Recent Court of Appeals Decision Highlights Loophole in California’s Prop 13

California’s Proposition 13 was originally billed as a way to keep elderly fixed-income homeowners in their homes by preventing the government from sharply increasing their property taxes. The proposition capped the maximum amount that the assessed value of real estate could go up by no more than 2% per year, which meant that the rates of increase of property taxes were similarly slowed. What was not advertised to the state’s voters in 1978 when the proposition enthusiastically passed, however, was the fact that Proposition 13 equally limited the ability of the government to raise property taxes on commercial real property, thereby giving businesses as much, if not more, of a tax break as it did grandma.

The way the law was written, real property could only be reassessed when there was a “change in ownership.” Generally, according to the government’s own regulations, a change in ownership occurred for any portion of real property that was directly acquired. Therefore, for example, if a person were to directly buy 10% of an apartment building, that portion of the building would be subject to reassessment to its full cash value. As a result, the property tax associated with that 10% portion would be adjusted upwards to reflect the increased value of the property due to its change in ownership.

Through a quirk in those regulations, however, if the real property is owned by an entity such as a partnership, and the same person above buys 10% of the entity that owns the property instead of buying the property itself, no property tax reassessment occurs. In fact, that person could buy up to 50% of the owning entity and not subject the underlying property to any property tax reassessment whatsoever.

The tax profession has known about this loophole in the property tax law for years, but only very recently has the loophole attracted the scrutiny of the public and legislators thanks to Michael Dell.

During 2006, Michael Dell purchased the historic Fairmont Miramar Hotel in Santa Monica. He did so not by buying the hotel outright, but by purchasing a 48% stake in Ocean Avenue LLC, the partnership that directly owned the hotel. An additional 49% of Ocean Avenue was purchased by Dell’s wife through her trust. Finally, the remaining 3% of the partnership was purchased by Dell’s business partners. As a result, the hotel completely changed owners, but no one single person or entity acquired more than 50% of the entity owning the hotel. Therefore, according to the regulations, there was no “change in ownership” that would trigger a property tax reassessment, saving Dell hundreds of thousands of dollars.

In a bid to remedy the result, the County of Los Angeles reassessed the property and stuck Dell with the bill. Dell’s lawyers took the county to court in 2013 and won, with the court stating that Dell’s purchase followed the government’s own written technical guidance.

Just recently in the middle of 2014, the California court of appeals affirmed this verdict, which has caused even more grumblings in public circles that the result is not in keeping with the spirit of the law. In this vein, California legislators Tom Ammiano and Raul Bocanegra proposed a bill to close the loophole, but business groups have managed to put the brakes on its progress. And, given Proposition 13’s hallowed status in the eyes of the California electorate, it is unlikely that there will be substantive change in the law by those voters, or from those who are elected by them to serve.

In California’s high tax environment, property tax planning is an essential consideration for real estate ventures. Bartlett, Pringle & Wolf, LLP specializes in all aspects of these ventures, including their structuring to maximize income, estate and property tax efficiencies. If you are involved in real estate ventures and need expert advice on any aspect of these ventures, please feel free to contact me at (805) 963-7811 or dclark@bpw.com.