatic negative impact on a property's value.

Takings. Use of eminent domain may reduce the remainder of the property to a legal non-conforming use which may not be altered to accommodate a commercially viable use. Alternatively, commercial uses on a state highway may be untouched by highway takings, but diverting traffic to a new highway kills viable commercial use of properties on the abandoned roadway.

More examples

Other sources of incurable obsolescence span a wide range, from changing industry practices and preferences to evolving government regulations, markets and natural phenomena. Zoning or regulatory changes may restrict usage, for example. The property may no longer meet current tenant needs regarding loading dock height, or access by delivery and customer vehicles. Nearby development or street construction may inundate the property with surface water. Properties have incurred incurable obsolescence for their intended uses from light pollution, and from disruptive air traffic following a change in flight patterns.

Property owners discussing excessive taxable valuation with the assessor should recognize that the assessor has employed the cost approach to value. While cost may be a value indicator, it lacks relevance in situations involving incurable obsolescence. Help the assessor to look beyond cost by showing how obsolescence reduces the property's value in the marketplace.

In preparation for meeting with the assessor, an owner seeking a reduced assessment should look for negative conditions beyond the control or ability of the owner to correct within the boundary of the property. Be prepared to discuss with the assessor how the conditions affect the property value. Bring plat maps, photos, restrictive regulations and ordinances, and any documents that entail restrictions on the use of the property — legal, physical or otherwise — and an explanation of how these matters negatively affect the property's value.

While there is no cure for incurable obsolescence, there are treatments for unfair tax assessments. When incurable obsolescence results in lost improvement value, the owner is entitled to an appropriate downward adjustment of the assessed value. 

Legal covenants often cause excessive property taxation for mall owners that are looking to redevelop.

The repurposing of malls and anchor stores is a popular topic in community development circles, but legal restrictions make redevelopment extremely difficult. Often locked into their original use by covenants, malls and anchor stores are often grossly overvalued for property tax purposes.

In pursuing a redevelopment, taxpayers should ensure the properties are fairly assessed and taxed.

Debilitating obsolescence

It is difficult to overstate the plight of malls and department store anchors. Gone are the halcyon days when the mall was everyone's shopping destination. There is even a website, www.deadmalls.com, devoted to failed malls. Credit ratings of most anchor store operators have fallen below investment grade. Commentators usually blame the retail apocalypse on e-commerce and shifting consumer spending habits.

COVID-19 exacerbated these trends and mall foot traffic has been slow to recover. Some chains, including Neiman Marcus and JCPenney, have filed bankruptcy. E-commerce volume surged in 2020 and 2021 before tapering in 2022. To date, e-commerce and brick-and-mortar sales have not yet reached an equilibrium.

One in five American malls have fully closed and remain "zombies" without a redevelopment plan, estimates Green Street Advisors, a commercial real estate analytics firm. A December 2022 article from The Wall Street Journal that detailed the "long death" of the White Plains Mall noted there is no shortage of dying malls. The article observed that converting enclosed shopping centers to other uses remains a "difficult feat." Repurposing, while much-discussed, has not really happened.

The question is why. The answer relates, at least in part, to legal challenges inherent in changing the property's use.

Tied hands

Any property valuation begins with a "highest and best use" analysis. A basic assumption about real estate directs that the price a buyer will pay reflects that buyer's conclusions about the property's most profitable use. Competitive forces within the local market shape a property's highest and best use, but that use must reflect practical and legal restrictions.

Many people incorrectly assume that governmental requirements pose the only legal restrictions on use. Zoning ordinances may impose barriers, owners of neighboring properties may object to redevelopment proposals, or there may be other hinderances to changing the property's use.

Zoning limitations pale in comparison to restrictions in recorded easements and unrecorded operating agreements between mall owners and anchor department stores. While zoning may permit non-retail uses, private agreements generally do not.

Malls would be economically unfeasible without department stores and inline stores that symbiotically drive traffic to each other. Generally, anchors own their pads and inline tenants lease space from the mall owner. A typical mall is subject to two levels of private restrictions designed in an earlier time period to promote the efficient functioning of the mall for retail stores.

Recorded operating restrictions or restrictive easement agreements (REAs) impact the entire mall and its anchors and are generally binding for 40 years or longer. Typically, substantive amendments to the REA require the consent of all parties, and their economic interests are not always aligned.

Unrecorded operating agreements govern the relationship between individual anchors and the mall owner. Terms typically address tenancy, hours of operation, required years of operation under a specified tradename and the size of each anchor and the mall. Operating agreements also generally restrict the size and construction of improvements on the anchor pad and regulate usage.

A simple example involves anchors using stores as a delivery point for e-commerce, a concept known as buy online, pick up in store (BOPIS). Many REAs and operating agreements severely limit implementation of this concept.

But what if the mall's highest and best use is no longer retail? E-commerce and changed consumer practices undermine the REAs' and operating agreements' ability to ensure the property's success, but those private agreements are understandably focused on preserving retail usage.

The common party to these agreements is the mall owner, making it the logical purchaser when an anchor looks to sell. The potential economic return on any proposed redevelopment must be sufficient to encourage an entrepreneur to take the redevelopment risk for the mall and/or anchors.

Legal risk escalates the economic risk. For example, owners of some anchor properties seek conversions to multifamily or industrial use as salvation from the "retail apocalypse." Even if they overcome zoning objections, attempts to change REAs and unrecorded operating agreement restrictions may require unanimous consent among owners with competing economic interests.

The anchor pad may not even be worth its unimproved land value since its use is restricted to retail under the REAs and operating agreements.

Property tax implications

While mall owners and anchors struggle to remain viable in the changed retail environment, ad valorem property taxes pose an immediate challenge. Most states value property as what a willing buyer would pay to a willing seller, but the glory of malls and anchors before e-commerce generally encourage high property tax valuations.

Assessors performing an income-based assessment seldom recognize how anchor chains' plunging credit ratings affect value. The sales-comparison approach is equally challenging, as anchor property transaction volume has plummeted since 2006.

Most sales involve a change to non-retail use and thereby require unanimous consent. Consent is easier to obtain when the new use increases foot traffic to the remaining inline tenants and anchors, but it is easy to envision anchors holding the process hostage in an attempt to force the purchase of their failing stores.

REAs and unrecorded operating covenants make calculation of an anchor's value extremely difficult. They also call into question the comparability of previous transactions to repurpose anchors in the same mall, since those anchors may have agreed to one specific new use but may object to another.

REAs and operating agreements often hamstring mall and anchor redevelopment. Most were signed before e-commerce and did not envision retail losing its vitality. The parties to these covenants often have divergent economic interests and perspectives, and the natural party to lead redevelopment — the mall owner — must overcome these hurdles.

In the short term, however, owners should address highest and best use with assessors to reduce property tax burdens until their zombies can be brought back to life.

Nuances of ownership and operations can reduce or eliminate ad valorem liability for property owners.

How municipalities and counties tax medical real estate can vary by modes of ownership, location and how a property affects the local economy. Much, however, depends on each taxing entity's goals and its degree of interest in attracting hospitals, creating medical hubs, enlarging commercial areas or encouraging excellent health care locally.

A typical approach to achieving some or all of these goals is for local government to control the property. This can be through outright ownership, where the facilities are leased out. Governments can also create an economic zone and issue bonds to finance the area's development. Each of these methods poses property tax issues.

In a direct ownership scenario, the government owner is exempt from taxation. The operating and management company that leases the property has tax liability for its going concern, however. That going concern has untaxed intangible value, but also will have onsite assets such as medical equipment that can be taxed under standard code approaches at fair market value. They can also be taxed under a modified fair market value, which is a common incentive designed to entice investment by medical businesses.

If the local government chooses a development-bond approach, it will create a development district entity to issue bonds, with proceeds from bond sales paying for construction of the hospital or other facility. A private entity would lease the facilities under the cost of the bonds, with lease payments going toward retiring the bonds. Lease provisions would set out agreed-upon valuations for property tax purposes. These valuations can be flat or adjusted over time. Once the bonds are paid off, the terms of the lease can be extended or modified.

After using one of these favorable property tax techniques to establish a footprint for a healthcare district, development or zone, the governmental body may widen its impact by offering lower taxes within the area. These adjustments would favor medical facilities that support hospitals or medical practices nearby.

For example, a community could use tax breaks to encourage construction of medical office buildings. If the economic district includes other buildings that would be useful to the healthcare industry, it can offer similar tax incentives to encourage development and use of those facilities. Likewise, such incentives can be used for standalone facilities within the economic district.

For governments that do not envision a medical district but want to foster broader access to healthcare providers, tax policy can create special tax methods without uniformity restrictions. This would encourage small medical investments throughout the community. Examples would include free-standing treatment facilities such as "doc in a box" walk-in clinics, urgent care facilities and small medical office buildings.

Strategies for tax exemption

In Georgia, hospitals can be owned in a couple of ways to avoid taxation. First, the government can own the hospital and lease it to a non-profit manager or operator. So long as the lessee remains a non-profit, the real property is tax exempt. If the leasehold transfers to a for-profit entity, the tax exemption disappears and the management or operational entity becomes responsible for the property tax.

Second, the local government can create an economic development zone using bonds. Within any leaseholds created by the bond issuer, property tax responsibility can be addressed by contract. This can range from zero liability to points on a sliding scale, and will usually correlate to the gradual elimination of the bonds.

Another scenario involves an exempt property that is then acquired by a for-profit operator. In Michigan and Georgia, such a transfer will void the tax exemption, subjecting the facility to full taxation at fair market value. A question remains about a retransfer of the operations to a non-profit, which may or may not restore the tax exemption. In Minnesota and Kansas, the ownership is through the government but the facility must be operated as a non-profit.

In some jurisdictions hospitals can be a taxing authority. In Texas and Iowa, rural hospital districts can levy a component of the property tax millage rate. The hospital district then uses that portion of the millage rate to pay part of its operating expense. This allows rural hospitals to maintain their operations by spreading costs throughout the community, rather than to the users of the system. In recent years states have tended to reduce property taxes overall, which has squeezed revenue for rural health systems in states that allow hospitals to participate in taxation.

Personal property, which is movable property such as medical equipment, can be treated in different ways. If the operation is a non-profit, the personal taxes are exempt. Liability is more complicated if the owner of the personal property is a for-profit entity operating within an exempt property; in such instances the personal tax rates apply.

On the other hand, a non-profit may operate within a taxable medical office building, in which case the personal property is still exempt. In fact, a building may have multiple tenants, some of which are non-profits and some of which are for-profit. In such a scenario, each business would have to be examined to determine whether personal tax exemptions apply.

New York City has published three tax-year assessments since COVID-19 swept into our world. The New York City Tax Commission and New York City Law Department have had ample opportunity to reflect and refine their thinking on those assessments.

The disease broke out in Wuhan, China, in late 2019 and soon spread around the world. Most of New York City noticed its impact in February and March of 2020 as businesses shut down at an accelerating rate, warranting government mandates and additional closures.

So, what did New York City do for the 2020-2021 tax year? It significantly raised tax assessments. The Tax Commission and other review bodies refused to base their valuations upon the devastating catastrophic effects of COVID-19 that had ravished the city.

Why do this? The answer is technical. New York City values real estate on a taxable status date, which is Jan. 5 each year. On Jan. 5, 2020, COVID-19 did not exist in assessors' evaluation process. Nor did it exist in the review of assessments later in the year.

Employment restrictions, mask mandates and lockdown requirements made it impossible to operate theaters, hotels, restaurants and many other businesses. These restrictions took effect long before the first installment of property tax payments for the 2020-2021 year had to be paid. Yet hotels found that their tax bills exceeded their total revenue. Other businesses had similar experiences.

The city's next assessment, for the 2021-2022 tax year, reduced assessments by 10 to 15 percent in some sectors, and by as much as 20 percent for hotels. It was too little, too late, and many businesses were failing. The assessment review process was slow and unsympathetic to the plight of businesses devastated by COVID-19.

The Jan. 5, 2022 assessment roll attempted to recoup a modest amount of the value trimmed from taxpayers' properties the previous year in spite of the destructive effects of the Omicron variant that were at their height on the Jan. 5 valuation date. That is the truth: New York City's newly released fiscal 2022-2023 property tax assessment roll presents a market value of almost $1.4 trillion, an 8 percent increase in taxes and estimated taxable assessments of $277.4 billion. That sounds like too much!

Real estate tax increases have come at a time when most property owners and businesses have not even begun to recover from the pandemic's economic impact. Foreign and business travel have disappeared; street traffic is down and empty storefronts abound.

Commercial rents in Herald Square, for example, are down 27 percent from pre-pandemic levels. However, high bills due to ever-increasing inflation remain to be paid. Mortgages, payrolls and maintenance costs add to the burdens of businesses in New York City. Most properties are still struggling, and many are falling behind.

The hospitality sector has been hit especially hard. Hotel revenues and prices have dropped to unsustainable levels. COVID-related rules and fears have evaporated any sustainable growth in tourism. One example of the pandemic hotel market value decline is the recent sale price of the DoubleTree Metropolitan at 569 Lexington Ave., which was 50 percent less than the price it sold for in 2011.

While a few market values have increased, tax increases should have been delayed. For Class 1 real estate, which includes residential properties of up to three units, total citywide market value rose 6.7 percent to $706.8 billion from the previous year's tax roll.

For Class 2 properties­ — cooperatives, condominiums and rental apartment buildings —the total market value registered $346.9 billion, an increase of $27.8 billion, or 8.7 percent, from the 2022 fiscal year. For Class 3 properties, which include properties with equipment owned by gas, telephone or electric companies, market value is tentatively set by the New York State Office of Real Property Tax Services at $43.6 billion.

Last but definitely not least, total market value for commercial properties (Class 4) increased by 11.7 percent citywide to $300.8 billion. Manhattan had the smallest percent increase in market value at 10.3 percent. Class 4 market value is down $25.2 billion, or 7.7 percent, below its level for the 2021 fiscal year. Hotels registered a market value increase of only 5.3 percent.

These slight increases in market value do not warrant this year's increase in taxes. Businesses are still being affected by the economic impact of the pandemic and need time to recuperate. The city's Department of Finance admits that although values increased for the 2023 fiscal year, they remain below the 2021 fiscal year values for many properties due to the impact of the pandemic.

The Department of Finance also acknowledged in its announcement of the tentative tax roll that commercial property values remain largely below pre-pandemic levels. This underscores why the increase in taxes should have been delayed, at least until properties and businesses attain pre-pandemic values.

Strategies for Relief

In appealing assessments, property owners can improve their chances for obtaining relief by quantifying property value losses. For hotel owners and operators, this means gathering documentation showing closure dates, occupancy rates and any special COVID-19 costs incurred. Most industry forecasts anticipate at least a four-year recovery period for hotels to reach pre-pandemic revenues.

Retail and office property owners should be prepared to show any declines in gross income and rents received or paid on their financial reports filed with the city. Residential landlords should list tenants that vacated and those that are not paying rent.

In conclusion, tax assessments must reflect the entirety of what this pandemic has done to the real estate industry over the past 24 months. New York City authorities must provide tax relief for property owners, and taxpayers and their advisors will need to take an active part in obtaining reduced assessments.

A recent order from the Ohio Board of Tax Appeals highlights a troubling aspect of real property tax valuation in the Buckeye State, where school districts wield extraordinary authority to influence assessments. In this instance, courts allowed a district to demand a taxpayer's confidential business data, which it can now use to support its own case for an assessment increase.

Ohio is one of the few states that permit school districts to participate in the tax valuation process, allowing a district to file its own complaint to increase the value of a parcel of real estate, and permitting a school district to argue against a property owner that seeks to lower the taxable valuation of a parcel of real estate.

Steve Nowak, Siegel Jennings Co.

Generally, school districts looking to increase tax revenue will review recent property sales for opportunities to seek assessment increases. Likely candidates for an increase complaint include real estate that changed hands at a purchase price or transfer value that exceeds the county assessor's valuation. That is not always the case, however.

In the case that gave rise to this article, there was no recent sale of the subject property, which is a multi-story apartment building. The apartment building owner had done nothing to draw any assessor's attention to their property in recent years — it had not been listed for sale, for example, nor had the owner recently refinanced the property.

Blind assertions

In the apartment building case, the school district filed a complaint to increase the county's valuation from $3.85 million to $4.63 million. At the local county board of revision hearing on the school district's complaint, the school district failed to present any competent and probative evidence that the apartment complex was undervalued as currently assessed.

The school district could not present evidence of a recent sale because there had been no sale. The school district also failed to present an independent appraisal witness to testify that the apartment complex was undervalued. Not surprisingly, the county board denied the school district's request to increase the valuation of the subject property.

This is where things got tough for the property owner, and where other Ohio taxpayers may face similar dilemmas. Having received the county board's denial of its complaint, the school district filed an appeal to the Ohio Board of Tax Appeals (BTA) to relitigate its argument that the apartment complex was undervalued.

Once a case is appealed to the BTA, the parties to the case obtain the right to conduct discovery. This is a process intended to help parties in a legal disagreement to "discover" or learn the case and evidence the opposing side may present against them.

Here, as part of its discovery requests, the school district asked that the property owner provide directly to the school district copies of rent rolls, income and expense information and other business records.

Not wanting to turn over such sensitive information, the property owner filed a motion for protective order and requested the BTA deny the school district's prying requests into the day-to-day operations of the apartment building's financial performance. Because discovery is granted as a matter of right on appeal and the threshold for discovery requests is fairly low, the BTA denied the property owner's request for a protective order.

Facing what it believed to be an unconstitutional infringement of its right to privacy, the property owner appealed the BTA's decision denying the request for a protective order to the next appellate level. The taxpayer laid out its arguments of why the school board's baseless complaint seeking to increase the property owner's valuation was unconstitutional.

The appellate court was unmoved, however, and issued a short order upholding the BTA's decision denying the property owner's motion for protective order.

Private data shared

Faced with the appellate court's order, the apartment building property owner was left with no choice but to turn over to the school district years of rent rolls and years of income and expense records for the property. The school district then provided the property owner's own confidential and sensitive business information to the district's appraiser.

Thus, after failing to produce sufficient supporting evidence of its original valuation assertions, the very evidence the school district will now rely upon to increase the property owner's real estate valuation (and tax bill) will have been provided by the property owner itself.

Cases like the one outlined above illustrate the unfettered discretion that school boards have in deciding on what properties to seek increased valuations. This puts Ohio real estate owners' rights at risk, and needs to be responsibly and reasonably curtailed.

Judith Viorst, author of the children's book Alexander and the Terrible, Horrible, No Good, Very Bad Day, had nothing on 2020. By virtually every metric, 2020 was a terrible, horrible, no good, very bad year.

Most states have some sort of catastrophe exemption for a property tax abatement or reduction tied to a defined disaster event. These statutes are state-specific, however, and few states had authority to address whether a property had to have sustained physical damage to qualify for catastrophe relief on property taxes.

Most states, including Texas, eventually concluded that some form of physical damage was necessary for property values to be reduced following a disaster. Its neighbor, Louisiana, went the other direction, concluding that its disaster statute did not require physical damage, only that the property be inoperable due to a declaration of emergency by the governor. Accordingly, property values for the 2020 tax year could be reduced in Louisiana due to COVID-19-related economic losses.

Pandemic paper trails

Fortunately, 2021 gives all taxpayers a fresh start. Most states use Jan. 1 as the "lien date," or valuation date for determining fair market value of property subject to ad valorem tax. For income-producing properties, taxpayers now have a full year's documentation of COVID-19 impacts, which more accurately demonstrate the fair market value of their properties in the current, COVID-19 economic climate. At a high level, such documentation may include financial statements with year-over-year and month-over-month comparison of revenues to expenses and profits to losses.

Drilling down, taxpayers should be able to demonstrate the source of these changing numbers, such as reduced employee hours, decreased production outputs and sales, unoccupied rooms, canceled conferences and the like. Comparable sales information should also now be available.

This information generally relates to economic obsolescence, which is a loss in value due to causes outside the property and which are not included in physical depreciation. Taxpayers also must consider whether their property exhibits functional obsolescence, or a loss in value due to the property's lack of utility or desirability.

Functionality is tied to a property's amenities, layout and current technology. A property's functional obsolescence is measured through reduced or impaired use. Taxpayers can quantify the lack of use in 2020 and compare it to pre-2020 capacity and usage in arguing for a reduction in taxable value.

Value and evolving utility

Historical information is key to the taxpayer's case — as is evidence of adaptation to current market trends. For instance, a year ago, who would have imagined that neighborhood and big-box stores of all stripes would start delivering their products directly to customers' homes? Suddenly, abundant check-out lanes, wide aisles, sampling stations and sprawling parking lots are unnecessary. Retailers would rather have drive-thru lanes and dedicated carryout parking.

Hotels have been similarly affected. Traditional amenities such as atriums, event space and intimate lounges that preclude safe social distancing are passé. Motels with open-air access are enjoying a renaissance. Resourceful restauranteurs have figured out how to make street-side dining desirable. Patios are now essential. While many of these changes in use are likely temporary, some are expected to be longer-lasting.

Consider commercial office space. Prior to the pandemic, many office-using employers permitted only limited remote work but working from home has now become the new normal. Facility planners expect the traditional office environment to shift to a hybrid model, with expanded remote working, office-sharing, and fewer in-person communications. Large conference rooms are out and state-of-the-art multimedia systems have taken their place.

These trends impact real estate values because they affect how property is used, or more importantly, not used. Commercial real estate developers will not be laying out offices the same way they used to, and hoteliers will not be building out the same large conference centers post-COVID. And the reality is that much existing buildout, furniture and equipment is going unused. So for now, a replacement cost analysis is the most appropriate valuation method for those property types, because it reflects the functionality of the property and the fact that the property would not be rebuilt as is.

Of course, as more and more businesses adapt to post-pandemic market trends, the lack of utilization may be deemed industrywide rather than property specific. At that point, appraisers should treat the lost value as economic obsolescence, which is value losses stemming from factors occurring outside the property. In either case, taxpayers should be prepared to demonstrate the inutility of their property, and the cost of such inutility, to reduce taxable value.

Better than terrible

Whether or not 2021 is radically better than last year, at least taxpayers are now in a better position to show the adverse impact the pandemic has had on fair market values. And if that translates to lower ad valorem tax liabilities, then this decade is off to a very good start.

Protest any tax assessment that doesn't reflect the cost to remediate any existing environmental contamination.

Owners of properties with environmental contamination already carry the financial burden of removal or remediation costs, whether they cure the problem themselves or sell to a buyer who is sure to deduct anticipated remediation expenses from the sale price. Fortunately, New York law allows those property owners to reduce their property tax burden to reflect their asset's compromised value.

Tax types

Most local governments in the United States impose a property tax on real estate as a primary source of revenue, levied and calculated by either ad valorem or specific means. Latin for "according to value," ad valorem taxes are imposed proportionately based upon the market value of the property. Thus, the higher the market value, the higher the real estate tax.

Specific taxes, on the other hand, are fixed sums without regard to underlying real estate value. School, county and town governments nearly always compute real property taxes using the ad valorem method, whereas lighting, garbage or sewer districts typically apply specific taxes. Because school and county/town taxes account for the overwhelming majority of a property tax bill, property owners frequently use assessment litigation concerning the market value of the subject property to reduce assessments and, as a result, lower the real property tax burden.

The cardinal principle of property valuation for tax purposes is that assessments cannot exceed full market value. Many states including New York codify this in their constitutions. The concept of full value is regularly equated with market value, which is the highest price a willing buyer would pay and a willing seller accept, both being fully informed.

Disagreements often arise if the subject property is afflicted with environmental contamination. The treatment of environmental contamination and remediation costs is of particular concern to both owners and municipalities. Owners seeking to depress taxable values and thereby reduce their tax burden claim these expenses dollar-for-dollar off the market value under the principle of substitution. In other words, a proposed buyer would not pay more than $8,000 for a parcel worth $10,000 which needs $2,000 of remediation.

On the other hand, municipalities would prefer the adoption of a rule (either via legislation or court decision) barring any assessment reduction for environmental contamination. Otherwise, they claim, polluters would succeed in shifting the cost of environmental cleanup to the innocent taxpaying public, in contravention of the public policy of imposing remediation costs on polluting property owners and their successors in title.

Pivotal case

Fortunately for property owners, a seminal 1996 court decision guides the treatment of environmental costs to cure taxable value in New York. In Commerce Holding Corp. vs. Town of Babylon, the petitioner purchased 2.7 acres of land in the Town of Babylon, Suffolk County. A former tenant of the property had performed metal plating on the premises and discharged wastewater containing multiple heavy metals into on-site leaching pools, ultimately resulting in the severe contamination of the parcel. The owner filed tax appeals and argued the value of the property should be reduced by the considerable costs needed to clean up the parcel.

As expected, the town's position relied on a public policy approach and urged the court to reject any argument for a reduced assessment. Ultimately, the case traveled to New York's highest court, which summarily rejected the public policy arguments that polluters should not be rewarded with lower assessments.

Instead, the court applied the constitutional and statutory requirements of full market value assessments, holding that the full value requirement is a "constitutional" mandate which cannot be swept aside in favor of public policy. Thus, property must be valued as clean, with the value reduced by the costs to cure the remediation per year. Challenges seeking the limitation or outright reversal of the Commerce Holding case have been continually rejected.

A recent clarification

The New York State Court of Appeals did not address remediation again in a property tax litigation context for almost 20 years after Commerce Holding. In a 2013 case, Roth vs. City of Syracuse, a property owner sought to have the assessment on certain rented properties reduced because of the presence of lead-based paint.

The court declined to expand the application of Commerce Holding in this case for two significant reasons. First, the owner continued to rent the buildings and collect income. Second, the owner had not taken any steps to remove or remediate the lead paint and restore the properties. Thus, to successfully claim an assessment reduction, a property owner should not stand idle but take definitive actions to remediate the property. 

Statutory law continues to require that assessors value only the real estate, not the success or lack thereof, by the owner of the real estate.

Assessors and their minions frequently take the position that an occupied store is more valuable than an unoccupied store, a conclusion commonly referred to as the "Dark Store: theory. Owners of big-box retail properties and their tax advisers bristle at this erroneous contention, because real property taxes are just that– a tax on the value of the real estate.

It is the assessor's function to value the property's real estate components, which consist primarily of land, bricks and mortar; or in the cases of most big boxes, land, concrete, pop-up concrete or metal slabs. It is a common but mistaken practice of assessors to place a greater taxable value on a big box occupied by a major retailer than on a vacant building of equal design, construction and utility.

This errant valuation methodology has given rise to controversy played out through expert testimony and sophisticated argument before administrative agencies and the courts. It is in this context that the term "Dark Store theory" has come into play.

A call to action

Owners of big-box real estate need to deliver a consistent response in the face of this increasingly pervasive and costly misconception. And because informal meetings between the owner's representative and the assessor are limited in time and scope, providing little opportunity for sophisticated argument, these owners must take a position that can be expressed in laymen's terms and understood by the average taxpayer.

That message is that the dark store theory is not a theory at all. It is a reality. The real estate components of occupied buildings have the same value as the real estate components of vacant buildings.

Dark Store theory has become part of the dialogue when valuing commercial properties for taxation. It's vilified as though it were a new concept with dark connotations, like the revelation of a new and insidious scheme by Darth Vader. In fact, its underlying concept is as old as the exercise of determining value for any purpose.

Unless a particular property has actually sold on a particular date, any opinion of its market value is hypothetical. Any such opinion is subject to informed disagreement within the boundaries of accepted valuation methodology. The standards of that methodology, as expressed, for example, in the Uniform Standards of Appraisal Practices, require that the value of a property is based on the willing-buyer, willing-seller concept. The assumption is that a willing buyer wants to buy and use the property.

Logic, not to mention all standards of appraisal practice, dictates that the hypothetical buyer is buying the property for some purpose. Whatever that purpose, it precludes the seller's continuing to use the property. This discussion is independent of a sale-leaseback transaction, which is a financing strategy.

The reality is that the buyer wants to use the property, as is the case across the spectrum of property purchases.

A residential parallel

The same concept applies to the sale of a suburban bungalow. When the Smiths buy a home from the Joneses, they expect the Jones family to vacate the property by the closing date. The Smith family bought the property expecting it to be available for occupancy on the closing date. Nothing about the selling family's success or possible dysfunction affects the purchase price.

In valuing single-family homes, assessors do not discuss the resident families' success (all the children became neurosurgeons). Yet assessors effectively do so in valuing big boxes, which by all valuation standards must be deemed available for occupancy as of the date of closing.

One does not hear the expression "dark house theory," because the assumption of availability of the property for use by the buyer at closing is intrinsic to the transaction. In appraisal parlance, the concept has been and remains that the exchanged property is "free and clear of all encumbrances," ergo vacant, or in current usage, "dark."

Many big boxes, typically measuring in the neighborhood of 100,000 square feet, have come on the market in recent years due in part to changing consumer buying patterns and reduced store counts by retailers. There is a tendency among assessors to over-value properties occupied by the surviving big-box retailers, in effect imposing a form of income tax that they justify by citing retailers' over-all company sales, while turning a blind eye to the availability of big boxes standing dark in the same market.

The sales volume and profits produced by a big-box store are as unrelated to the real estate's value as apple pie is to a computer. Thus, two side-by-side buildings of the same size and specifications, with one housing a high-profit retailer and the other an empty or dark box, have the same real estate value.

​True to campaign promises, the new Cook County assessor has proposed sweeping legislation that borrows the most burdensome tax requirements and penalties from jurisdictions across the country. But will this enhance transparency or simply saddle taxpayers with inaccurate assessments and the need for costly appeals?

The 2018 race for Cook County Assessor ended in Fritz Kaegi beating out incumbent and long-time political powerhouse Joseph Berrios. Kaegi's campaign promises targeted the "insider" game of property tax appeals and proposed to bring fairness and transparency to the Illinois property tax appeal system.

The proposed requirements would only be imposed on commercial or income-producing properties worth more than $400,000, or residential properties with seven or more units worth more than $1 million. Residential properties with six units or less, as well as mixed-use commercial/residential buildings with six or fewer apartment units and less than 20,000 square feet of commercial area, are exempt from reporting income data.

In Cook County, these commercial properties will be required to submit income and expense data to the assessor prior to July 1 each year, and attest to the truthfulness of such information. Counties outside of Cook County may adopt the same requirement.

Property owners who fail to file the required information may receive a notice from the assessor demanding its submittal. If the taxpayer fails to report the income pursuant to the notice, the taxpayer will be fined 2 percent of the previous year's total tax bill. If the taxpayer still does not submit evidence within 120 days of the original notice, the proposal adds a second penalty of 2.5 percent of the prior year's tax bill.

As if these financial penalties were not enough, the taxpayer who fails to provide the information within 120 days is precluded from appealing the subject property's tax assessment. Furthermore, the Cook County State's Attorney's office is granted the right to subpoena the income and expense data from the tax payer on an annual basis.

None of the legislation eliminates the right to appeal to the Board of Review, however.

So, will the proposed statute bring fairness and transparency to the appeal process? No.

Round hole, square peg

The requirement to file income and expense data is not revolutionary. In many cases, taxpayers file appeals based directly on the property's income data rather than incur appraisal expenses. On the other hand, income-producing properties that commission an appraisal will provide the income and expense data to the appraiser in order to explain any differences between the actual rents in the subject property and the market rents used to calculate the assessment. Thus, the new rules will not necessarily bring more transparency to the values of multimillion-dollar commercial properties.

For the institutional investor, the greatest concern about the proposal is the validity and application of the collected income and expense data. As the old saying goes "garbage in, garbage out."

The assessor claims that the collection and aggregation of data directly from taxpayers will help identify the true rental market value of specific real estate. The concern is that taxpayers will be reporting a variety of unadjusted rents rather than market rates. Market rates take into account the differences between gross, modified and triple net leases, as well as tenant improvements, concessions, length of lease, sale-leasebacks and a host of other factors. Without adjustment to market rates, the data will be incorrect and the assessments will be inflated. This will produce a higher rate of appeal on an annual basis and impose greater appeal burdens on all involved.

Furthermore, the new requirements will bring the greatest harm to smaller commercial investors who may not be filing property tax appeals at all. Many of these are mom-and-pop organizations that keep handwritten ledgers and have market values between $400,000 and $1 million. The annual reporting requirement and respective penalties would be financially burdensome to taxpayers in this group, many of whom never undertook the expense of filing an appeal. Now those taxpayers may be open to valuation increases on an annual basis and have to spend money on appraisals and attorney representation.

And transparency?

The proposed statue prohibits "non-personal income and expense data" the assessor collects from being accessed through Freedom of Information Act searches. Does this indicate that the data sets the assessor produces cannot be analyzed by the taxpayer for accuracy? Where is the fairness and transparency in that?

If the statute passes, the hurdle for Illinois taxpayers will be to clearly identify the difference between market rents and actual rents for each of their properties, which may result in extremely burdensome requirements and penalties. The mandated steps may require intricate analysis and could result in property owners expending time and money responding to annual notices for documentation, fines for noncompliance, and the inability to challenge illegal assessments as a right.

Much of the income-and-expense statements, rent rolls and other data the assessor seeks are already available in documentation currently being submitted in support of annual appeals. Based upon this readily available data, the assessor should be able to generate guidelines that reflect current rental rates, occupancy levels and capitalization rates.

If Cook County taxes need reform, this is not the reform.

''While Republicans and Democrats remain divided on the overhaul's benefits, there is a single undeniable fact: The sharp reduction of the corporate tax rates from 35 percent to 21 percent will be a boon for most businesses"

President Trump's Tax Cuts and Jobs Act is the first sweeping reform of the tax code in more than 30 years. Signed into law on Dec. 22, 2017, the plan drops top individual rates to 37 percent and doubles the child tax credit; it cuts income taxes, doubles the standard deduction, lessens the alternative minimum tax for individuals, and eliminates many personal exemptions, such as the state and local tax deduction, colloquially known as SALT.

While Republicans and Democrats remain divided on the overhaul's benefits, there is a single undeniable fact: The sharp reduction of the corporate tax rates from 35 percent to 21 percent will be a boon for most businesses. At the same time, employees seem to be benefiting too, with AT&T handing out $1,000 bonuses to some 200,000 workers, Fifth Third Bancorp awarding $1,000 bonuses to 75 percent of its workers, Wells Fargo raising its minimum wage by 11 percent and other companies sharing some of the increased profits with employees. Companies are showing understandable exuberance at the prospect of lower tax liability, but investments many firms are making in response to the changes may trigger increases in their property tax bills.

Some companies already are reinvesting in their own infrastructure by improving and upgrading inefficient machinery or renovating aging structures. Renovations to address functional or economic obsolescence can help to attract new tenants and, most significantly,command higher rental rates for the same space.

The real property tax systems in place for most states are based on an ad valorem (latin for "according to value") taxation method. Thus, the real estate taxes are based upon the market value of the underlying real estate. Since the amounts on tax bills are based on a property's market value, changes or additions to the real estate can affect the taxes collected by the municipality.

Generally speaking, most renovations such as new facades, windows, heating or air conditioning will not change the value or assessment on a property. The general rule is that improvements that do not change the property's footprint or use, such as a shift from industrial to retail, shouldn't affect the property tax assessment. However, an expans1on or construction that alters the layout of a property can -and usually does -result in an increased property assessment. Since realestate taxes are computed by multiplying the subject assessment by the tax rate, these changes or renovations can significantly increase the tax burden.

Tax Exemptions Available for Property Improvements

Recognizing that this dynamic could chill business expansions, many states offer a mechanism to phase-in or exempt any assessment increases. This can ease the sticker shock of a markedly higher property tax bill once construction is complete.

New York offers recourse in the form of the Business Investment Exemption described in Section 485-b of the Real Property Tax Law. If the cost of the business improvements exceeds $10,000 and the construction is complete with a certificate of occupancy issued, the Section 485-b exemption will phase-in any increase in assessment over a 10-year period. The taxpayer will see a 50 percent exemption on the increase in the first year, followed by 5 percent less of the exemption in each year thereafter. Thus, in year two there will be a 45 percent exemption, 40 percent in year three and so on.

Most other states have similar programs to encourage busmess investments and new commercialconstruction or renovations. The State of Texas has established state and local economic development programs that provide incentives for companies to invest and expand in local communities.For example, the Tax Abatement Act, codified in Chapter 312 of the tax code, exempts from realproperty taxation all or part of an increase in value due to recent construction, not to exceed 10 years. The act's stated purpose is to help cities, counties and special­ purpose districts to attract new industries, encourage the development and improvement of existing businesses and promote capital investment by easing the increased property tax burden on certain projects for a fixed period.

Not long ago, the City of Philadelphia enacted a 10-year tax abatement from realestate taxes resulting from new construction or improvements to commercial properties. Similarly,the State of Oregon offers numerous property tax abatement programs, with titles such as the Strategic Investment Program and Enterprise Zones.

Minnesota goes a step further and automatically applies some exemptions to real property via the Plat Law. The Plat Law phases-in assessment increases of bare land when it is platted for development. As long as the land is not transferred and not yet improved with a permanent structure, any increase in assessment will be exempt. Platted vacant land is subject to different phase-in provisions depending on whether it is in a metropolitan or non-metropolitan county.

Clearly, no matter where commercial real estate is located, it is prudent for a property owner to investigate whether any recent improvements, construction or renovations can qualify for property tax relief.