Managing Commercial real estate taxes in California’s challenging market


Troy M. Van Dongen | Contributor

Without a doubt, it is difficult to find something upbeat about California’s current commercial real estate market. Property owners, economists and appraisers all agree that the market is facing one of the most challenging times in decades. For example, in San Francisco, an office tower that was worth $300 million in 2019 sold just a few months ago for less than $70 million. Several hoteliers in the city have stopped making payments on their loans, and national retailers that have been leaders in the market for decades have announced plans this year to close their San Francisco shops.

The owners of the city’s premier downtown shopping mall also announced recently that they are abandoning the property because of plunging sales, high vacancies and low foot traffic. Of course, these problems are not limited to Northern California. Earlier this year, the largest landlord of office space in downtown Los Angeles announced that they are defaulting on loans tied to two of their downtown office towers. The vacancy rate for downtown office space in Los Angeles is at a staggering 24%, followed closely by San Diego with a vacancy rate of 22%.

And to make matters worse, desperate local governments are becoming increasingly aggressive in their attempts to extract cash from commercial taxpayers. For example, Los Angeles recently passed a measure that increases the city’s transfer tax rate, which when combined with the county rate, now imposes a tax of almost 6% on realty sold for more than $10 million. Despite the incessant flow of negative news regarding the state’s commercial real estate market, there may be an upside for legal entities that own property in the Golden State. As explored in this article, investors who acquired real estate at the height of the market have an opportunity to reduce their property taxes and may even be able to lock in relatively low assessments for as long as they own the property. To benefit from this opportunity, however, one needs to understand how real estate is taxed in California.


When California’s voters passed Proposition 13 (known informally as Prop 13) in 1978, the state’s constitution was amended to provide that, among other things, the maximum property tax rate cannot exceed 1% of the property’s full cash value. Prop 13 also introduced the concept of assigning a “base year value” to locally assessed real estate. The base year value was defined to be the full cash value of the property as shown on the assessment roll for the 1975 tax year unless the property is purchased, newly constructed or changes ownership after the 1975 tax lien date.

Importantly, under Prop 13, a given property’s base year value cannot increase by more than 2% each year. So, regardless of how fast a given property’s market value may increase, its assessable value cannot increase by more than 2% percent annually unless (1) a new owner purchases the property, (2) new construction takes place on the property or (3) the property experiences a so-called “change in ownership” (discussed further below). As originally enacted, Prop 13 overlooked the possibility that property values could go down. So, in November 1978, Proposition 8 (Prop 8) was passed to provide that property assessments may be reduced when there is a decline in market value.

In other words, due to the combined effects of Propositions 8 and 13, the taxable value of locally assessed real estate is limited to the lesser of its fair market value or its base year value. Prop 8 adjustments, however, are only temporary in nature and do not establish a new base year value for the property. Thus, if the property’s market value returns to, or exceeds, its base year value in later years, its assessed value may be increased immediately back to the adjusted base year value—regardless of whether such increase exceeds the 2% annual inflation factor established by Prop 13. Although Propositions 8 and 13 were self-executing, and many of their provisions are straightforward, they did not define what constitutes a “change in ownership” nor was it clear how the propositions would apply to real estate owned by legal entities. Consequently, shortly after the enactment of Propositions 8 and 13, a task force was created by the California State Legislature to recommend a policy for implementing these propositions.


On its surface, the phrase “change in ownership” seems obvious. But, given its importance in the context of Prop 13, its definition became very important. After Prop 13, a change in ownership is one of the few instances when real estate can be reassessed for purposes of taxation. The task force debated this issue for months and ultimately concluded that the phrase referred to a transaction that (1) transfers a present interest in real property, (2) transfers the beneficial use of the property and (3) the property rights transferred are substantially equivalent in value to the fee interest.

The task force also recommended that the Legislature enact a statute, including this general definition, followed by a series of statutory examples applying the basic definition to common factual situations. Unfortunately, the definition of what constitutes a change in ownership for real estate owned by legal entities became a very controversial topic. In general, the controversy revolved around the question of whether a legal entity should be treated as a separate property taxpayer or whether the law should look through the entity to the ultimate owners of the real estate (i.e., those who own interests in the legal entity). Under what came to be known as the “ultimate control” theory, real estate would be treated as owned by whoever had the power to control the property.

So, if the real estate were owned by a corporation with a majority shareholder, the existence of the corporation would be disregarded, the majority shareholder would be treated as the owner and a change in the identity of the majority shareholder would be considered a change in ownership of the real estate. Similarly, if a majority shareholder were to contribute real estate to the corporation, no change in ownership would occur because the shareholder continued in “ultimate control” of the property even after the transfer. Under a different theory—the “separate entity” theory—the existence of the legal entity would be respected and, therefore, a transfer of real estate to or from the entity would be considered a change in ownership requiring reassessment. On the other hand, a transfer of ownership interests in the entity (e.g., stock) would not be a considered change in ownership.

Ultimately, the task force recommended that the Legislature adopt the separate entity theory because shareholders and partners typically have no individual possessory rights in the entity’s real estate, and because the separate entity theory would reduce administrative and enforcement problems presented by the ultimate control theory. The task force also stressed that whichever approach was to be adopted, the Legislature needed to apply that approach consistently. Notwithstanding the above recommendations, the Legislature adopted an amalgam of the two theories, respecting the existence of the legal entity in some instances and looking through the entity to the ultimate owner(s) in other instances. Additionally, the Legislature created statutes distinguishing between transfers of interests in real estate by and to legal entities and transfers of interests in the legal entities themselves.

Under these statutes, transfers of property from one entity to another generally would require reassessment, but the purchase or transfer of corporate stock, partnership interests or other ownership interests in legal entities generally would not. The Legislature also established several exceptions to the general rules. For example, transfers of property between or among affiliated corporations, including those made to achieve a corporate reorganization, are not considered reassessable events if the voting stock of the corporation making the transfer and the voting stock of the transferee corporation are each owned 100% by one or more corporations related to a common parent, and the common parent corporation directly owns 100% of the voting stock of at least one corporation in the chain(s) of related corporations. Also, transfers of property by and to legal entities that result solely in a change in the method of holding title to the real estate, and in which proportional ownership interests of the transferors and transferees remain the same after the transfer, do not constitute a change in ownership.


Regarding transfers of ownership interests in legal entities, there are two major exceptions to the general rule that such transfers do not require a reassessment of the real property owned by the entities. First, a reassessable event is considered to occur when a corporation, partnership, limited liability company (LLC) or other legal entity or any person either (1) obtains through a reorganization or any transfer direct or indirect ownership or control of more than 50% of the voting stock in any corporation that is not a member of the same affiliated group of corporations; (2) obtains through any transfer direct or indirect ownership of more than 50% of the total interest in partnership or LLC capital and more than 50% of the total interest in partnership or LLC profits; or (3) obtains through any transfer direct or indirect ownership of more than 50% of the total ownership interest in any other legal entity.

Second, a reassessable event is considered to occur when more than 50% of the “original coowners” interests are transferred. As set forth in the rules, if a property is transferred to a legal entity in a transaction excluded from reassessment because the transaction merely resulted in a change in the method of holding title with no proportional changes in the ownership interest of the transferors and transferees, then the persons holding ownership interests in that legal entity immediately after the transfer are considered the “original coowners.” So, whenever shares or other ownership interests representing cumulatively more than 50% of the total interests in an entity are transferred by any of the original coowners, a change in ownership of the real property owned by that legal entity shall be deemed to have occurred, and the property that was previously excluded from a change in ownership will now be subject to reassessment. Naturally, over the years, taxpayers have tested the limits of the general rules discussed above, and the exceptions thereto. And, to the disappointment of many taxpayers seeking to avoid reassessment, the courts have held that several sophisticated transactions result in reassessable events. At the time, taxpayers viewed these decisions as setbacks.

Now, however, these very transactions set a framework for what taxpayers can do to strategically trigger a change in ownership in order to reset their property’s base year value to a level comparable to today’s fair market value. In other words, if an entity acquired real estate in California in the 2015 to 2019 timeframe and/or paid a price that is significantly higher than the property’s current market value, then that property’s base year value is probably considerably higher than it would be if the property were to change ownership today. Thus, if the owner were to initiate a transaction that triggered a change in ownership today, the ceiling on the property’s assessable value would likely be reduced permanently in accordance with Prop 13 and future assessment increases would be limited to no more than 2% annually. For example, the courts ruled that a corporation’s attempt to structure a merger and reorganization transaction (sometimes referred to as a “double reverse triangular merger”) resulted in a change in ownership for all the real estate owned by the corporation, even though the company’s shareholders remained in control of the newly formed parent corporation.

Although the taxpayer in that case was attempting to avoid reassessment, if an entity were to perform the same transaction today—when the market values are relatively low—then the real estate owned by that entity arguably would experience a change in ownership, forcing reassessment of the property to a new base year value derived from the current market. Similarly, if a given property’s base year value was set using a methodology that improperly captured the value of intangible assets (e.g., goodwill, brand value, workforce in place), now may be an opportunity to permanently correct those errors. As investors in the hospitality industry know, tremendous progress has been made recently in the methodologies deemed acceptable for determining the assessable value of hotel properties. The courts have handed down several taxpayer-friendly decisions, holding that the primary methodology used by assessors across California to value hotel properties fails to properly identify and exclude nontaxable intangible assets. Those cases provide strong authority for using valuation methodologies that generally result in lower assessed values than when using the assessor’s preferred methodology.

And, if coupled with a strategic change in ownership, the methodologies could result in a favorable base year value on a going-forward basis. Of course, there are numerous transactions that a taxpayer can devise to trigger a change in ownership—not just those based on the court decisions, but on the statutes and regulations as well. The advantage for legal entities (as opposed to individual property owners) is that the Legislature has enacted statutes that make it easier for these entities to trigger a change in ownership. One only needs to turn to the materials published by the California State Board of Equalization to find transactions that trigger a reassessment. Nonetheless, taxpayers should undertake such transactions only if they have real estate that has a relatively high base year value (i.e., property that was acquired or reassessed at a value higher than the property’s value in today’s market) and, even then, only after consideration of the potential transfer taxes at issue and consultation with legal counsel well-versed in the nuances associated with California’s property tax laws.


Now, perhaps more than ever, corporations, partnerships and other legal entities are well-advised to review the current values of their California real estate in comparison to the property’s current assessed value and trended base year value in order to determine if action is warranted. It likely makes sense for many taxpayers—particularly office property owners—to file assessment appeals seeking reductions in the assessed value pursuant to Prop 8. (The regular appeals filing period began on July 3, 2023, in each county and will end on September 15, 2023, for counties like San Francisco, Alameda and Santa Clara where the assessor mails assessment notices by August 1, 2023, to all taxpayers with property on the secured roll. For counties where assessment notices are not mailed by August 1, 2023, the filing period ends on November 30, 2023.) However, for those taxpayers who find that their property’s trended base year value is significantly higher than the property’s current fair market value, they may be in a position to strategically trigger a change in ownership and lock in lower assessments for the long term.

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