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LEASE AGREEMENT REFERENCE GUIDE 1010: RETOOLING THE TAX CLAUSE FOR DEFLATIONARY PERIODS $24.95


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Lease Strategies
1010

Product Overview

This LARG contains the following items:

Drafting Real Estate Tax Clauses A Deflationary Environment, Tenant Talking Points For the Tax Clause, The Pro-Tenant Real Estate Tax Rider, and the Lease Clause Critique: The Integrated Pro-Landlord Operating costs and Real Estate Tax Clause.

Number of Single Spaced Pages: 12

 

Excerpt

RETOOLING THE TAX CLAUSE FOR DEFLATIONARY PERIODS

 

This LARG focuses upon an old friend--the real estate tax clause. The decline of commercial real estate values in the US over the last five years or so makes this an ideal time to re-examine tax clause boiler plate. The first section in this issue looks at some of the likely effects of falling commercial values, and how they might affect the commercial lease. The second part lists a number of tenant considerations concerning the tax clause. The third section contains a pro-tenant real estate tax rider, and the Lease Clause Critique features an "integrated" tax and operating cost clause drafted from the landlord's perspective.

Drafting Real Estate Tax Clauses For A Deflationary Environment

The free fall in commercial real estate values which started in the mid to late 1980's has already put many local governments in a fiscal jam of epic proportions. Traditionally, such local governments have raised their revenues almost exclusively from real estate taxes paid by residential and commercial property owners. The decline in commercial property values means that residential owners will be forced to pay more of the total tax pie to maintain the same level of local government services, unless such governments take the politically risky course of either raising taxes or cutting services. At least, those are the conclusions of two recent Working Papers published by the Urban Land Institute (see the end of this article for the exact titles and ULI details).

The ULI projects a 32% drop in US commercial real estate values between 1989 and 1994 on a global basis. Although the precise amount of decline varies by market, this computes to a 25% drop in real estate taxes paid by commercial owners and an increase of 40% for the average residential owner during that period. It also means that the residential share of real estate taxes will increase from 65% in 1989 to 73% in 1994, with a corresponding drop in share for commercial owners.

Getting Out the Crystal Ball

But what does all this mean to commercial landlords and tenants, and to the real estate tax clauses in their leases? Plenty. Specifically, it is likely that:

  • Local governments will be casting about for "substitute" taxes to replace declining commercial real estate tax revenues. Likely candidates include gross receipts taxes, rent taxes, and expanded sales tax levies.
  • Both commercial landlords and tenants will have renewed interest in their tax clauses with regard to specific definitions of taxes to be paid by tenants on a pro-rata basis and with regard to the treatment of "substitute" tax issues.
  • Some cost conscious commercial landlords may view declines in real estate taxes as an opportunity to make one time capital improvements to their properties or to include other extraordinary operating expenses in operating or common area maintenance (CAM) costs passed through to tenants for payment. Reduced tax levels may give landlords the ability to make such improvements and still hold aggregate tax and operating cost amounts to prior year levels.
  • Where market conditions permit, landlords will seek to use operating cost or CAM clauses which include taxes as one element of such costs, and use base year, base amounts, or expense stops to permit maximum flexibility for the landlord in "managing" operating or CAM costs paid by the tenant. Integrated clauses usually contain very broad definitions of operating costs which may cover new or substitute taxes not expressly covered by the tax clause. (See the Lease Clause Critique for an example of such "integrated" clauses.)
  • In certain markets, the tenant contribution for real estate taxes will fall below the amount specified in the lease for the "base year" or the "base amount" of real estate taxes to be paid by the tenant. This will undoubtedly prompt the landlord to seek to renegotiate such base amounts for lease renewals or for options, since the tenant is customarily liable only for its share of taxes in excess of such base amounts.

The titles of the Working Papers published by ULI mentioned are: "The Impact of Declining Property Values on Local Government Finances" (March 1993), and "The Effect of The Collapse Of Commercial Property Values on Local Government Revenues and Tax Burdens" (May 1993). ULI's address is 625 Indiana Avenue, N.W., Washington D.C. 20004-2930.

Tenant Talking Points for the Tax Clause

Tenants generally encounter pro-landlord real estate tax clauses in leases they negotiate and sign. In some cases, landlords use integrated operating or CAM cost clauses which incorporate real estate taxes as part of operating or CAM costs. In other cases, the tax clause stands on its own as a separate section of the lease. In response, many tenants have developed their own riders designed for use with pro-landlord forms (see the following section for an example).

Notwithstanding the landlord's approach, the definitions contained in the real estate tax clause are critically important for both the landlord and the tenant. Frequently, such clauses provide that numerous items which are not actually real estate taxes are to be included within the definition of taxes, making such items subject to reimbursement by the tenant. In reviewing the real estate tax language in the lease, the tenant should focus upon the following issues:

  • Does the clause obligate the tenant to pay for tax increases due to the construction of tenant improvements performed for other tenants in the same building (i.e., is the tenant's pro-rata share of taxes increased by such construction)?
  • Does the clause expressly obligate the landlord to pay real estate taxes?
  • Does the clause require the tenant to pay its pro-rata share of taxes substantially in advance of when the landlord must actually pay those taxes to the governmental authority?
  • Are the costs of a tax contest (including fees for attorneys and consultants) considered to be taxes pursuant to the language in the tax clause?
  • Can the landlord bring a tax contest at any time in its complete discretion?
  • How many times can the landlord bring a tax contest (i.e., are there limitations upon the frequency of such proceedings)?
  • Can the tenant initiate a tax contest, with or without the landlord's approval?

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