Make Tenants Pay Tax on Their 'Overstandard' Improvements

Standard commercial net leases require the tenants to pay a pro-rata share of property taxes on an office building or shopping center based on how much of the space each occupies. As a result, when improvements cause the property’s tax assessment to go up, the big tenants pay the lion’s share of the tax increase. As long as the big tenants actually benefit from the improvement—whether to their own space or the common areas—it’s reasonable and fair for them to pay more than their smaller neighbors. The problem is that big tenants may end up subsidizing tax increases for lavish improvements undertaken by small neighbors, even if the big tenants don’t benefit from the improvement.

Tenants Shouldn’t Have to Pay for Neighbor’s Taj Mahal

“A big tenant shouldn’t have to subsidize another tenant’s Taj Mahal,” according to one California attorney. The good news is you can solve the problem by changing the tax “escalation” formula of your lease: Instead of prorating responsibility by square footage, make each tenant pay for any tax allocable to its own lavish—that is, “overstandard”—improvements. The approach will work in an office building or a shopping center—regardless of whether tenants pay a prorated share of the total property tax or a prorated share of the amount the property tax increases over a base year.

Include Overstandard Improvement Lease Clause

Your clause, like our Model Lease Clause: Make Tenants Liable for Tax on Their “Overstandard” Improvements, should do the following:

Set improvement cost floor. Say that a tenant must pay the increased property tax for an overstandard improvement, defined as any improvement that costs above a specific cost floor [Clause, par. a]. In setting the floor, determine the cost of building standard tenant improvements per square foot of usable space in your building, factoring in your property’s location and age, and average construction costs in your area.

Editor’s Note: Use the same cost floor in all leases in your building. Otherwise, tenants with higher cost floors will be forced to absorb an unfair amount of improvements made by other tenants. But as long as all tenants have the same floor, the clause will work even if average improvement costs rise above the floor.

State how much of tax increase tenant must pay for its overstandard improvements. Some owners agree to itemize the factors for an increase and others won’t. Just make sure your lease clause enables you to calculate the tenant’s tax increase responsibility in either situation.

> Follow itemized assessment. Some assessments list the factors the tax assessor considered when valuing the property. If the assessment indicates the portion of the tax resulting from the tenant’s improvement, that’s what the tenant should pay [Clause, par. b].

Example: A tenant spends $30 per square foot installing marble floors. The assessor says that $2,300 of the owner’s next annual property tax bill is a result of the marble floors. The tenant must pay $2,300. The owner would then subtract the $2,300 from the total property tax bill and prorate the remainder among all tenants. So, the tenant that put in the marble floors would have to pay $2,300 plus its share of the remainder.

> Use formula when itemization unclear. You also need an alternative method to calculate the tenant’s tax responsibility if the tax authorities in your municipality don’t itemize their valuations. One approach is to require the tenant to pay a portion of the total property tax that you can calculate by multiplying the tax rate for the building by the total overstandard costs of the tenant’s improvements [Clause, par. c].

Example: A tenant rents 8,000 square feet—7,120 square feet of which is usable—in an 80,000 square foot building. The overstandard cost improvement floor is $20 per square foot of usable space. The owner gives the tenant an improvement allowance of $20 per usable square foot ($20 x 7,120 = $142,400). The tenant spends an additional $30 per usable square foot of its own money for improvements ($30 x 7,120 = $213,600).

The total assessed value of the 80,000-square-foot building is $15,125,000, and the tax rate for the property is 1.06 percent. The owner pays annual property taxes of $160,325 on the building ($15,125,000 x 1.06%). Multiply the overstandard amount, $213,600, by the property’s tax rate, 1.06 percent. The tenant’s share of the tax resulting from its overstandard improvements would be $2,264.16. So, the tenant would have to pay the $2,264.16, plus its prorated share of the rest of the property tax.