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California ballot bid seeks to remove Prop. 13 commercial property tax cap to fund schools, hospitals, government

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California voters may soon get another chance to decide whether many commercial properties and operations should continue to be protected from the property-tax impacts of a hot real estate market.

Supporters of the measure say reform of 4-decade-old Proposition 13 allows for better funding of local schools, colleges, health care facilities and local government, and for converting long-held real estate into housing.

Opponents say the change will mean higher prices for consumers as owners pass tax increases on to tenants — a provision of many commercial property lease contracts — and in fewer hires as businesses compensate for those higher costs.

In mid-October, California Secretary of State Alex Padilla cleared the supporters of the initiative to start collecting the almost 1 million signatures needed by April 14 to qualify the measure for the November 2020 ballot.

“Our goal is 1.6 million signatures,” said Alex Stack, communications director for Schools and Communities First, a Los Angeles-based organization that’s the largest California campaign committee backers of the campaign. It had raised $7.6 million in 2018 when it launched and through September of this year, the latest state data available. That was before a Nov. 2 launch of a statewide petition drive.

Stack declined to say how many signatures had been collected so far.

It’s the latest attempt to change 41-year-old Proposition 13, which limits property-tax increases. Sixty-five percent of California voters approved Proposition 13 in 1978. It capped property taxes at 1% of assessed value as of the last change in ownership or new construction, and annual increases in the tax were limited to 2%.

The California Schools and Local Community Funding Act of 2020 seeks to create a split assessment roll. All residential and agricultural properties would continue to have Prop. 13 limits.

But commercial and industrial properties over $3 million in combined value would be reassessed to current market levels. The measure also would exempt up to $500,000 in personal property tax for small businesses.

Depending on the strength of the real estate market, the shift to a split roll is estimated by the state Legislative Analyst’s Office to increase annual revenue for education, health and safety services by $6.5 billion to $11.5 billion, after accounting for $500 million to $1 billion a year in lost income tax revenue and additional costs for county agencies involved.

California law allows property owners to deduct property tax payments from calculated income for personal and corporate taxes, so higher property taxes would reduce tax liability, according to the analyst’s office look at a 2017 attempt at a split-roll initiative.

One of the key benefits for property owners from Prop. 13 is locking in taxable value to a low growth rate, even if property valuation spikes. For example, the assessment roll for vacant and improved commercial and industrial property grew 6.4% in Sonoma County’s last fiscal year, which ends in June, and at 3.3% in Napa County to new record levels, according to those agencies.

But the rush for industrial real estate in Santa Rosa with cannabis legalization led to sizable double-digit jumps in resale value over a few years’ time.

The Howard Jarvis Taxpayers Association estimated that it has saved residents and businesses over $500 billion since inception. Problem is that the cap on property-tax revenue has left local governments turning to sales taxes and fees, according to Robert Kleinheinz, research director at Beacon Economics.

“The effect of Prop 13 is that it limits property tax growth and limits the benefits to local general funds, no matter what the rate of inflation or the actual cost of providing services to a jurisdiction’s residents,” he wrote amid the 2017 buildup to the current ballot effort.

He pointed to “fiscalization of land use” as a way local governments have sought revenue through higher building-related fees, but that has made housing more expensive to build. Split-roll supporters contend that by making vacant commercial or industrial land increasingly more expensive to hang onto, that will spur projects that will create more housing.

Yet the law’s provision for reassessment to market level can result in a big financial impact to commercial tenants, depending on lease structure and how long the previous owner had held the property before the ownership change or new project, say real estate attorneys.

Commercial real estate leasing prices are commonly quoted with notation as to how many property expenses the tenant will be paying a share of, in addition to a base rent per square foot. These are called single-, double- or triple-net leases (noted as N, NN or NNN), depending on whether the tenant is paying just property tax, those and insurance premiums, or also building maintenance, respectively. Single-tenant properties tend to have “absolute net” leases, while many retailers have some form of triple-net leases.

“The ones that are going to be hardest-hit are mom-and-pop tenants that are barely hanging on,” said Jeff Lerman, founder of San Rafael-based Lerman Law Partners, which has seven other offices. He regularly puts on seminars for real estate investors.

“At end of the day, the landlord needs a tenant. If it’s going to be more expensive for the tenant to afford the rent, it’s going to be property owners that are going to be the biggest loser, because they are going to have to reduce the rent they ultimately get. … Tenants only get so much for their services, and consumer does not care if it cost the tenant more to deliver that.”

Because of such concerns for property-tax pass-throughs, proponents of the split roll have proposed a phase-in schedule for certain commercial properties. If half or more of a property’s square footage are occupied by small businesses, the reassessment would be delayed until the 2025-2026 fiscal year or later, if authorized by the Legislature, according to Stack.

A split-roll revision to Prop. 13 may create a legal quandary for long-term lease agreements not nearing the time when owner and tenant would be negotiating renewal terms such as allocation of expenses for property taxes and insurance, according to John Friedemann, a partner in Santa Rosa law firm Friedemann Goldberg.

“There’s been an allocation of tax expenses but not an allocation that anticipated a significant increase in those taxes,” he said.

He wondered whether it would be handled under the legal doctrine of mutual mistake. It’s often illustrated by the thought experiment of pricey Van Gough artwork selling for a few dollars at a garage sale, in one situation to a buyer who didn’t know the real value and in another to a buyer who did know.

For a long-term lease, the question is whether a dramatic increase in property taxes after a split-roll change would come under the original allocation of tax risk.

“Or is it something that you might call a mutual mistake?” Friedemann asked.

A similar issue comes into play with real estate development, when parties anticipate returns, then the project is not approved, he said. The legal question is whether that event actually was unanticipated and whether risk of that happening had been properly allocated.

Yet a big fluctuation in property tax expense that’s passed through to tenants in leases with such allocation may only be an issue in initial years of the change, when properties are reassessed to market value, Friedemann said. After that, the tax increases may not be as steep.

Jeff Quackenbush covers wine, construction and real estate. Contact him at jquackenbush@busjrnl.com or 707-521-4256.

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