In 1978 California's Prop 13, which limited the opportunities to increase the assessed value of property, started a tax revolution that traversed the globe. Many families and educators blame Prop 13 for a steep decline in California's educational system by hamstringing the state's revenue base.
As most readers will know, Prop 13 required nearly all California properties to be reassessed at the purchase price or fair market value only upon a change of ownership. The ad valorem property tax was limited to no more than 1 percent of assessed value, with an annual adjustment equal to the rate of inflation or 2 percent, whichever is lower. This resulted in wildly different assessed values for comparable properties.
For example, an office building which had not been traded for 20 years would have a dramatically lower tax bill than an identical building next door that just sold. This "unequal" treatment was challenged on a number of constitutional grounds, but the California Supreme Court held that the will of the voters should prevail.
Split Tax Roll for Residential and Commercial Properties
The California Local Schools and Communities Funding Act of 2020 (Proposition 15 on the November 2020 ballot) would amend the State Constitution to undo Prop 13's protections for commercial and industrial properties, with certain exceptions, including exemptions for agricultural properties and small business owners.1 Prop 15 would create a split tax roll, one for residential and other exempt properties2 and the other for commercial and industrial properties, with the latter assessed at full market value phased in beginning in the 2022/2023 tax year.
Properties would be reassessed every three years. Residential and other exempt property would retain the benefits of Prop 13. The Legislative Analysist's Office estimates the additional tax revenue generated by Prop 15 between $6.5 billion and $11.5 billion per year.
If passed, the new measure would level the tax burden for most commercial and industrial properties by valuing them at fair market whether or not the properties were recently sold or transferred. For properties that have not been reassessed in a long time, this could mean a huge jump in property taxes but would remove the cost disadvantage suffered by recently transferred properties.
Prop 15 Impact on Landlords and Tenants
Most California leases are structured as a gross lease, with the tenant paying real estate taxes over a base year, or on a triple net (NNN) basis, with the tenant paying all of the real estate taxes (or a proportionate share if occupying only a portion of a building). Property owners, who occupy their own properties, and tenants in California will see an increase in their occupancy costs if Prop 15 is passed.
Landlords often provide estimates of tax and expense pass-throughs based on the most recent year's taxes. Landlords should now caveat any estimate of taxes based on whether Prop 15 passes. Current tenants may be facing a big tax bill, which could be as large, in some cases, as the base rent.
Tenants looking for space now may wish to defer leasing decisions until after the results of the November election are known. Alternatively, tenants could limit considerations to recently reassessed buildings to minimize the risk of unanticipated tax increases.
1 Prop 15 also exempts certain small businesses from personal property tax; for other businesses, it provides $500,000 exemption.
2 Read the Act or speak with your counsel to determine if these apply to you. The full text can be found at this link by scrolling down on this page.