How Your Landlord's Tax Reduction May Cost You
Over the past several years, the market value of San Francisco office buildings has dropped by more than 30%. Indeed, in some cases, asset values have declined much more, as evidenced by valuations associated with vacancy-challenged asset sales over the past couple of years. Importantly, a large percentage of the San Francisco office market either traded or was financed in the years prior to the pandemic, when valuations were high and debt was cheap. These activities created increased tax revenue for the city.
California’s Prop 13 establishes the most recent sale or financing value as the basis upon which property tax is calculated. Hence, much of the market is currently taxed at high valuations. This creates a disconnect between the amount of tax and the value of the asset, causing owners to appeal the assessed value. Appeals must be filed annually and can take up to 2 years before an owner will realize the benefit. But given the disparity between assessed value and market value, many owners are filing appeals.
Tax appeals create a large exposure for the City of San Francisco. According to Mark Ong of Independent Tax Representatives, LLC, if the 7,585 appeals in 2023/2024 result in just a 10% reduction in taxes, it translates to over $200m in refund obligations for the city. Remember, market values are down more than 30%, so a 10% estimate is very conservative. The city of San Francisco has currently set aside approximately $70m for tax refunds, an amount that appears to be substantially below the projected obligation.
Changes in taxation affect not just the city and building owners, but also office tenants. Tenants must be aware of how tax appeals impact the lease expense. They should be protected from having the tax base year lowered by temporary reductions in tax liability due to appeal. Why? Because these reductions are temporary; and, whereas the tax base is otherwise prohibited from increasing more than 2% annually, it can increase significantly more in any given year in which the appealed value is increased. Consider, for example, a building that was acquired in 2019 for $800/sf. The tenant’s tax base year is tied to the $800/sf valuation. Now, say the current market value is $400/sf and the owner successfully appeals to lower the taxable value to $400/sf. If the tenant lacks Prop 8 protection, its tax base year will be lowered to the new tax value (e.g., $400/sf). While the appeal value remains in place, the tenant will pay tax increases above the $400/sf value (2% annually). However, once the market improves, the city will be able to raise the taxable value, including taking it all the way back to the original assessed value ($800/sf). In this case, the tenant will suddenly be exposed to a massive tax increase. Similarly, office tenants moving into a new building must take care to ensure the base tax value is not tied to an appeal value, as this will create an artificially low base tax value, exposing the tenant to big increases. If not properly navigated, the current tax environment can create significant tax liabilities for tenants.