Tax Abatements as a Shield for Looming Property Tax Increases

Fall 2013

Throughout the Great Recession and well into what has become an extended period of slow recovery, the tax revenue base for municipal governments has been shrinking. According to a 2012 National League of Cities year-end survey, “National League of Cities Research Brief on America’s Cities,” 2012
was expected to be the sixth consecutive year of year-over-year declining municipal revenues. Municipal revenues are not expected to rebound in real time with the economy, because assessment and collection of real property taxes — a primary revenue driver — lag anywhere from 18 months to several years behind changes in property market values. Thus, the outlook is grim for the municipal tax base for the foreseeable future.

At the same time that municipal tax bases are shrinking, local governments must continue to fund basic services, address a growing inventory of deferred infrastructure maintenance, and undertake other large-scale, high-priority projects. Notwithstanding substantial cuts to basic services and other austerity measures, existing sources of municipal revenue are projected to be insufficient to fund the growing deferred infrastructure maintenance problem. The American Society of Civil Engineers, in its “2013 Report Card for America’s Infrastructure,” estimated that through 2020, the investment necessary to maintain the current infrastructure in a “good state of repair” will be $3.6 trillion, of which $1.6 trillion is unfunded. Much of this burden is expected to be borne by municipal governments.

head shot of Jaclyn Maloney

Jaclyn Maloney

Inevitably, municipal governments will be forced to address the shortfall in the municipal tax base. The quickest way to effectuate an increase on the property tax base is to increase the levy (that is, the tax rate) in addition to ongoing reassessment efforts. Future property tax increases, which often coincide with a recovering real estate market, create a new risk for the commercial real estate community and its lenders because of their immediate impact on operating cash flows.

One way for commercial real estate owners to address the risk of increasing property taxes is through the use of tax abatement tools. Real property tax abatement involves the reduction of or exemption from taxes for a set period of time. Typically, the taxpayer is required to pay the base amount of taxes during the abatement period and any other agreed-upon payments in lieu of taxes.

The availability of and requirements to obtain tax abatement vary by state, although the purpose is generally the same: to encourage investment in certain types of real estate, such as blighted, commercial, manufacturing, or other types of properties that are perceived to provide an indirect public benefit. Abatement traditionally is granted for a property when substantial improvements or new construction are planned. Ordinarily such improvements result in increased real property taxes, but with abatement, funds that otherwise would be used to pay the increased taxes can be invested in the project.

Tax abatement also can be a valuable tool to minimize the impact of unpredictable future tax increases even when capital improvements to the property are not contemplated, such as when a property has been sold or significant tenant improvement work completed. While these two events traditionally are not tied to an increase in valuation and thus increased property taxes, at this stage the lending and investment community often looks to address the risk of unknown property tax increases.

Amerimar Enterprises’ acquisition of 1102 Grand in Kansas City, MO, provides a recent example of the use of tax abatement as a shield for future property tax increases. Amerimar purchased the building and constructed significant tenant improvements to accommodate a data center tenant. The improvements were expected to have a nominal impact on the value of the property and thus no real impact on the property taxes. However, the risk of tax increases in Kansas City is particularly great because of looming local government obligations to finance infrastructure-related improvements.

Amerimar sought tax abatement to secure a predictable tax obligation for future years. It asked to have the assessment level frozen at the purchase price, even though the property’s valuation for tax purposes was one-third less. As a result, the abatement increased the immediate tax burden to a higher level than what the developer would otherwise have anticipated, but the developer received a significant return in the form of a flat, secure, and predictable tax obligation for future years.

The real estate community should expect to see this unique use of tax abatement become more prevalent in the coming years, as the private sector becomes less likely to assume the growing risk of significant tax increases caused by nondevelopment factors.