The Split Roll May be Coming – Are You Prepared?

This November, California voters will decide Proposition 15, which if passed, will dramatically transform the real property tax structure for commercial properties in California. Known as the “split roll” initiative, Proposition 15, with only a limited number of exceptions, will require commercial properties to be regularly reassessed with no cap on increases in real property taxes. Proposition 15 will not, however, eliminate the existing Proposition 13 protections for residential properties.

In 1978, in what Time magazine dubbed the Tax Revolt!, an overwhelming majority of California voters passed Proposition 13, limiting real property taxes to 1% of the assessed value and capping increases in the assessed value of the real property at 2% per year unless a “change of ownership” occurs. In general, a change of ownership occurs if a property is sold or if the owner enters into a lease of 35 years or more, at which time, the assessed value becomes the market value or purchase price. As passed, Proposition 13 specifically applies to all types of taxable real property, including residential and commercial properties. Interestingly, in the same 1978 election when Proposition 13 was passed, voters rejected a competing proposition (Proposition 8) that attempted to “split” or treat differently the tax burden between residential and commercial properties.

Proposition 15 is the most recent attempt to “split” how residential and commercial properties are taxed by eliminating the change of ownership requirement for reassessing the taxable value of most commercial properties. If voters approve Proposition 15, commencing with the 2022-2023 tax year, county assessors will reassess commercial properties “not less than once every 3 years” to determine each such property’s “full cash value” for property tax purposes. Proposition 15 provides that the California Legislature will still need to establish a “Task Force on Property Tax Administration” to recommend needed statutory and regulatory changes to implement Proposition 15, including a phase-in process and provisions for the timing and processing of assessment appeals.

Proposition 15 specifically does not apply to residential properties and properties used for commercial agricultural production. In addition, commercial properties with a fair market value of $3,000,000 or less (subject to increases for inflation) are excluded from the “split roll.” However, the exclusion does not apply if the potentially excluded property is directly or indirectly owned by a person or entity who owns other properties where the aggregate value of all properties exceeds $3,000,000. The residential portion of mixed-use buildings are excluded from the split roll, while the commercial portions of such mixed-use properties are subject to reassessment. Finally, Proposition 15 provides that for properties where 50% or more of the occupied square footage is occupied by a “small business,” as defined by the initiative, the split roll reassessment will not occur until the 2025-2026 tax year.

Note that Proposition 15 exempts all of the tangible personal property of a “small business” from taxation by the State and for businesses not qualifying as a “small business,” the initiative exempts up to $500,000 in tangible personal property from taxation by the State.

In the event Proposition 15 passes, it will have a dramatic economic impact on landlords and tenants throughout California. Upon full implementation, the State’s fiscal analyst estimates that Proposition 15 will generate between $8 billion and $12.5 billion in additional revenues each year, with most of the revenues raised to be distributed to local governments, special districts, K-12 school districts, and community colleges.

Unless a lease contains a cap on increases in taxes or other similar limitations, a landlord whose lease allows the landlord to pass through all property taxes, or at least the increases in taxes, will be able to collect from the tenant the increases in taxes due to Proposition 15. Therefore, it is expected that in such circumstances, unless tenants can further pass through the costs to their customers, commercial tenants in occupied buildings will bear the biggest brunt of the tax increases due to Proposition 15. In vacant commercial buildings, landlords will be fully responsible for paying such increases.

Landlords and tenants should review their existing leases to understand the potential impacts of Proposition 15. For leases currently being negotiated, parties may want to include specific language allocating responsibility for paying increases in taxes in the event Proposition 15 is adopted by the California voters.

Both landlords and tenants should carefully monitor the outcome of the vote on Proposition 15 because if the initiative passes, it will have a dramatic impact on the economics of the commercial landlord-tenant relationship for years to come. If the initiative does not pass, proponents of the split roll will likely continue to seek reforms to Proposition 13 via the California Legislature or the initiative process.

About the Authors

Dan Myers is the chair of the Real Estate Practice Group at Wendel Rosen LLP and a member of the Commercial Lease Dispute & Resolution Team. Dan represents clients in leasing, purchase and sale and other real estate transactional matters. Buddy Rowell is the chair of the Wendel Rosen LLP Litigation Group and a member the Commercial Lease Dispute & Resolution Team. Buddy represents clients in a range of litigated matters, including leasing, real estate, and partnership disputes. Dan and Buddy can be reached by email at dmyers@wendel.com and browell@wendel.com.