The Commercial Tax Loophole and Property Tax Reform

By Gerardo Sandoval

San Francisco is losing hundreds of millions a year in property taxes, primarily by losing property reassessment battles with large corporations that can afford to spend millions to win a single assessment appeal and have their property taxes lowered. This paper explains the problem and proposes a solution to the revenue crisis San Francisco is experiencing.

On a small scale, the Assessor's Office has a number of tools to make sure corporations and large commercial property owners are paying their fair share based on current law. The Assessor's Office, however, does not have the ability to institute broader reform measures that could permanently ease the burden on homeowners and make commercial property owners responsible for a greater percentage of the tax burden. These reforms would likely take a vote by the people of California or legislative action in Sacramento. Nonetheless, overall issues of tax fairness and the commercial tax loophole are relevant to any discussion on property tax reform, either at the level within the operating procedures of city and county government, or within the broader framework of statewide reform.

Tax Burden Increasingly Put on Residents

The property tax burden for California homeowners has increased from 32.0 % in 1979-80 to 38.1% in 2001-02 + a 20% increase. Meanwhile, the share paid by commercial property owners has steadily decreased.

Change in Relative Tax Burden for Homeowners

The San Francisco Controller's Office annual report on property taxes paints an even bleaker picture. San Francisco homeowners carry an even greater tax burden than homeowners across the state. The Controller's report indicates that single family residences amount to 43% of the city's assessed valuation, while commercial properties account for only 33%.

San Francisco Controller's Report of Property Tax

The increase in property tax burden for homeowners is tied to a range of factors, including the building boom of the 1980s, the commercial property tax loophole and the flood of assessment appeals by large companies.

In San Francisco, supplemental property tax revenue has dropped each of the past four years. In the last year, supplemental property tax revenue dropped by $9,444,800 or 22%.

The decrease, according to the Treasurer's report, was due primarily to a reduction in prior years' assessed values of commercial properties and to a decline in the number of ownership changes of those properties.

At the same time, secured property taxes increased by $50,885,101 due largely to home price appreciation. The result is that since Prop. 13, homeowners have been carrying an increasing proportion of the property tax burden while commercial properties are enjoying a decrease.

Assessment Appeals

Over the past four years in San Francisco, the burden on homeowners has been further exacerbated by the drop in commercial property tax revenue, as many large companies have won their reassessment appeals, and by a steep increase in housing prices.

The total number of assessment appeals has spiked in the last four years, despite the fact that the economy has made significant progress in recovering following the events of 9/11 and the nationwide recession.

Controller's Assessment Appeals Valuation

These appeals take one of two forms: Proposition 8 Appeals and Calamity Appeals. Proposition 8 was passed in November 1978 to amend Prop. 13. According to the Controller's Report, "Proposition 8 requires County Assessors to annually enroll either a property's Proposition 13 value (maximum increase of two percent or CPI annually, whichever is lower), or its current market value as of the January 1 lien date of each year, whichever is less." This means that when the current market value of a property is lower than the Prop. 13 value, the lower value replaces the Prop. 13 value. These values, known as "Prop 8 Values," must be reviewed annually.

The second form of appeal is known as a calamity claim, usually filed after a fire, earthquake or other disaster that has drastically reduced the value of a property. Following September 11th, some property owners filed calamity claims due to the economic impacts of the terrorist attacks. The State Board of Equalization determined that these claims do not fit the legal requirements of a calamity and no relief was granted in 2001-2002. Most assessment appeals involve a claim by the owner that the market value of a property is lower than the Prop. 13 assessed value.

The Assessed Value to Market Value Gap

The assessed-value-to-market-value discrepancy could be in the billions of dollars. There is no comparison study of this discrepancy in San Francisco, but there are three estimates of the commercial tax differential in Los Angeles and the State of California based on assessed to market values. Based on the large discrepancies indicated by these studies, it's clear that San Francisco is losing millions of commercial property tax dollars every year. If all commercial properties were reassessed in 2002, the state would realize the following tax gains at the time of that reassessment. Future gains would be equivalent to the periodic increase in the real estate market.

a. Method 1 (Source: LA County Assessor's Office): Looking only at Los Angeles County, the market to assessed value discrepancy in LA County was estimated to be $47 billion, meaning the total commercial tax differential for the state is about $1.9 billion in lost revenues. b. Method 2 (Source: Sexton and Sheffrin study, 2002 ): Looking only at LA County, the market to assessed value discrepancy in LA County was estimated to be $84 billion, meaning the total commercial tax differential for the state is about $3.35 billion in lost revenues. c. Method 3 (Source: California Board of Equalization): The market to assessed value tax differential for the state is about $2.4 billion in lost revenues.

If all commercial properties were reassessed at market value, San Francisco and the State of California would see a significant bump in tax revenues. With the added income, government agencies could give some consideration to lowering taxes or increasing some services. The budget deficits that we've grappled with over the last few years in San Francisco would not seem quite as daunting.

Closing the Commercial Property Tax Loophole

Following the passage of Prop. 13 in 1978, reassessment of a property is triggered by one of two events: (1) If the original owners of the legal entity cumulatively sell more than 50% of the entities ownership shares and (2) if any single individual or other legal entity acquires more than 50% ownership control of the entity. These criteria provided a large and complicated tax loophole for some business entities to avoid having their properties reassessed, even when there's an ownership change.

Ownership of a business can change over time without ever triggering a reassessment. According to a recent Senate report analyzing Prop. 13, it's possible that a majority share of ownership of a legal entity can change over time without ever being considered a change in ownership for reassessment purposes, as long as no one partner in the business acquires a majority share of ownership. This means that some large companies could be using this loophole as a way to keep their commercial property values low and create a heavier tax burden for everyone who pays their fair share.

Perhaps just as troubling, the Senate report suggests some believe that many business owners may not be reporting changes in ownership of their legal entities, either to avoid reassessment or out of ignorance. The county assessor may never identify these changes and the property will remain at its base-year value. This oversight is much more likely to occur with changes in business ownership than with transfers of real property "because there is no clear need or incentive for a business to report such a change, unlike reporting transfers of real property." County assessors often find out about changes in ownership through indirect means (e.g. through the Legal Entity Ownership Program or by following local business news) which, according to the Senate report, suggests there is a real possibility that businesses undergo a change in ownership without detection and without reassessment of their properties at full market value.

There is also no incentive to compel honest and timely reporting. If a business fails to submit a Preliminary Change in Ownership form with a deed of sale, the fine is only $25. According to the Revenue and Taxation Code, Section 480.1, failure to accurately complete the Statement of Change in Control and Ownership of Legal Entities upon request from a county assessor is punishable by a fine of 10 percent of the taxes applicable to the new base year. Additionally, assessors only have eight years to identify these changes in ownership due to a statute of limitations.

Tax Loopholes Create Business Disincentive

The loopholes are not only about lost tax revenues, which affect city services. Just as troubling, the loopholes create large tax disparities among similar businesses, which gives the business with the older base-year assessment a competitive advantage over a newcomer. The California Tax Reform Association looked at assessment differences among several Sacramento hotels and commercial buildings. According to the chart below, they found a range of taxes, from as low as $0.14 per square foot for land that was assessed quite a while ago to as high as $1.70 per square foot for land with a recent base year. Taxes paid on the buildings range from $0.18 to $2.56 per square foot.

A Senate report pointed out that in Contra Costa County during the 1980s, a Macy's store was reassessed after a change in ownership. Its tax base jumped to 250 percent higher than a competitor in the same shopping mall. While no similar study has been conducted in San Francisco, it's likely we would see the same discrepancies. Owners of the 50 properties valued at more than $85 million in San Francisco and currently seeking downward reassessment are likely to make this same argument at their reassessment appeals. They will argue they cannot compete in a marketplace where their competitors are saddled with much smaller tax burdens. And instead of reassessing properties with artificially low tax bases to level the competitive playing field + which is prevented by Prop. 13 + the companies seeking reassessment aim to lower their own tax liabilities to gain a competitive edge.

Senate Bill 17

California State Senator Martha M. Escutia, chair of the Latino Caucus, proposed Senate Bill 17 (SB17) last December to narrow Prop. 13's commercial property loophole, in an effort to relieve homeowners of an increasingly heavier tax burden than commercial property owners. SB17 says that when "all real property owned by a legal entity that is not a publicly traded company, as defined, in the state has undergone a change in ownership when over 50% of the ownership interests in that entity have been transferred to one or more persons or entities in one or more transactions during an assessment year," a reassessment would take place. The bill would also require legal entities that own real property to file a change of ownership statement with the Board of Equalization within 60 days of the transaction for all changes of ownership, not only, as current law states, when a majority ownership interest changes hands. These provisions are not overbearing and even fall short of the call by some to reassess all commercial property on an annual basis. Nonetheless, Escutia's solution would have significantly narrowed the tax loophole as it stands. Unfortunately, Escutia tabled SB17 in June 2005 because no Republicans would vote for it and it needed a two-thirds vote. Currently, there are 25 Democrats and 15 Republicans in the State Senate. The bill needs at least 27 votes to pass. Escutia's office said the bill could be revived next session, but as of now there are no such plans.

Who is Hurt?

First and foremost, homeowners are being asked to carry a greater share of the property tax burden. But the impact goes far beyond them. The City and County of San Francisco has a $4 billion budget, roughly. That budget pays for our streets to be paved, for the county hospital to operate, for the much-needed social services that many of our residents depend on, for our police and fire departments and so on. These services are all at stake when large companies no longer pay their fair share. The economy and business marketplace are also hurt because older businesses with lower tax bases have a competitive advantage over newly established businesses that pay property taxes based on market rate assessments. This discourages competition in the marketplace and makes it harder for new businesses to enter an older industry.

Solutions

There is no silver bullet. Prop. 13 is likely here to stay. It's unfortunate that Senator Escutia's bill, which would have significantly narrowed the commercial property tax loophole, was not more broadly supported. The City and County of San Francisco, while probably not in a position to help swing the support of SB17 toward possible passage next year, needs to lobby for its passage nonetheless.

Tracking Change in Ownership

The Assessor is responsible for tracking changes in ownership and reassessing properties. Unfortunately, many transactions do not require filing a deed of sale with the county recorder. County assessors, however, can track changes in ownership in a number of other ways. Sometimes owners voluntarily inform counties of the change. Second, the county sends out business license renewal forms each year and county assessors could use those responses to determine any changes in ownership. Assessors can also investigate to determine ownership changes when they suspect an entity is failing to report such a change, but this can be very costly and may not yield enough benefit to make it worth while.

Stiffer Penalties

The incentives for businesses to accurately report changes in ownership are minimal, with some of the fines for non-compliance even less than $100. If the system of taxation on property is not going to change, the various fines for failing to report ownership changes should be increased. At the very least, the state should make organizations accountable for the properties they own and take responsibility to ensure all of their reporting requirements are handled. Without the threat of heavy fines, it's no wonder that some people speculate that the state, not to mention the City and County of San Francisco, is losing millions of dollars each year.

The Split Roll

Economists, public policy experts and even politicians have often discussed the idea of splitting the property tax rolls. The idea is that all commercial properties would be reassessed at full market value on a regular basis, perhaps on a one-, three- or five-year cycle. These reassessments would supercede any changes in ownership of business properties, while residential properties would retain their Prop. 13 protection from reassessment unless there is a change in ownership. This would directly address the problem with tracking changes in ownership, would create a level field for competitors in the marketplace and lead to a more equitable tax burden for homeowners. Unfortunately, this idea is strongly opposed by many Republicans, despite the fact that it would create a more vital economic environment that encourages fair competition among businesses.

Better Allocated Resources

At the local level, the Assessor's Office needs to put more resources in fighting assessment appeals by large corporations. The San Francisco Assessor's Office just lost the assessment appeal by the San Francisco Giants. Why? Partly because the Assessor's Office has a total budget of $500,000 for all assessment appeals while an organization like the Giants can spend that much or more on their single appeal. The Assessor's Office is being outgunned by big business interests. According to an April 2005 article in the San Francisco Chronicle, 50 companies owning properties valued at more than $85 million in San Francisco have filed assessment appeals, putting tens of millions of dollars of annual tax revenue at risk. The Assessor's Office needs to put the resources into winning those appeals.

The Assessor alone cannot solve all of the problems with commercial property assessments. But by focusing on collecting current taxes and fighting unwarranted assessment appeals, the Assessor can make sure that homeowners don't carry a heavier tax burden than they already do.