November 03, 2021

Change of Ownership: The Long-Term Lease Exception to California Property Tax Reassessments

As many commercial and retail operators know, a transfer in California property interests may lead to a sizable increase in a taxpayer’s property tax liability. Specifically, while property values are capped under Proposition 13 and related authority for ad valorem tax purposes at inflationary increases not to exceed 2% per year, a property becomes reassessable when, among other things, a change of ownership occurs. A “change of ownership” is defined as “a transfer of a present interest in real property, including the beneficial use thereof, the value of which is substantially equal to the value of the fee interest.” Cal. Rev. & Tax. Code § 60. A traditional sale of a parcel, naturally, constitutes such a change of ownership. And when such a transfer occurs, absent certain exceptions, the county assessor will revalue the property. In an era of appreciating property values, that new value likely will substantially increase a taxpayer’s property tax burden.

However, the California Revenue and Taxation Code contains a notable exception that impacts many commercial and retail business. In particular, many businesses forego real estate ownership and instead operate under a NNN lease. This scenario is relevant under Proposition 13 when the applicable lease is long-term. Specifically, the Code excludes a change of ownership reassessment when the purported transfer occurs on a property encumbered by a lease with a remaining term (including renewal options) of 35 years or more. Cal. Rev. & Tax. Code § 62(g). Most tenants operating under a sufficiently long-term lease should therefore be shielded from increased property tax obligations following the sale of the underlying property.

There are sound policy reasons for this exception. As articulated by a California appellate court, a contrary rule "could result in an enormous tax increase for a lessee that has erected major capital improvements on the land and whose lease requires the lessee to pay property taxes.” Dyanlyn Two v. Cty. of Orange, 234 Cal. App. 4th 800, 815 (2015) (citations omitted). Retail companies invest heavily in their rented sites, particularly when they choose to enter into a long-term lease. In exchange for that investment, they should not be penalized by unexpected tax increases for “a transfer over which the lessee has no control.” Id.

Certain procedures are typically required when a property is transferred, including filing a change of ownership statement. Problematically, many owners of property encumbered by a NNN lease do not properly notify the county that a long-term lease is in effect which would prevent reassessment of the property. As such, tenants are occasionally surprised to find a higher tax bill the following year.

A tenant operating under a long-term lease should be vigilant for any transactions that may increase its tax liability. Among other things, the tenant should coordinate with the owner to ensure that the owner properly notifies the relevant county that a long-term lease is in place when filling out paperwork related to the change of ownership. In the event that the county improperly reassesses the property, the tenant should consider reaching out to someone specializing in property tax in California to determine whether to contest the reassessment.

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