Loophole in Proposition 13 May Cost Counties Millions

Owners of some of the most valuable real estate in California stand to save--and county governments could lose--millions of dollars annually through an obscure but increasingly popular loophole in the Proposition 13 property tax law.

Some large corporate landowners are trying to escape huge tax hikes by taking advantage of a law originally intended only to make it easier for parents to give their homes to their children.

The lucrative loophole is raising the ire of state tax officials and some legislators, but efforts to close it are being fought by a broad coalition of business, real estate and banking interests. Tax officials disagree on how to interpret the law and limit its abuse.

If left unchecked, one legislator said, the loophole could cost California hundreds of millions of dollars annually in lost tax revenue.

Leaseback Sale

Although it has been part of the state tax code since 1979, the year after passage of Proposition 13, the loophole surfaced just last year, when Security Pacific Corp. sold its Pacific Bank Towers on Hope Street in downtown Los Angeles to Metropolitan Life Insurance Co. for $310 million.

Under Proposition 13 tax rules, properties usually must be reappraised at full market value when they are sold.

Security Pacific had agreed, however, to lease most of the office space back from Metropolitan as part of the sale arrangement. The bank and Metropolitan argued successfully that properties sold in leaseback arrangements are exempt from reappraisal for the term of the lease.

They relied on a little-known section of the Tax Code that was written as a family estate planning mechanism soon after passage of Proposition 13. The provision excludes property from reappraisal when provisions are made for the seller to continue occupying it. That section was meant to enable parents to deed the homes they live in to their children, while postponing a reappraisal of the property and subsequent tax hike until after the parents’ death.

Now that provision is being applied to commercial properties.

Security Pacific contended--and Los Angeles County Assessor Alexander Pope reluctantly agreed--that under the tax loophole, the 73% of the office tower that Security Pacific leased back from Metropolitan Life would be exempt from reappraisal. The ruling resulted in the loss to Los Angeles County of $1.5 million a year in potential tax revenue.

More recently, outcries have come from San Francisco County Assessor Sam Duca and San Francisco Mayor Dianne Feinstein, who claim that the chink in the law may cost the Bay Area millions of dollars in potential tax revenue.

Jarred, Then Shocked

Officials there were jarred originally by the $52-million sale of the Industrial Indemnity building late last year and the $358-million sale of Crocker Bank Plaza last spring. In each case the sales were structured as leasebacks and the parties claimed exemption from reappraisal for all or part of the buildings.

The biggest shock came with Bank of America’s $660-million sale in September of its San Francisco headquarters to real estate tycoon Walter Shorenstein.

A Bank of America spokesman said the bank will seek a property reappraisal exemption on 45% of its headquarters property, which would reduce the potential tax increase by $2.6 million a year. Bank of America is basing its claim for exemption on a related loophole. The bank and others maintain that under the law, there is no change in ownership when property is leased back for 35 years or more.

The tax reappraisal exemption has been claimed mostly by banks, which have used sale-leasebacks to cash in sizable real estate equities and bolster their reserves.

The exemption, however, is not confined to banks.

Fluor Corp., a major Irvine-based engineering and construction company, said it expects a reappraisal exemption for the developed part of its 137-acre headquarters in Irvine. Fluor sold the property for $340 million last July to Dallas-based Trammell Crow Co. and a subsidiary of First Winthrop Corp., a Boston real estate investment banking firm. Before the sale, the property was assessed at $122 million.

Assessor’s Review

The Orange County assessor’s office said it is reviewing the Fluor transaction to see how it should be treated under Proposition 13.

Matthew J. Nickels, regional financial manager for Trammell Crow’s Southern California region, said that if the entire complex is reappraised at market value, the higher tax levy would immediately be passed through to the Fluor Corp., which would have to pay substantially higher rent.

Several real estate accountants said that the potential benefit of the tax loophole is not great enough to motivate a corporation to enter into a sale-leaseback but that it does represent “gravy” in the transaction that no company can afford to overlook.

“The law provides this opportunity and, in the interests of controlling our costs and in the interest of our stockholders, we believe we have a responsibility to pursue it,” said Bank of America spokesman John Keane.

Critics of the law complain, however, that it exacerbates an inherent advantage that Proposition 13 gives to commercial property owners, who tend not to sell their properties as frequently as homeowners and therefore do not have their properties reappraised as often.

“It is just an outrageous situation,” said Assemblyman David Elder (D-Long Beach), who has sponsored legislation (AB 2528) at Pope’s request to specifically bar commercial properties from the tax reappraisal exemption.

‘Monumental Losses’

“I’m trying to stop the hemorrhaging,” Elder said. “We are talking (potentially) about monumental losses of revenue. It could be hundreds of millions of dollars a year over time.”

Elder said he has met strong resistance from lobbyists for business groups, including the California Taxpayers Assn., the California Chamber of Commerce, the California Bankers Assn. and the California Manufacturers Assn.

On his side, he said, are the Los Angeles Board of Supervisors, the County Supervisors Assn., the City and County of San Francisco, the City of San Diego, Fresno County and the California Tax Reform Assn.

So intense is the opposition to his bill in Sacramento, Elder said, that it barely squeaked through the Assembly, and then only after it had been amended so that it would not apply retroactively to completed sales.

Elder’s bill has stalled in the Senate Revenue and Taxation Committee, and Elder acknowledged that it does not have enough votes to win passage. To prevent the bill from being killed outright, Elder said, he sent it to an interim committee for further study. The first study meeting was canceled for expected lack of attendance.

Objections to Elder’s bill range from alleged ambiguity in language to its non-retroactive nature to potential constitutional problems that may arise from enforcing different taxing standards on residential and commercial real estate, a situation that is sometimes called a “split roll.”

“The Bank of America and Crocker are entitled to the same treatment under the law as the homeowner,” said Bill Bennett, property tax lawyer for Crocker.

George Cook, the bankers’ association director of state government relations, said that from the bankers’ point of view, Elder’s proposal is “a tax increase bill.”

The bill is also being stymied by opposition of the State Board of Equalization, an agency to which legislators look for guidance on real estate tax matters.

The Board of Equalization takes the position that new legislation is not needed because the Tax Code, if properly interpreted, clearly requires properties to be reappraised after sale-leaseback transactions.

Not all county assessors’ offices have agreed on how to interpret the law, however. For instance, the Los Angeles assessor previously decided to exempt leaseback properties, such as Security Pacific’s, when the leaseback provision is part of the sales transaction. The San Francisco assessor’s office has insisted on reappraising all leasebacks 100%. The San Francisco cases are being appealed.

In an attempt to persuade all assessors’ offices to walk in lock-step, the equalization board sent them letters that argue against granting reappraisal exemptions for virtually all sale-leasebacks, regardless of the length of the lease.

Jim Delaney, chief counsel for the board, said another letter is to be sent to the Los Angeles assessor’s office, directing that the Security Pacific building be reappraised in its entirety.

‘Looking for . . . Leadership’

“We had been looking for this kind of leadership from the board since this issue appeared,” said Los Angeles County assessor spokesman Mark Ryavec.

The state board’s letter, while clarifying its position, does not wield the force of law, however, and according to some corporate attorneys, it just throws one more opinion into the legal brouhaha. Lawyers on all sides say the monetary stakes are so great that they expect the law ultimately to have to be interpreted by a state appellate court.

Fred Main, tax counsel for the California Chamber of Commerce, objected that the board is “probably exceeding its power” by issuing a legal interpretation in a letter that he said he believes is tantamount to a rule change. He said the board appears to have circumvented the long process, which includes public hearings, for modifying a regulation.

The state’s smaller commercial property owners will also be watching the outcome of court cases that are expected to be waged by the corporate giants. “If they (the large corporations) win, there will be many more of these deals,” predicted Gary King, a partner in the accounting and consulting firm of Deloitte Haskins & Sells.

In at least two instances, assessors have already been thwarted in their attempts to uphold reappraisals of leasebacks. In one case, a Los Angeles Superior Court judge ruled against Los Angeles County in 1983 when it tried to reappraise a leaseback building in West Los Angeles that was sold by City Equities Corp. to Cal-American Income Property Fund IV. The decision has not been appealed.

An Orange County assessment appeals board reversed the Orange County assessor’s decision to reappraise a Mission Viejo computer manufacturing plant that the Burroughs Corp. sold last year to the Burroughs Employees Retirement Fund Trust. Burroughs leased back the plant for 15 years, with options for up to 35 years. County officials said they have not decided whether to appeal the case to the courts.