In states such as California, it is well settled that real property owned by the government is exempt from taxation. See, e.g., Cal. Const., art. III, §3. What happens, though, when states lease public lands to private persons? One would assume (correctly) that such private possessory interests are taxed, but how and, more specifically, on what appraised basis? The recent appellate decision in Cal. State Teacher’s Ret. Sys. v. County of Los Angeles (2013) 216 Cal.App.4th 41 addresses these questions, particularly in the light of appraisals of private possessory interests on public land.
Facts of Cal. State Teacher’s Ret. Sys. v. County of Los Angeles
Cal. State Teacher’s Ret. Sys. v. County of Los Angeles involved a certain office building owned in fee simple absolute by a public retirement system, the California State Teacher’s Retirement System (the “CSTRS”) and leased out to private tenants. Id. at 48. In 1998, two individuals leased space from the CSTRS at the subject office building to run a Mail Boxes, Etc. Id. at 49. The lease was for 1,280 square feet on the bottom floor of the building. Initially, the tenants leased the space for five (5) years. They leased the space for an additional five (5) years following the lapse of the first term. Id.
The Mail Box, Etc. lease required the tenant to pay “in addition to base rent…tenant’s proportionate share of operating costs for each calendar year to compensate for changes in landlord’s operating costs.” Id. The original lease obligated the Mail Box, Etc. tenants to pay all property taxes imposed in connection with the leasehold. The amended lease signed by the parties thereto in 2003 reiterated the tenant’s obligation to pay the proportionate “real estate tax” of the building. Id.
In 2007, the County of Los Angeles (the “County”) assessed the value of the subject leasehold interest at $418,618. Based on the assessed value, the County levied a tax against the subject tenant in the amount of $4,983.34. CSTRS paid the assessed tax, and then, along with the tenant, challenged the tax with the County. When the County upheld the tax as constitutional, CSTRS filed suit against the County. In so doing, the CSTRS argued that “the valuation methodology that the County Assessor used in making [the subject] assessment was unsound and did not properly apply the governing provisions [of law] in evaluating [the tenant’s] possessory interest under the [subject] lease. Id. at 50. CSTRS further argued that the County had incorrectly assessed the tax given that they appraised the real property on the full fee interest rather than just the leasehold interest, and that this valuation was much greater resulting in an unconstitutionally high tax. Id.
Relevant Legal Principles Addressed in Cal. State Teacher’s Ret. Sys. v. County of Los Angeles
The Court in Cal. State Teacher’s Ret. Sys. v. County of Los Angeles reiterated the following pertinent law in ruling on the constitutionality of the County’s appraisal:
(i) A lessee has a present possessory interest in a leased premises, while the lessor has a future reversionary interest and retains the fee title. In other words, when a possessory interest is created, the bundle of rights that constitute the fee simple interest is delivered into a possessory interest (or interests) and a non-possessory interest (or interests). A possessory interest consists of a right to possess the real property for a period less than in perpetuity by a party (the tenant, or holder(s) of the possessory interest), while another party (the fee owner) retains the right to regain possession of the real property at a future date. Id. at 55.
(ii) Although publically owned real property is exempt from taxation, possessory interest in such land or improvements are taxable. This is in line with the constitutional mandate that all property shall be taxed. Accordingly, privately held possessory interests in real property owned by the government (at any level) are subject to taxation. Id. at 55-56 (internal cites omitted).
(iii) With respect to the standard for taxing possessory interests, all property is taxed according to its full value, meaning its appraised fair market value, unless an alternative standard of value is constitutionally prescribed. Id. at 56.
(iv) With respect to appraising (and taxing) leasehold interests, the appraiser (and/or assessor) must estimate the price a leasehold would bring on an open market under conditions in which neither buyer nor seller could takes advantage of the exigencies of the other. The tax to the tenant is based on this estimate only. This is because a leasehold interest is finite in duration. To this end, the appraiser must determine a term of possession for the interest (which, obviously, affects the value of the possessory interest – the longer the term of possession [or remaining term], the high the value of the possessory interest. Id. at 56-57.
Application of Legal Principles to Case Specific Facts in Cal. State Teacher’s Ret. Sys. v. County of Los Angeles
The County’s appraisal methodology, and subsequent taxation, as to the private tenant at the subject real property was flawed inasmuch as the County allocated the entire valuation of the building to the lessees thereof without any reduction for the value of the reversionary interest retainer by the public lessors, which owned the building in fee simple. Id. at 61. Further, the County made no adjustment to the assessment for the fact that the lease was winding down. Absent special circumstances, a taxable possessory interest normally declines in value with each passing year. However, the County assessed the subject Mail Boxes, Etc. leasehold interest toward the end of its term (in 2007 when the lease would run in 2008), based on nothing more than the acquisition price of the real property, trended forward. Thus, the assessment was improperly based on the fee simple value of the real property, rather than on the declining value of the lessee’s possessory interest.
In sum, the Court in Cal. State Teacher’s Ret. Sys. held that the value of the rights retained by an exempt owner of real property (e.g., a public entity) must be excluded from tax assessed values in order to determine the proper valuation of the private lessee’s taxable possessory interest (with the proper valuation of said interest being completed in accordance with the aforementioned legal principles). An appraiser does well to heed the legal principles addressed in Cal. State Teacher’s Ret. Sys. whenever valuing private possessory interests of publically held real property.
By: Joel T. Shackelford, Esq.
KAUFMAN DOLOWICH & VOLUCK, LLP