Negotiate Eight Real Estate Tax Protections into Your Lease

By Glenn S. Demby, Esq.

One of the key economic questions any commercial lease must address is whether the tenant is responsible for paying real estate taxes on the property and, if so, how much. More often than not, the tenant does have tax liabilities, but because of the money involved, the issue is often hotly negotiated. And while every deal is different and generally reflects the bargaining power of the sides involved, there are eight protections that owners should seek in any negotiation with their tenants over tax allocation terms in the lease.

1. Whether the Tenant Must Pay Taxes at All

The threshold issue is whether the tenant should have to pay any property taxes on the commercial property it leases. There are two fundamental models:

• Gross leases, in which the owner pays 100 percent of property taxes on the building; and
• Net leases, in which the tenant pays a percentage of the taxes (and perhaps other operating costs) directly corresponding to its actual use. There are three kinds of net leases:
  
  • Single net leases, where the tenant pays a pro-rata share of the building’s total property tax based on the proportion of space it leases;
  • Double net leases, in which the tenant is responsible for base rent plus a pro-rata share of property tax and insurance; and
  • Triple net leases (also known as net net net leases), the most common arrangement, in which the tenant pays base monthly rent plus net property taxes, insurance, and common area maintenance (CAM).

If you use a gross lease, you can stop reading. But if you use a net lease, you have more work to do.

2. Which Taxes the Tenant Is Responsible For

First, you need to define exactly which taxes the tenant is responsible for. At a minimum, owners should insist that tenants pay “property” or “real property taxes,” including not just annual taxes paid to the state and municipality but assessments, levies, and additional charges imposed for using or improving the land for the tenant’s benefit. Show this language to your attorney before using it in your leases:

Model Lease Language

The Tenant shall be liable for all taxes levied against leasehold interest of the Tenant or personal property and trade fixtures owned or placed by the Tenant in the Leased Premises, as well as any assessments, ordinary and extraordinary, attributable to or against the Leased Premises.

If you have more bargaining power, you may be able to require tenants to pay certain kinds of non-real estate taxes related to their use of the property such as sales, franchise, or other business taxes. But make sure you talk to a CPA or attorney about the kinds of taxes you can shift to tenants. For example, it’s generally not legal to make tenants pay estate taxes on the land.

3. What Percentage of Taxes the Tenant Must Pay

The lease needs to say how much of the particular tax the tenant is responsible for paying. Allocation of tax liability is typically based on percentage of square footage the tenant uses, but there are important differences in deciding which square footage to count. Options:

• Useable space—the percentage of the total area of the space in the building that the tenant can use, including the usable parts of the leased premises and the common areas;
• Rentable space—the percentage of the building that the owner can rent out—a more favorable formula for tenants of buildings with vacancies; and
• Rented space—the percentage of the building that’s actually rented regardless of whether it’s rentable (and excludes common areas).

4. The Tenant’s Responsibility for Tax Increases

You also want to hold the tenant responsible for any tax increases that occur during the lease term. The most common form of “escalation” clause is to require the tenant to pay a proportionate share of the difference between the actual property taxes (and operating costs) you incur: 

• During the “base year,” which is typically the first year of the lease; and
• Each subsequent year after the base year.

Example: A tenant occupying 10 percent of a building with total property taxes of $100,000 during the base year must pay $10,000 in that year. In the next year, total property taxes increase by 5 percent to $105,000. Result: The tenant’s tax liability would also increase by 5 percent, from $10,000 to $10,500 [10% x ($105,000 - $100,000)].

As with any other economic term, you may be in a position to negotiate for a more favorable escalation formula. Examples include setting the base rate to a year pre-dating the lease when tax rates were lower so you can charge the tenant for a tax increase during the first year of the lease and/or requiring the tenant to pay a bigger percentage of the increase rather than one proportionate to the space it occupies.

5. Which Escalations the Tenant Is on the Hook For

Although tenants may be willing to accept an escalator, they’re also apt to insist that the formula account only for tax increases associated with their use of the property. This would include tax assessments for improvements that benefit the tenant and its business, such as additional parking spaces or construction of amenities that attract more customers to a shopping center.

Tenants may also try to cap the amount of escalations in a given year and/or over the aggregate term of the lease.

6. Whether Tenant’s Responsibility for Taxes Includes PILOTS

PILOTS, or Payments In Lieu Of Taxes, are payments made by an owner to a local government to compensate for lost tax revenues resulting from the way the owner uses the property. For example, a city may ask a developer for PILOTS after agreeing to cut or waive property taxes as an incentive for the developer to build an office building. If you intend to participate in such an improvement program on the leased land, make sure the tenant’s obligation to pay for taxes extends to PILOTS.

7. The Method of Tenant Tax Payments

Make sure the lease sets out a tax payment procedure and timetable. Try to get the tenant to agree to make estimated tax payments each month, especially if your mortgage requires you to make monthly tax escrow payments. Set the deadline for tenant tax payments for about a week before the day of the month when escrow payments are due.

Model Lease Language

From and after the Commencement Date of this Lease, Tenant shall pay Owner during each month of the Lease no later than twenty-one (21) days after the date on which the same may become initially due, all estimated real estate taxes and assessments applicable to the Leased Premises, together with any interest and penalties lawfully imposed thereon as a result of Tenant’s late payment thereof, in accordance with the tax allocation formula set forth in this Lease.

8. Whether the Tenant May Contest Property Taxes

Your tenant may think that a property tax it’s obligated to pay under the lease is too high and try to contest it by bringing a formal legal proceeding against the government. That can embroil you in a legal mess—and it may actually result in a higher assessment. So you want to be sure you handle any contests. Ban the tenant from contesting any taxes for which it’s responsible under the lease without your express consent. At a minimum, require the tenant to pay the disputed amount or post a bond or letter of credit in the amount before bringing the contest. Also make the tenant indemnify you against any losses you incur as a result of the contest.

Last but not least, require the tenant to pay a portion of your legal costs and perhaps a management fee to compensate you if you decide to contest a tax for which the tenant is responsible and are successful in getting it reduced. Otherwise, you might get stuck footing the entire bill for an initiative that helps both you and the tenant.

Example: A New Jersey shopping center owner succeeded in getting a property tax reduced. In addition to passing along a refund to all tenants, the owner assessed each one a pro-rata rent hike to cover its legal expenses in bringing the contest. A tenant cried foul and the court was sympathetic. The tenants reaped the benefits of the contest and the lower tax rate, the court acknowledged. But, it quickly added, the lease didn’t expressly say anything about the owner’s being entitled to reimbursement for obtaining it and ordered the owner to refund the extra rent [Developers v. Wegmans Food Mkts., November 2013].

Glenn S. Demby, Esq. is a corporate attorney and award-winning legal journalist who specializes in explaining the law in plain English and helping business leaders overcome their regulatory challenges. He can be contacted at glennsdemby@gmail.com.