Alert October 20, 2020

California Property Taxes: Major Changes May Be Coming

California real estate investors and other stakeholders need to pay close attention to Proposition 15, The California Schools and Local Communities Funding Act of 2020 (a.k.a. the “split-roll” initiative). If passed in the November 2020 election, the initiative would significantly change how commercial and industrial properties are taxed in California.

The California State Constitution currently caps ad valorem property tax rates for both commercial and residential properties at 1% of the “full cash value” at the time of acquisition, with increases to assessed values capped at no more than 2% per year regardless of the property’s actual fair market value. The 2% annual cap on increases to a property’s assessed value remains in place so long as there is no “change in ownership” or “new construction” (as such terms are defined under California law). This has been the law in California since the passage of Proposition 13 on June 6, 1978. 

If Proposition 15 is passed, non-exempt commercial or industrial properties would no longer be subject to the above reassessment framework. Rather, the split-roll initiative would repeal Proposition 13 protections for commercial and industrial property owners (including vacant land not zoned for residential use and not used for commercial agricultural production) by redefining “full cash value” under Article XIIIA of the California Constitution, thus requiring market-value reassessment of commercial and industrial properties every three years. The initiative is expected to raise an estimated $8-12 billion in tax revenue annually for schools and local governments.

If passed, existing commercial property owners as well as their tenants, can expect significant implications related to their California property taxes moving forward. The change would be phased in beginning in fiscal year 2022-2023. Properties such as retail centers whose occupants are 50% or more small businesses (as defined in the proposed law) would be taxed based on market value beginning in fiscal year 2025-2026 (or, at a later date that the legislature decides on).

Owners and tenants of commercial and industrial properties will need to review their leases to understand how the potentially significant increases in property taxes will be allocated between the parties. With respect to triple net investments, owners would be able to pass through these higher tax costs to their tenants which could impact lease renewals and place downward pressure on rents. Owners of properties with gross or modified gross leases, such as office or industrial buildings, may be forced to bear the burden of the tax increase themselves.

The ballot measure does not affect the value assessment of (i) residential properties (including multi-family, but excluding any portion of the property that is used for commercial and industrial purposes), (ii) agricultural properties, (iii) vacant land used for open space, park or equivalent designation, and (iv) owners of commercial and industrial properties with combined value of $3 million or less. The exemption for commercial and industrial properties will not apply if any of the direct or indirect beneficial owners of such real property own a direct or indirect beneficial ownership interest(s) in other commercial and/or industrial real property located in California, which such real property in the aggregate (including the subject property) has a fair market value in excess of $3 million. In addition, the initiative would exempt small business tangible personal property from taxes and $500,000 in value for a non-small business tangible personal property.

Although the proposition will redefine what “full cash value” under Article XIIIA of the California Constitution means for commercial and industrial properties when it comes to property tax reassessment, the existing change in ownership statutory framework may still be relevant to transfer taxes owed by commercial and industrial property owners in jurisdictions that have enacted ordinances triggering transfer tax upon a change in ownership. Thus, a change in ownership may still trigger significant transfer taxes upon a sale of property or a change in control of an entity that owns real property in California. 

In recent months, the initiative has gained momentum due to the effects COVID-19 has had on local governments. According to a poll conducted by the Public Policy Institute of California, as of September 2020, 51% of likely voters said they would support the initiative, with 40% opposed and 9% undecided. The proposition requires approval by a simple majority of voters for passage.

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