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Property Tax Resources

Oct
17

The Supreme Court Takes On Tax Takings

Justices recognize owner rights extend to surplus proceeds from properties sold after tax sales.

Federal courts rarely adjudicate property tax matters, which have traditionally been the province of state courts. In May 2023, however, the U. S. Supreme Court issued a unanimous decision in a case that squared state property tax law up against the Fifth Amendment takings clause, which prohibits taking private property for public use without just compensation.

Taken for taxes

The events leading to Tyler vs. Hennepin County, began in 1999, when Geraldine Tyler purchased a Minneapolis condominium that she occupied until she moved into a seniors housing community in 2010. Ms. Tyler retained ownership of the condominium but failed to pay property taxes on it for several years, resulting in approximately $2,300 in unpaid taxes and $13,000 in interest and penalties.

Acting in accordance with Minnesota tax forfeiture procedures, Hennepin County seized the condominium and sold it for $40,000. This extinguished Ms. Tyler's $15,000 tax debt, and Hennepin County kept the remaining $25,000.

Minnesota's tax forfeiture procedure required the county to give the delinquent taxpayer adequate notice of the tax sale; notably, the procedure lacked a mechanism for a delinquent taxpayer to assert a claim to any sale proceeds remaining after paying off the tax debt.

Ms. Tyler brought a putative class action suit against Hennepin County in Minnesota federal court alleging that Hennepin County's retention of $25,000 in excess proceeds from the sale of her condominium was a taking of property without just compensation, and therefore an unconstitutional violation of the takings clause. The lower courts rejected her claims, and the case made its way to the U.S. Supreme Court.

The Supreme Court first noted that the takings clause does not itself define private property which, if taken by a state, requires compensation. The Court then conducted a thorough analysis of historical practice and traditional property law principles to determine that the surplus value remaining after a forfeiture sale constituted compensable property under the takings clause.

The Court concluded that the right to surplus proceeds is simply an extension of the corresponding interest in the underlying property. Thus, the Court recognized that a taxpayer's compensable interest in property applies to the underlying property itself and to equity in that underlying property in the form of excess proceeds generated from a forfeiture sale of that property.

Accordingly, while Hennepin County had the power to sell Ms. Tyler's home to recover the unpaid property taxes, it could not use the tax debt "as a toehold" to confiscate more property than was due, the Court stated. Doing so effected a "classic taking in which the government directly appropriates private property for its own use," such that Ms. Tyler was entitled to just compensation from Hennepin County.

Mechanisms mandate?

Unfortunately, the Supreme Court's recognizing a property right in surplus proceeds does not mean that states must now automatically return surplus proceeds to delinquent taxpayers. Nor does it directly address how states should administer their tax forfeiture sales to prevent infringing on taxpayers' constitutional rights.

But the Court did give some guidance in Tyler as to what statutory measures might prevent a takings clause violation. The Court cited Nelson vs. City of New York, decided in 1956, in which the city foreclosed on properties for unpaid water bills. Under the applicable ordinance, the aggrieved property owners had an opportunity to request the surplus from any sale by filing a timely answer in the foreclosure proceedings asserting that the properties had a value exceeding the amount due.

The property owners failed to do so, however. The Supreme Court held that, because the owners did not take advantage of this procedure, they forfeited their right to the surplus. Because the ordinance did not absolutely preclude an owner from obtaining the proceeds from a judicial sale but simply defined the process through which an owner could claim the surplus, there was no takings clause violation.

States are already reacting to the Tyler decision. In New Jersey and Virginia, courts have struck down state court tax sale procedures as unconstitutional under Tyler. Nebraska has amended its tax sale statutes to conform with Tyler.

Louisiana is following suit: Under current law, a tax sale grants the purchaser a prospective ownership interest in the form of a tax lien. This lien represents a claim on the property but does not confer immediate ownership rights. The purchaser can acquire full ownership after the redemption period has passed.

After Tyler, the Louisiana Legislature proposed amending the state's constitution to require adding to the state's tax sale procedures a process for delinquent taxpayers to claim any excess proceeds from a tax sale. The measure must be approved by the electorate and is on the December ballot for voter consideration.

Chief Justice John Roberts noted in Tyler that a taxpayer must render unto Caesar what is Caesar's, but no more. While states are conforming their laws to Tyler, taxpayers and aggrieved property owners must still comply with governing statutory procedures to claim their surplus and prevent Caesar from getting more than he is entitled to.

Angela W. Adolph is a partner in the Baton Rouge office of Kean Miller LLP. The firm is the Louisiana member of American Property Tax Counsel, the national affiliation of property tax attorneys.
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Sep
16

Taxing Office-to-Residential Conversions

Taxpayers transforming office buildings into living space can argue for a lower property tax assessment.

The conversion of obsolete office buildings to new uses is a growing trend in many markets, especially in dense urban centers. Unfortunately, properties under reconstruction can continue to incur hefty property tax bills, even when the asset lacks a rent stream to help offset the owner's costs.

The right arguments can help these taxpayers reduce their property tax liability during a building conversion, however, and set the stage for an accurate, fair assessment of the asset's adjusted market value under its new use. The taxpayer's challenge is to understand how reconstruction affects market value and to show assessors how those forces affect taxable value.

Obsolescence and opportunity

Demand for office space was already faltering when the COVID-19 pandemic accelerated occupancy declines. Since then, remote work and space sharing among office workers has further reduced the amount of offices companies need, with many tenants returning space to property owners as leases mature.

Normally, appraisers value multitenant office buildings under an income approach, attributing rental income per square foot as a starting point for valuation. When the space loses market viability, the per-square-foot rent variable declines and lowers the net valuation for tax purposes.

Expanding this result over an entire central business district can erode the tax base significantly as older buildings lose value. Many older properties struggle to compete with newer spaces, in addition to suffering from declining post-pandemic user demand. In essence, the older office towers were hampered by economic obsolescence.

Downtown office vacancy rates now exceed 25 percent in many major cities, dealing a significant blow to market value and, subsequently, tax value. Obviously, owners and city government share a common goal of maximizing property usage, which increases revenue to the owner and tax value to the government.

One solution gaining traction in markets with strong residential demand is converting obsolete office buildings to residential apartments or condominiums. This is a multistep process that can take considerable time, possibly spanning one or more tax years.

Investments in time

The first task in a conversion is to empty the building, an often protracted process that simultaneously reduces the property's income and market value. Waiting for each lease to expire while revenue streams decline can be an expensive exercise. Taxpayers should ensure that the assessor has factored in this negative movement in the building's value under the income approach. When few tenants remain, the owner may choose to buy out the remaining leases.

Reconstruction begins with demolishing building components that will not fit the future use. For example, suspended ceilings commonly used in office buildings are unsuitable for living spaces and would need to be removed.

While this phase can start before the building is completely empty, it cannot be finished until the building is unoccupied. During this period, the income generated is virtually zero and has a continued negative effect on the building's market value and taxable value.

The project design will be partly determined by the local apartment market. Creating a product that will compete successfully for tenants has a direct impact on cost, finish work and amenity choices. During this stage, the owner is incurring costs without generating income from the property.

Because the building is as an empty space during conversion, income-based valuation methods no longer apply. Appropriate value would be that of an old, empty building that is economically obsolescent. Further, the value would be lower than when the building still had office tenants.

New beginnings

The building owner can begin to attract potential residents during the conversion. While tenants may sign leases, they will not be paying rent until the building has received a certificate of occupancy from local government.

This marketing period is an extension of the construction phase that could bring the start of a residential rent stream closer by having tenants lined up. This gives the owner a vision of future value and may also allow a return to the income approach to valuation by more clearly defining the property's function.

Once the property is available for residential use, a different revenue stream will begin and grow as tenants lease the units. Clearly, taxpayers should make sure assessors apply the income approach as the building moves toward full occupancy. Residential units typically generate lower rent per square foot than office properties, but healthy occupancy will more than make up for the slight reduction from the asking rental rate on an obsolete office building in a declining market.

Usage conversion is a long and meandering trail that a property owner must travel before a new use can begin to generate revenue and a return on investment. By protesting tax assessments that fail to reflect the asset's diminished value during this process, taxpayers can at least defend against an unfair tax burden.

The steps outlined here for transitioning from office to residential space have many moving parts and presuppose the owner has identified residential demand to support the new use. Many urban cores have experienced an uptick in urban living, however, and with the right circumstances, many old buildings can be converted for increased use. Consequently, while the process is time consuming, the net result may prove invaluable to the owner and taxing authority.

Brian Morrissey is an attorney and partner at the Atlanta law firm Georgia Property Tax Counsel, the Georgia member of American Property Tax Counsel, the national affiliation of property tax attorneys.
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Jul
31

Property Tax Disaster Overshadows Memphis

Outdated valuations create risk of assessment increases under Shelby County's 2025 reappraisal.

In late 1811 and early 1812, West Tennessee's New Madrid Fault produced several earthquakes greater than magnitude 7.0, swallowing the town of Little Prairie, Missouri, in liquefaction and temporarily reversing the flow of the Mississippi River to crest its banks and create Reelfoot Lake.

Almost 200 years later, pseudo-scientist Iben Browning infamously sparked an earthquake frenzy by predicting another major New Madrid quake would occur on Dec. 3, 1990. School children of the 1990's likely still remember earthquake drills in the classroom and "earthquake kits" (trash cans filled with food, water and medical supplies) assembled and stored in basements and garages for years after.

Fortunately, Browning's prognostication was a dud and nothing happened. Still, those living above the New Madrid Fault today know in the back of their minds that "The Big One" could hit at any time.

For taxpayers, that time may be 2025, when Shelby County Assessor Melvin Burgess will reappraise properties countywide to 100 percent of fair market value for the first time since 2021. It may not shake buildings to the ground or flood low-lying areas, but the 2025 reappraisal could do grievous damage to unprepared taxpayers.

Market heat builds pressure

During the Shelby County reappraisal in 2021, the market was recovering from the 2020 slow-down in lending and sales transactions due to COVID-19. The assessor seemed to take the pandemic into account, refraining from aggressively capturing all of the market's growth from 2017 to 2019.

Low interest rates helped transaction volume accelerate in 2021 and the first half of 2022, however, quickly putting distance between the assessor's mercifully low appraisals and actual market value. The real estate market cooled after interest rate hikes in late 2022, but the value differential was already significant. A sales ratio study by the Tennessee Division of Property Assessments indicated the overall level of assessor's value in Shelby County was 75.87 percent of actual market value by Jan. 1, 2023. That ratio could be even lower for individual properties.

Shelby County's 2025 reappraisal program will aim to eliminate such undervaluations. The bigger the current undervaluation, the bigger the taxpayer's potential increase next year.

This is a major flaw in long reappraisal cycles: Undervaluations expand over the course of the cycle like geothermal pressure until the difference suddenly, and sometimes catastrophically, vaporizes in a single year with a massive increase in assessed value.

These delayed assessment adjustments and resulting tax increases make budgeting more difficult than would more frequent but less dramatic reappraisals. The Tennessee Legislature has been considering shorter reappraisal cycles, but none of the proposals have passed both houses yet.

Bad timing for a big setback

Property tax increases are never convenient, but 2025 could be especially poor timing. If interest rates stay relatively high and operating expenses keep rising, tax increases may arrive when there is no room to accommodate them in over-stressed taxpayer budgets.

Even in 2024, a non-reappraisal year, the mayor of Memphis has proposed a monstrous tax rate increase for properties inside the city. It is doubtful the city will raise rates as much as the mayor wants, but a 2024 increase in city taxes before the assessor's 2025 reappraisal could create back-to-back blows that are hard to absorb.

Preparing for "The Big One"

Hiding under a desk or filling a trash can with supplies will not stop a major assessment increase in 2025, but there are other ways to prepare.

1. Understand the timeline. The assessor will formally certify 2025 values by April 20, 2025, but value-change notices are expected around mid-March or early April. Appeals must be filed to the Shelby County Board of Equalization, with a likely deadline of June 30. The city of Memphis sends tax bills around July that are due by the end of August. Shelby County taxes are due by the end of the following February.

2. Anticipate the increase. Don't be caught off guard by a higher tax bill. It is important to estimate the assessor's reappraisal value and develop a realistic 2025 property tax budget. If the assessor's new value is unreasonably high, it can be challenged through a timely appeal to the Shelby County Board of Equalization. Some amount of increase is likely to be fair and supportable, however, so adjusting tax escrows in advance would be prudent.

Property tax professionals can help

Preparing for the 2025 reappraisal needn't be a daunting process. A property tax professional can provide a tax estimate in preparation for the 2025 reappraisal, and if the assessor's new value is too high, file an appeal.

Taxpayers preparing for The Big One to rattle their real estate would be well served to consult a property tax professional in advance. An experienced advisor can help identify the fault lines of undervaluation and brace-up vulnerable budgets before the reappraisal strikes.

Drew Raines is a shareholder in the Memphis law firm of Evans Petree PC, the Arkansas and Tennessee member of the American Property Tax Counsel, the national affiliation of property tax attorneys.
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Jul
02

Single-Family Rental Communities Suffer Excessive Taxation

To tax assessors, an investor's single-family, build-to-rent neighborhood is a cluster of separately valued properties.

Multifamily investors are accustomed to paying property taxes based on an assessor's opinion of their asset's income-based market value. But for the growing number of developers and investors assembling communities of single-family homes and townhomes for rent, tax assessment is more complex and potentially troublesome.

The difficulty for these taxpayers is that most assessors shun the income approach to valuing single-family rental properties. In the following paragraphs, we examine the roots of this common assessor stance, and explore strategies that may help taxpayers argue for a more predictable, apartment-like treatment for their single-family rental communities.

Similar, but different

Multifamily construction has delivered a tremendous volume of apartment properties over the past decade. Once stabilized, these assets have been relatively simple to value by relying on market rents, occupancy, expenses, and cap rates.

On the heels of this apartment construction, the nation is seeing a proliferation of investor-backed, single-family construction and acquisitions of large blocks of homes and townhouses for use as rental properties. This may take the form of constructing a multitude of homes or townhomes in a single development. Alternatively, it may involve the acquisition of many existing homes or townhomes in a localized area.

A concentration of adjacent or proximate single-family residences operated as rentals can enable owners to achieve economies of scale for management, maintenance, groundskeeping, repair and similar costs, similar to the operation of a large apartment complex or group of complexes. In most jurisdictions, however, the similarity between apartments and communities of rental homes and townhomes doesn't extend to valuation for property taxation.

As a rule, houses and townhomes are individually platted and therefore have separate tax parcel numbers. For existing properties acquired from third parties, this is expected. When it occurs with new construction, however, it typically results from the developer's decision to create true townhouses and single-family houses, as opposed to a traditional rental complex. The reasoning for this decision may be complex, but at the gate it appears to be a protective measure to allow for subsequent sales of the units.

For taxing purposes, each separate parcel – house or unit – is valued separately and independently, just as if individually owned and occupied for personal use by a homeowner. The taxing authorities value these properties using a market-comparable-sale approach, just as if the units were individually owned for personal use.

This is causing a good deal of consternation among investors who seek to have the units valued utilizing the income approach, and for those who would like to value assembled units collectively. The owner of a row of inline townhomes, for example, may prefer to have the properties valued as one economic unit, in the nature of an apartment complex.

Case law insights

The North Carolina Property Tax Commission in two recent cases affirmed that assessors must use the comparable sales approach to individually assess independent, platted rental homes. In those cases, (Mingo Creek Investments III LLC and American Homes 4 Rent Properties One LLC), commissioners set forth numerous reasons for their decisions.

Those cited factors included a legal requirement that each separately platted parcel be separately taxed. Additionally, the common owner was able to sell off a single unit at any time, and lacked an apartment owner's common control over amenities and other units. Not all units in a particular development are necessarily owned by the same entity, and in the cited cases there was a history of buying or selling of the individual units or neighboring units.

Assessors often make the policy argument that where single-family rental units exist in common with units that are individually owned for personal use, applying a different valuation method to those held for rent would create inequitable results. It would also raise uniformity concerns, because similar properties would be taxed differently. The same inequity issue that applies to a rental residential unit also applies to homes used as vacation rentals. To value rental single-family residences using an income approach and the neighboring, owner-occupied, single-family residence by the comparable sale approach would create inequities and a lack of uniformity.

Taxpayer tactics

So, where is the investor to go from here?

The elements addressed in each of the two Property Tax Commission decisions issued thus far, together with the policy considerations, limit the taxpayer's options. An investor or developer could common-plat the residential rental units in the development stage, creating a single plat that could be more readily valued with an income approach.

If the owner or developer is unwilling to common-plat the assemblage of rental homes or townhomes but seeks to have them valued for tax purposes under the income approach, it appears they would at least have to consider imposing common control restrictions on the parcels to create, as nearly as possible, the functional equivalent of an apartment complex.

For example, a development or ownership regime could impose not only common ownership but also common control over all the units, including a prohibition on the sale of individual units, or perhaps restrictions that the sale of a specific unit would not release that unit from the common control mechanism. Such a mechanism would be akin to a 100 percent developer-controlled homeowners association.

From a practical perspective, the developer could prohibit investors from selling individual properties until the developer chooses to start divesting itself of the project piecemeal. At that time, the developer could amend the restrictions, since it would still have total control because no units had been sold, and therefore no third parties had vested rights. At that time, it is likely the taxing authority would change the valuation method to a comparable sales approach.

Further, the developer would most likely need to ensure that the units under such common ownership and control would be physically distinct from neighboring properties. For example, all the units could be in a designated subdivision or portion of a development, as opposed to being alongside units held for personal use by their owners. By so doing, the developer could hopefully remove the uniformity argument.

From a market perspective, the units held for rent under common ownership and control would never be for sale on the open market as single units, at least so long as the restrictions remained in place.

As to appraisal, the appraiser could either apply the income approach to each unit, or appraise the combined residences as one economic unit and then apportion value among the units, so that each tax parcel receives a separate value. This is not to say this approach would be accepted by a tax court, but it would address many of the concerns espoused to date against use of the income approach for separately platted residential units held for rent.

These valuation regimes described above may prove too restrictive for some investors, in which case they would appear stuck with the current process. In all events, before becoming wedded to any plan, taxpayers should at least run the numbers both ways – using income and comparable sale approaches – to be certain the value difference is worth the effort of contesting their assessment. 

Gib Laite is a partner in the law firm Williams Mullen, the North Carolina member of American Property Tax Counsel (APTC), the national affiliation of property tax attorneys.
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Nov
22

Industrial Property Tax Gets Personal

Differentiate personal property from real estate values for fair tax treatment.

North Carolina taxes both real estate and personal property, but differing valuation schedules and processes for the two types can lead to confusion and inflated tax bills for industrial property owners. Understanding how assessors value industrial properties can help those taxpayers detect issues and contest unfair assessments.

Dual processes

North Carolina requires assessors to revalue real property at least every eight years. The value as of Jan. 1 of the valuation year then remains constant until the next valuation, unless specified changes in the property occur to trigger a change in the assessment. Many counties revalue every four years, and a few, even more frequently.

Assessors use a market analysis to determine real property's taxable or fair market value. This involves applying one or more of the three valuation approaches: cost, comparable sales, or income.

The state requires annual valuation of personal property based on installed cost, which is subject to the applicable trending and depreciation schedules. For the most part, taxing authorities rely on the taxpayer's annual business personal property listing to determine what items of personal property are present, the installed cost, and the trending and depreciation schedule applied. The counties follow schedules for auditing the property tax listings, and most disputes that arise stem from these audits.

With industrial real estate, the two tax schemes can create conflicts based on property components that could be considered either real estate or personal property, depending on circumstances. For example, reinforced foundations or specialized wiring for unique machinery could be considered a real estate improvement, thereby adding value to the real estate, or they could be considered personal property subject to depreciation and trending.

Although the tax rate applied is the same for both real estate and personal property, categorization can significantly affect taxable value. Real property improvements enhance market value on a more permanent basis, while personal property value is generally presumed to decline because of annual trending and depreciation.

And of course, no one wants to be taxed twice on the same property: once by having a component or improvement included in the real estate value, and again by having it taxed as personal property.

Defining characteristics

How can a taxpayer determine what is real and what is personal in their industrial property? Generally, personal property items are movable and not permanently affixed to real estate. An issue of intent arises, however, if the item can be removed but not without causing serious damage to the real estate.

A rule of thumb in the North Carolina Department of Revenue's Personal Property Appraisal and Assessment Manual instructs assessors to classify all property and investment necessary for the operation of machinery and equipment as personal. Examples are wiring, venting, flooring, special climate control, conveyors, boilers and furnaces, dock levelers, and equipment foundations. Stated another way, property used as part of a process, or that is in place to support equipment, is generally personal property.

On the other hand, Department of Revenue staff regard items in the plant for lighting, air handling and plumbing for human comfort to be part of the real estate. The department's appraisal and assessment manual includes an extensive chart, and each county's published schedule of values may also provide a helpful listing.

It is often difficult to know whether the county has included what could be classified as personal property in its calculation of real property value. Regardless, if the taxpayer has not listed such items on the annual personal property submissions, it will be difficult to argue after the fact that they should have been excluded from the real estate value.

Taxpayer strategies

Taxpayers can argue for a reduced assessment by identifying personal property items improperly classified as real property in the assessor's calculations and seeking to have them treated as personal property subject to trending and depreciation. Knowing where to look for personal items will help the property owner in this task.

A critical item to be generally classified as personal property is any leasehold improvement. Leasehold improvements often look like real estate but are owned and controlled by the tenant for the lease term. These are items the tenant paid for and received under terms of the lease or other contract, and were installed for the tenant's use. Leasehold items almost always facilitate the tenant's business.

In deciding whether these items are real or personal property, the taxing authority will apply a test akin to a traditional fixture analysis, determining the manner of affixation, whether the item can be removed without serious damage, and whether it is intended to remain permanent. In the end, the assessor will apply a "totality of the circumstances" test, including the lease terms.

The tenant - as the owner of the leasehold improvements - is required to list those items as personal property. The landlord should monitor the tenant's personal property submissions to ensure that all tenant improvements are being listed. This will help to avoid leasehold items being considered as part of the current real estate valuation.

Unlike a traditional fixture analysis, and dependent on the lease terms, the improvements may be taxed to the tenant during the term of the lease. When the improvements are left to the landlord at the end of the lease term, the taxing authority will need to consider assigning any remaining value to the real estate.

The owner of an industrial property needs to be cognizant of how the assessor is valuing both the real estate and personal property, and how those components are taxed. This requires knowing what improvements are included in the valuation of the real property as of the valuation date, and tracking the annual personal property tax listings, especially those submitted by a tenant. Finally, taxpayers must be timely in correcting any erroneous assumptions or listings.

Gib Laite is a partner in the law firm Williams Mullen, the North Carolina member of American Property Tax Counsel (APTC), the national affiliation of property tax attorneys.
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Oct
19

Fair Property Taxes Vital to Manufacturers

Tax considerations often drive site selection and form an importance piece of the reshoring puzzle.

COVID-19 laid bare many problems inherent in offshore supply chains and spurred widespread interest in reshoring manufacturing to the United States. As companies and communities explore site selection and expansion opportunities, they should remember that manufacturing profitability often hinges on tax strategy.

Staging a comeback

For the first time in decades, industry and the public sector are working to make American manufacturing competitive in a rapidly changing global marketplace. The recent enactments of the Inflation Reduction Act, the Bipartisan Infrastructure Law and the CHIPS and Science Act have directed billions of dollars into enhancing domestic manufacturing capacity.

The semiconductor industry presents a high-profile case study. The United States holds 12 percent of the world's semiconductor manufacturing capacity, eroded from 37 percent in 1990. The CHIPS Act's $52 billion in federal funding is intended to strengthen domestic semiconductor manufacturing, design and research and reinforce the nation's chip supply chains, fortifying the economy and national security along the way.

Simultaneously, the United States is becoming a leading producer of electric vehicles and vehicle battery plants. Since 2021, announced U.S. investments in semiconductors and electronics exceed $166 billion, and announced U.S. investments in electric vehicles and battery manufacturing exceed $150 billion.

Deciding where manufacturing occurs depends partly on proximity to suppliers, available labor, distribution hubs and customers, and operating costs. Property tax is typically a significant component of operating costs. That's why tax abatements on real property and equipment are a commonly offered incentive.

Most states offer incentives to attract industry, and one of the hotbeds for increased American manufacturing has been the southeastern United States, specifically South Carolina, Georgia and North Carolina. All are leaders in foreign direct investment.

Abatements generally provide a manufacturer with predictable property taxes, helping to overcome the uncertainty of future tax liability that can put companies at a disadvantage. An example is South Carolina's "fee in lieu of tax" agreement (FILOT) which offers manufacturers predictable and consistent taxation. Generally, FILOT agreements fix tax rates and the value of real estate and improvements for the length of the agreement, while allowing manufacturers to depreciate the value of machinery and equipment.

FILOT agreements can have up to a 50-year term. However, by fixing a manufacturer's real property value at actual cost without depreciation, the owner's taxes over time may be higher than they would be without the agreement. That's because they do not account for depreciation, valuation changes or required improvements to accommodate changes in the marketplace for the manufacturer's product.By locking in the real property value, the manufacturer receives the benefits of predictability and protection from higher taxes on appreciating real property.In exchange, however, the manufacturer loses the benefit of any depreciation and takes the risk of a locked-in property value if the property's market value diminishes.

Other states offer different incentives including more traditional property-tax abatements, where a manufacturer receives a grant as a partial rebate or discount on the new property taxes the project creates. Since tax rates and taxable value assessments change over time, these systems can provide less certainty for manufacturers than FILOT-type agreements, but potentially offer more long-term flexibility to respond to changing tax rates, depending on how the agreements are negotiated.

As a manufacturer's industry evolves and demand for its products changes, flexibility to appeal tax assessments can be a key to maintaining profitability and competitiveness.

Committed but flexible

Certainly, a manufacturer is better off in an appreciating real estate market by fixing the value of the real estate and improvements. Organizations negotiating for incentives should protect their ability to protest unfair assessments of taxable value, however, because valuing a manufacturing plant in the traditional ad valorem system is challenging and subject to controversy.

For example, most state ad valorem property tax systems define "value" as a variant of "market value," assuming an exchange between a willing buyer and a willing seller. However, will the buyer of a manufacturing facility benefit from the features of a specialized building constructed for a different manufacturer's specific needs? The answer is usually "no."

Manufacturing facilities are special-purpose properties, which The Dictionary of Real Estate Appraisal defines as a "property with a unique physical design, special construction materials, or a layout that particularly adapts its utility to the use for which it was built." And changes in the manufacturing process can render many buildings economically obsolete.

If the facility's use is no longer viable, it should be appraised as an alternative use. This necessarily occurred as American industry declined. Often there were no manufacturers who could effectively use single-purpose buildings vacated by other manufacturers, necessitating drastic value reductions.

An assessor's three traditional valuation methods all have limitations. A sales comparison approach is difficult when the production facility has essentially been designed to produce specific products. Put differently, finding sales of comparable facilities can be extremely challenging.

An income approach requires a market rent calculation, but manufacturers historically own their facilities, making an income approach difficult. A cost approach using actual cost ignores that the same building might not be appropriate to respond to changes in the marketplace for the product being produced. The cost approach without depreciation also limits the manufacturer's flexibility in responding to changes in the marketplace for its product.

Remember, too, that a manufacturer must be nimble, as changes in the market or technology can render an entire plant (or industry) obsolete virtually overnight. Adapting processes may require equipment upgrades or replacement, structural modifications or other changes that affect property value.

The speed at which manufacturers need to be able to adapt to a changing marketplace, the strong desire for certainty in costs and the difficulties in valuing manufacturing facilities for tax purposes all argue in favor of valuing real property and improvements on the basis of cost less depreciation.

Successful reshoring will require focused efforts by the public and private sector, together with sensitivity to industry's need to be nimble and the implications of historical incentives to ensure that reshored industry remains competitive. Flexibility offers the key to long term success, and property taxes form an important piece of the puzzle.

Those cities and states looking to maintain or increase their manufacturing footprints should be mindful of this lesson in packaging incentives to attract and maintain manufacturers, and manufacturers should think critically about the valuation of their facilities for property tax purposes when evaluating competing incentive offers.


Morris Ellison is a partner in the Charleston, South Carolina, office of law firm Womble Bond Dickinson (US) LLP, the South Carolina member of American Property Tax Counsel, the national affiliation of property tax attorneys. Whit McGreevy is an associate at the firm.
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May
19

Office-to-Residential Conversions Present Costly Problems

Developers should understand the property tax implications before attempting to repurpose buildings in downtown Washington, D.C.

With office vacancy rates in the District of Columbia at 20% and climbing, officials believe that converting office buildings to residential space is an important component of revitalizing Downtown Washington.

These complex projects pose both practical and administerial challenges, however. For developers, one important consideration of such a redevelopment is its real estate tax implications.

High hopes

District leaders announced earlier this year that they hope to add 15,000 residents to the central business district over the next five years – an ambitious goal. The hope is that bringing residents to live downtown will create a more vibrant neighborhood where people live, work, and dine.

The stark reality is that the District of Columbia has one of the lowest return-to-office rates in the country. Actual occupancy in the D.C. metro was only 43% in mid-April and drops below 25% on Fridays, according to Kastle Systems, which tracks office occupancy. Workers simply aren't returning to Downtown D.C.

While residential conversions may be one piece of the puzzle in addressing D.C.'s downtown woes, converting an office building into a residential property is no small feat. Here are a few important factors relating to real estate taxes to keep in mind when considering an office-to-residential conversion.

Real property tax rates

Real property tax rates in the District vary considerably from residential to commercial real estate. Residential properties, including multifamily apartment buildings, are taxed at a 0.85% rate. The commercial tax rate, which is used for office buildings, is more than double that rate at 1.89% for properties assessed over $10 million.

To the extent a property contains both residential and commercial space, D.C. will apply a mixed-use tax rate based on the pro-rata allocation of residential versus commercial space. Consequently, how the District classifies a property can have an immense impact on tax liability and carrying costs.

Timing of reclassification

A costly misstep would be to assume that the tax rate will immediately change from 1.89% to 0.85% after an office property is acquired for residential conversion. In fact, if there is any commercial use continuing at the building, the commercial tax rate will still apply.

Moreover, the District historically has been inconsistent in its application of when a building should "convert" from commercial to residential for purposes of tax classification. Although the D.C. Code provides a property should be reclassified when there is no current use and the property's highest-and-best use is residential, some assessors have taken a more aggressive approach and argued that the property should not be reclassified until the redevelopment is more than 65% complete.

Property acquisition

An additional hurdle lies in the acquisition process itself. When an office building is acquired for a residential conversion, higher transfer and recordation taxes apply. For commercial and mixed-use properties, the transfer and recordation taxes are 5% of the sale, as opposed to 2.9% for a purely residential building.

The mayor's proposed 2024 budget would allow the higher transfer and recordation tax rate to expire later this year, but the D.C. Council had not adopted the measure at the time of this writing and may or may not allow the higher rate to sunset. Under the current code, there is no exception for the acquisition of an office property that is being purchased for purposes of a residential conversion.

Abatements

Finally, in an effort to spur redevelopment, the mayor has announced her intention to offer tax abatements for office-to-residential conversions that meet certain criteria. At this point, it is difficult to determine the financial implications of the tax abatement program for a specific redevelopment because there is no set formula for deriving the amount of an abatement.

What is known, however, is that there are specific requirements to qualify for the abatements. Among other conditions, these include:

  • Affordability. 15% of the housing units must be affordable.
  • Location. The redevelopment must be within a specific geographic area.
  • Designated contractors. 35% of the construction contract must go to specific business enterprises that have been certified by the District.

These requirements further complicate the already challenging task of successfully executing an office-to-residential conversion.

In short, the real estate tax implications of an office-to-residential redevelopment are highly dependent on the unique facts and circumstances of each case, and the varying tax rates can have huge implications for a property's development budget. A developer considering such a conversion should contact experienced counsel early in the process.

Jonathan L. Cloar is a partner at the Washington D.C. law firm Wilkes Artis, the Washington D.C. member of American Property Tax Counsel, the national affiliation of property tax attorneys. Sydney Bardouil is an associate at the firm.
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Mar
08

Tax Implications for Mall Redevelopments

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

Repurposing 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 over-valued 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 anchors. Gone are the halcyon days when the mall was everyone's shopping destination. There is even a website, 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 ecommerce 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, filed bankruptcy. Ecommerce volume surged in 2020 and 2021 before tapering in 2022. Ecommerce 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 Wall Street Journal article describing 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 day 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 ecommerce, 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? Ecommerce 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 the mall owner 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 under the REAs and operating agreements to retail.

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 pre-ecommerce glory of malls and anchors 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 ecommerce 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 the zombie can be brought back to life.

Morris Ellison is a partner in the Charleston, South Carolina, office of law firm Womble Bond Dickinson(US) LLP, the South Carolina member of American Property Tax Counsel, the national affiliation of property tax attorneys.
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Mar
02

Property Tax Pitfalls in 'Crane City USA'

Tennessee's appeal process allows Nashville taxpayers to challenge the complicated assessment of new construction.

Over the past decade, Nashville has enjoyed a baffling explosion of growth that sent cranes shooting up all over the city, festooned with developer names like Bell, Clark and Giarratana. Highrise towers of glass and steel rose out of the old rail yards like the emerging monolith in the opening scene of "2001: A Space Odyssey" multiplied in a funhouse mirror.

The Metropolitan Government is eager to add new projects to its tax rolls, and its Assessor of Property decides when and how that happens. The assumptions made by the Assessor's office about a project's cost and timing dictate how quickly and how much a new building is taxed. So, as always, taxpayers need to keep an eye on what the assessor is doing.

The assessor's difficult job has become even more complicated in the post-COVID quagmire of supply chain failures. Twelve-month projects have stretched into 24-month projects, and the assessor's assumptions about completion times have been thrown out of whack. To make matters worse, Tennessee's property tax statutes were not designed to give relief for construction delays or lengthy projects, and the clock is ticking.

New Construction Assessed at Material Cost

The last Davidson County reappraisal was in 2021, and the next will be in 2025. Normally, the assessor's values remain unchanged over the four-year cycle, but new construction is an exception to that rule.

Under the statute for assessing projects under construction, if a new improvement is partially complete on Jan. 1, the assessor is to value the property for that year at land value plus the cost of materials used in the improvement as of that date. This materials-only value favors taxpayers because it excludes labor costs.

The construction documents that are generally accepted as evidence of project costs do not typically segregate labor versus material costs, however. Those costs are most often listed as combined totals, making the exact material costs difficult to determine.

One example from a recently reviewed document described work that included a $279,000 line item for "caulking." Unless labor and materials are both included in that number, that's a heck of a lot of white goop! Rather than demand proof of exact material costs, assessors will sometimes allocate material costs based on a pre-established rule of thumb.

Substantially Complete?

Now for the tricky part. The new construction statute allows assessors to pick up new improvements after Jan. 1, so long as the structure is "substantially complete" prior to Sept. 1 that same year. So, for example, if a building is 50 percent complete at Jan. 1 and 100 percent complete at Sept. 1, the assessor will prorate at the 50 percent value for eight months of the year, and at the 100 percent value for four months of the year. If the improvements are not "substantially complete" by Sept. 1, the assessor must wait to pick up the as-complete value in the following year.

Tennessee has no statutory definition of "substantially complete" for purposes of adding the full value to the tax rolls, but cases make it clear that tenant finish-out and certificates of occupancy are not required. In the absence of simple, objective standards for completion, assessors make subjective judgments about completion that may not favor the taxpayer. Taxpayers can challenge those judgments through an administrative appeal.

Adding Insult to Injury

Under Tennessee law, new improvements may not be valued as incomplete for more than one year after construction began. Now, your immediate reaction might be, "That's ridiculous! How can you value an incomplete property as complete just because it took longer than 12 months to construct!?"

The assessor in Davidson County has taken the position that the statute prevents them from using the taxpayer-favorable, materials-only value in the second year a property is incomplete. They will likely still use the cost approach to determine the appraised value but add back the cost of labor that was taken out in the first year, greatly increasing the tax burden before the property is generating income. The legislature has not acted to provide relief from this further insult to developers already injured by increasingly protracted construction timelines.

The Good News

Tennessee assessors are only authorized to reassess a property at specific times, but taxpayers can appeal the assessor's Jan. 1 value of Nashville property to the Metropolitan Board of Equalization every year. If the assessor issues a prorated assessment for a new construction project later in the year, the taxpayer can appeal that value directly to the State Board of Equalization.

In light of the complexity of Tennessee's law on the assessment of new construction, owners of new projects in Nashville should seek counsel as to whether their assessments are fair and legal and avail themselves of the right to appeal if appropriate.

Drew Raines is a shareholder in the Memphis law firm of Evans Petree PC, the Arkansas and Tennessee member of American Property Tax Counsel, the national affiliation of property tax attorneys.
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Mar
16

The Tax Appeal Life Cycle

District of Columbia taxpayers can appeal assessed property valuations through three levels of review.

In the District of Columbia, a prudent taxpayer must observe important steps and deadlines to appeal a real property tax assessment. Strict code provisions, government policies and procedures govern the appeal process, so understanding the typical lifecycle of an appeal provides a head start in making sure a property is fairly assessed.
Here is a look at what to expect as a case advances:

Assessment and notification
Assessors reassess all real property in the District each year using a Jan. 1 valuation date that precedes the start of that tax year. For example, Tax Year 2023 runs from Oct. 1, 2022 through Sept. 30, 2023. Thus, corresponding assessed values are as of Jan. 1, 2022.

The District typically will mail assessment values and update the MyTaxDC.gov website on or around March 1 each year, sending its estimate of market value to the owners of more than 205,500 parcels. This will be the taxpayer's first glimpse of the valuation and potential tax liability for the following tax year.

These assessed values are released without supporting documentation, however.

To determine how an assessor derived the value, the taxpayer or a duly authorized agent must contact the Office of Tax and Revenue to request a copy of the assessor's workpapers. These documents will be critical in formulating the basis for any possible appeal.

1.) Office of Tax and Revenue
The first-level tax appeal deadline is April 1. While the property owner may not have all the relevant documents they need to properly analyze their assessment by this time, the taxpayer must meet the filing deadline or waive their right to any further appeal for the tax year.

Fortunately, the first-level petition is a one-page form completed online and requires only basic property information to satisfy the requirement. Continuing with a first-level appeal, however, demands further analysis.

The assessor may use one of the three common approaches to derive a proposed value — the income, cost and/or sales comparison approach — or any other approach that can be supported. For large commercial properties, the most common practice is to use the income approach in conjunction with the District's mass-appraisal model.

Mass appraisal uses market assumptions based on property type, submarket and classification. These assumptions derive from taxpayer-submitted income and expense reports (I&E) for the previous tax year. The assessor derives the property's net operating income using market assumptions and divides the result by a market capitalization rate loaded with the applicable tax rate. Or, in the case of retail properties, the assessor uses a net lease rate and an unloaded capitalization rate to arrive at taxable value.

Consequently, the yearly filing of income and expense reports is an integral part of the assessment process and is mandatory for most owners of income-producing properties. At the beginning of each calendar year, the District issues its notice of income and expense report filing requirements, along with unique access and submission codes for taxpayers to report their sensitive financial information using an online portal.

This portal opens in January, giving taxpayers adequate time to comply with the I&E submission deadline, which is on or about April 15 each year. (Due to a holiday, Tax Year 2023 I&Es are due Monday, April 18, 2022.) Timely compliance with this requirement is imperative, as failure may result in a 10 percent penalty on the subsequent tax year's liability. A local tax advisor can be a great help with this complicated process.

Once complete, and when applicable, the I&E will be a vital component to the analysis and validity of a tax appeal. If the taxpayer believes an appeal is warranted, they can move to a first-level hearing. This administrative appeal to the assessor of record generally occurs in May or June. The assessor reviews information the taxpayer provides and can adjust the value by first-level decision.

2.) Appeals Commission
If the initial appeal does not provide a satisfactory result, property owners may continue to the next administrative level. The taxpayer must initiate an appeal to the Real Property Tax Appeals Commission (RPTAC) within 45 days of the first-level decision or forfeit additional appeal rights.

Filing a petition with RPTAC requires the taxpayer to produce specific information such as property and financial data as well as supporting evidence to prove the current assessment is incorrect.

In other words, the assessment is presumed correct unless and until the taxpayer proves otherwise. RPTAC hearings generally occur between early October and the end of January. Hearings before a panel of two or three commissioners allow both parties to argue their positions and to answer commissioners' questions. The Commission should issue its decisions by Feb. 1 of the relevant tax.

3.) D.C. Superior Court
The District issues real property tax bills in March and September of the relevant tax year. This means, barring extraordinary disruptions that can include global pandemics, administrative appeals should be completed prior to the issuance of these bills.

If an administrative appeal does not achieve a result the taxpayer believes is fair, a further appeal to D.C. Superior Court is available.

To appeal to the Superior Court, the taxpayer must first pay all taxes in full and file a petition by Sept. 30 of the related tax year.
The proceeding will ostensibly become a "refund" lawsuit and may take several years to reach a resolution. However, if successful, taxing entities will be required to provide an additional 6 percent interest with any refund amount.

Importantly, any tax representative must be an active member of the D.C. Bar Association to handle this stage of appeal, which is a court proceeding. Therefore, to maximize the effectiveness of a tax appeal, a local tax attorney is best situated to guide a taxpayer through the life cycle of a property tax appeal.

Sydney Bardouil is an associate at the law firm Wilkes Artis, the District of Columbia member of American Property Tax Counsel, the national affiliation of property tax attorneys.
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