Leases Checking: Property Tax Invoices

Most tenants with escalation clauses in their leases, when receiving an invoice for real estate taxes (usually billed annually or semi-annually), simply pay the bill and assume the correct formula has been applied in determining the tenant’s pro rata share. Astute bookkeepers may pull a copy of the lease out of the bottom drawer to verify the formula; once having done so, they are likely to assume that all is well and issue a check.

However, often all is not well for a number of reasons. It is possible that the tenant is overpaying, sometimes by large amounts, its share of the tax bill for the building in which the tenant occupies space. Four mistakes frequently found by audits of property tax bills are:

• Failure of the landlord to share refunds
• Inclusion of the other property tax bills
• Failure of tax bills to reflect tax abatements
• Incorrect use of higher tax rate

Sharing Tax Refunds. All tax jurisdictions permit owners to file an objection to the valuation of their property by the tax assessor and request a hearing. Owners frequently retain legal counsel and appraisal experts who will seek to demonstrate why the assessment was inaccurate. Often, landlords are very successful in recovering significant amounts through such appeals. In many big cities, including New York City, landlords hire lawyers on an annual contingency basis to protest real estate tax assessments.

A properly drafted tax escalation clause will entitle the tenant to share pro rata in tax refunds received by the landlord, after the landlord has recovered all the costs associated with the appeal. The refund often is to be made in the form of a rent credit rather than an actual reimbursement in cash. Notwithstanding the lease provision, audits frequently show that refunds are not made unless the tenant discovers that the appeal has been successful. In some cases, property taxes have been reduced over a period of years without any refunds to tenants, notwithstanding the clear requirements of the lease.

Observation: A proper lease audit will review public records as a matter of course to determine if any tax appeals have been made and the results of the appeals.

Inclusion of the Other Property. Tax assessments are made on the basis of “tax lots.” Sometimes, a building may take up only a portion of a larger parcel that has been assessed as a single tax lot, in which case the building tenants will be paying a share of the taxes on the vacant land from which they derive no benefit. In this situation, an initial allocation of the property taxes should be made between the vacant and the improved portions of the tax lot. The taxes allocated to the improvements should then be divided up among the tenants and the landlord in accordance with the lease provisions. Furthermore, if the landlord occupies spaces in the building for its own use, the tenants’ share in the aggregate should not include such space unless specified in the lease.

Observation: In the case of a shopping center or other project with common areas used by all tenants, typically the tenants are responsible for their share of taxes on the common area. However, the methods of allocation for each tenant’s share of such taxes differ. For example, under the flat-rate method, the tenant pays a certain number of cents per square foot. Under the more common fractionalization method, each tenant pays a designated fraction of the total. Negotiating a tenant’s fractional share involves so many considerations that the unprepared tenant can easily end up paying more than it intended. Determining the proper share requires a study of the lease provision and of the landlord’s application of the method set forth.

Tax Abatements. In many localities, buildings may benefit from tax abatement programs designed to encourage new development or property rehabilitation. These programs create a special problem in connection with tax escalation clauses. The abatements usually phase out over a period of years, gradually increasing the dollar amount of taxes imposed on the building without regard to whether the overall tax rate and assessment has increased. This results in tenants paying a share of higher property taxes even though the increase does not truly represent an increase in operating costs as provided in the lease. Consequently, tenants can be billed incorrectly for property taxes not currently payable because of the abatement program.

An even worse situation can occur when a base tax year is fixed in the lease for a property that has not yet been fully assessed and is also receiving tax abatements. An unwary tenant can see the property taxes double over a short period of time, when in reality the fully assessed value of the property has remained constant. The proper solution is to negotiate a tax escalation clause that requires the base year tax to be calculated without the effect of any tax abatement and which reflects the value of the fully completed improvements.

Incorrect Tax Rate. Property taxes can go down as well as up. In recent years, discoveries of property contamination (i.e., asbestos) has often resulted in lowered assessments and, consequently, lowered taxes. In addition, tax rates are sometimes reduced to attract new business to the locality and increase employment opportunities. Inadvertently, a landlord may fail to reflect the reduced taxes on the current year’s tax invoice to the building tenants. A properly conducted lease audit will reveal such errors.

Conclusion. The incorrect billing of real estate taxes to tenants can have an enormously compounding effect in the case of a lease. Audits by qualified professionals can protect tenants against overcharges or enable the tenant to seek recourse when overcharges have been made. Please contact us to discuss.