Compromise on Tax Hikes Resulting from Sale of Property Early in Lease

Any time a property is sold there’s the possibility that the sale will trigger a tax assessment. And that creates the risk of a major real estate tax increase. Who pays for that increase when and if it occurs? Obviously, tenants won’t want to. They try to exclude tax increases resulting from a building sale from the taxes they must pay. While landlords often go along on this point, they may pay a hefty price to the extent it cuts the property’s price value when they eventually sell it.

Here’s a leasing strategy to consider that has worked very well for an attorney in San Francisco: Have the tenant pay only a percentage of any tax increase resulting from the sale of the property in the first few years of the lease term.

This solution offers a compromise that’s fair to both sides. It protects tenants against having to pay the full amount of sudden, unforeseen tax increases that result from the sale of the property early in their lease term. But if the property is sold after the first few years of the lease term, the arrangement allows the new owner to pass on the full amount of any tax increase and do it at a time when tenants will be better prepared to pay it. The compromise preserves the value of the property by enabling the new owner to pass on to tenants at least some, and potentially all, of the tax increases it would otherwise have to pay itself. Here’s how it works.

Tax Payments Affect Selling Price

When commercial property is put on the market, potential buyers and lenders focus on the amount of real estate taxes for which the owner must be reimbursed under its lease. Many if not most leases require tenants to pay a pro rata share of tax increases above a base-year amount. Any increases not payable by tenants come out of the new owner’s pocket once it acquires the property. This has an impact on the purchase price—to the tune of $10 to $15 cut for every annual real estate tax dollar the new owner can’t collect from tenants.

Example: Suppose the annual real estate tax on a property valued at $5 million is 1 percent ($50,000) and the property is sold for $10 million. There’s a chance the tax could double to $100,000. If the buyer can’t pass on the $50,000 increase, it will seek to cut the purchase price of the property by at least 10 times that amount, i.e., by $500,000.

New Owners Often Get Stuck Paying the Tax Increase

Since selling the property doesn’t have a direct effect on building operations or provide a direct benefit to tenants, many tenants feel that any resulting tax increase should be excluded from their tax payment under the lease. The new owner is the one who should pay the increase, they feel. Owners often give in on this point (especially if the tenant is large and economically powerful) because selling the property feels like a remote contingency when the lease is first signed. However, this concession can become very costly 5, 10, or 15 years down the road when the lease remains in effect and the owner is finally ready to sell.

Asking tenants to pay taxes on the property’s value is reasonable, says the San Francisco attorney. After all, if the property has a below-market assessment when tenants sign a lease, “they should be saving their pennies for the time when the property gets assessed at its true value.”  

Offer Tax Relief in Early Years of Lease

Timing matters. If a property is sold soon after the lease is signed, tenants may be unprepared and unable to pay for a big tax hike. Accordingly, it makes sense to offer to protect tenants from increases in the first few years of the lease term while still allowing owners to pass on the full tax hike if the property is sold later.

The way it works: If taxes increase as a result of the building’s sale during the first few years of the lease, tenants pay only a set percentage of the tax increase, depending on the year of the lease term the sale happens. The attorney uses a four-year compromise along the following lines:

• If the sale occurs in the first year of the lease, tenants pay none of the increase;
• If the sale occurs in the second year, tenants pay 25 percent of their pro rata share of the tax increase;
• If the sale occurs in the third year, tenants pay 50 percent of their pro rata share of the increase; and
• If the sale occurs after the third year, tenants pay 100 percent of their pro rata share of the increase.

Example: A property is sold in year 3 of a tenant’s 20-year lease. The property is reassessed resulting in a $1,000 per year increase in the tenant’s pro rata share. The tenant would be on the hook for only 50 percent of the increase—$500 per year—for the remaining years of the lease. But if the sale occurred the next year, year 4 of the lease, the tenant must pay the full $1,000 per year for the rest of the lease.

You can adapt our Model Lease Clause: Collect Percentage of Tax Increases After Sale that Occurs Early in Lease, below, to use this strategy in your leases.

Dealing with Tax Increase Caps

Many leases cap tenants’ annual tax increases at a particular amount or percentage. But you can still use this arrangement with such leases simply by calculating the tenant’s tax amount in accordance with the formula and then applying the cap.

Example: The property is sold and reassessed in the second year of a tenant’s lease. The tenant has a 6 percent cap on annual tax increases. Instead of the 25 percent increase for a second-year reassessment, the tenant would pay a 6 percent increase. If the cap is set up so that taxes increase 6 percent each year until all of the increase is passed on, the tenant’s payment would go up 6 percent each year until the full 25 percent is paid.