Celebrated nationwide as a taxpayer revolution when adopted, California’s Proposition 13 changed the nature of the state’s revenues and resulted in lower property taxes for properties held long-term.
The initial idea was to protect taxpayers against artificially inflated assessments and even, in some cases, to protect against assessment at the true value. Many voters sympathized with senior citizens whose homes appreciated as California real estate became ever-more pricey, but whose incomes were fixed. The idea of forcing an elderly person to sell a home because s/he couldn’t afford the increasing property taxes was unappealing.
Under Prop 13, values were frozen at 1975-76 assessments and could not increase more than 2%/year from that base. In general, a sale or a capital improvement were the only occasion for an increased assessment.
It sounds great: taxes that rise gradually and predictably, roughly in accordance with long-term inflation and not reflecting temporary price bubbles. But the implementation of Prop 13 has created some surprises for owners and tenants, particularly those not based in California.
Let’s consider just a few of those surprises.
- Annual increases limited to 2%. California owners expect their property taxes to increase annually, but by no more than 2%, and projections probably incorporate that assumption. But as the recession ends, property owners who were successful in reducing their assessments based on falling real estate values are discovering that the reduction is only temporary, and the 2% annual increase continues to be measured from the assessment before the reduction. A buyer of property in Year 1 for $10 million who managed in Year 3 to have it reassessed at $8 million finds in Year 4 that the assessment jumps from $8 million to $10,612,080.
- Tenants’ responsibilities under net leases. Net leases shift costs of occupancy, including property taxes, to the tenant. Out-of-state tenants expect periodic bumps in property taxes as the value of the property increases. It’s an unhappy surprise when the landlord sells its interest (or even reorganizes its equity in a way treated as a transfer of the underlying property). The old assessment, which could be very old, is replaced with the new purchase price, and property taxes jump. There’s nothing gradual, or, to the out-of-state tenant, predictable here. The tenant can be protected by appropriate language in the lease – but landlords rarely agree.
- Delays in assessment. Even California purchasers can be caught off guard by the assessor’s schedule. Frequently, assessors fall behind in updating assessments to reflect transfers. The new owner is billed at the same level as the old owner – until the assessor catches up and delivers the supplemental assessment (boosting the current-year taxes) and the escape assessment, which recaptures the incremental amount for the period since the transfer – for a potentially huge hit that year. It may be a challenge to correct and collect past underpaid pass-throughs where tenants may have turned over.
The taxpayer revolution can be surprisingly painful to taxpayers. Calls for change have failed, as they would require a constitutional amendment.
This article was written by Kathleen Smalley, a real estate partner in the Los Angeles office of Locke Lord LLP. Assistance was provided by Alfred M. Clark, III, a real estate partner in the Los Angeles office of Locke Lord LLP.
VIEWS EXPRESSED ARE THE PERSONAL VIEWS OF THE AUTHOR AND DO NOT REPRESENT THE VIEWS OF LOCKE LORD LLP, ITS PARTNERS, EMPLOYEES OR ITS CLIENTS. FURTHERMORE, THE INFORMATION PROVIDED BY THE AUTHOR IS NOT INTENDED TO BE LEGAL ADVICE AND DOES NOT CREATE AN ATTORNEY-CLIENT RELATIONSHIP.