Market Insight: Guest Articles Distressed Real Estate Loans and Their Property Tax “Kicker” by Theodore F. Bayer, Esq.
June 2008

If you are confronted with a distressed loan secured by a deed of trust recorded against California real estate, it is time to get familiar with Proposition 13 (“Prop. 13”), the state’s property tax framework. What you don’t know could cost you dearly—and timely action can enable you to avoid, or at least minimize, unanticipated out of pocket costs.

Property taxes provide funding for many vital local services; thus, it is not surprising that the lien for unpaid property taxes and penalties is superior to all other liens against a property, regardless of the time of their creation. A deed of trust may have been recorded in 2005, when there were no tax delinquencies; however, upon foreclosure in late 2008, any unpaid property taxes from the 2006, 2007 and 2008 tax years, plus penalties, become the obligation of the entity that acquires title upon foreclosure. Because California has a 5-year waiting period before a property can be sold for tax delinquencies, most borrowers in distress simply ignore property taxes. As a result, the opportunity, both to eliminate or reduce penalties and to challenge the property’s assessed value, is lost. Savvy lenders faced with this scenario are well-advised to initiate early action to minimize the resulting impact on their bottom line.

Economic Impact of Delinquent Property Taxes

One of the primary benefits of Prop.13 is its imposition of a maximum tax rate. In California counties, tax rates range from 1% to 1.14% of a property’s assessed value. The other main component of the initiative is the restriction on annual increases in a property’s assessed value. Utilizing the purchase price paid for the property as its “base year” assessed value, Prop. 13 limits annual increases in that value to 2% until the property is sold or transferred. If a property was acquired for $8,000,000 in mid-2005, its assessed value in 2008 could increase to $8,489,664. Assuming an applicable tax rate of 1.1%, resulting taxes are $93,386; and penalties for late payment are 10% ($9,386) in the 2008 year. If taxes remain unpaid at June 30, 2008, additional penalties accrue thereafter at the rate of 1.5% per month ($1400).

Although California’s tax rates are among the nation’s lowest, the dramatic run-up in values since 2003 has resulted in a significant property tax burden on virtually every property purchased in the past 5 years. The on-going penalties associated with an owner’s failure to make timely payment exacerbates the obligation. A lender who views a troubled loan only in terms of a principal write-down is shocked to learn of the magnitude of this additional, inescapable out-of-pocket expense. For that reason, a sophisticated lender must take the initiative as early as possible.

Protective Measures Available to Lenders

A lender dealing with a distressed loan has two primary proactive measures available to it: payment of property taxes before delinquency and attempts to lower the property’s assessed value. Each of these actions is extremely time-sensitive.

Annual real property tax bills are payable in two installments; the first installment is delinquent after December 10 and the second, delinquent after April 10. Most well-drafted deeds of trust give a lender the right to make payment of property taxes when it can demonstrate reasonable grounds to believe that the owner would not make timely payment. Because unpaid taxes become the obligation of the foreclosing lender (or purchaser at the foreclosure sale), a diligent lender will ensure that taxes are paid prior to delinquency to avoid penalties. Additionally, since an appeal of a property’s assessed value cannot be asserted unless all taxes owing with respect to the challenged assessment have been paid—even when the property’s current market value clearly is lower than its assessed value—failure to pay also eliminates the ability to secure a lower assessed value.

In certain counties, the Assessor will consider reducing a property’s assessed value before issuance of the annual tax bill if substantial, reliable evidence supports the reduction. If unsuccessful (and in those counties which do not encourage this approach), a timely valuation appeal must be filed. The filing period runs from July 1—September 15 (or, in many counties, November 30); failure to file before the applicable deadline precludes any further challenge to the assessed value for that tax year. Once an appeal has been filed, the Assessor is forced to consider reliable evidence that demonstrates that the property’s assessed value exceeds its current market value. Loan documentation often provides a lender with the right to engage, or to force the borrower to engage, the Assessor in these pre-bill discussions and to file an appeal. Because each $1M reduction in assessed value achieved through discussions and/or appeal reduces taxes by approximately $11,000, this is usually the most impactful action available to a lender.

Inaction is Not an Option

Property taxes are an obligation imposed on the real property; if an owner fails to make payment, the county ultimately will proceed against the property, not the delinquent owner. Given the priority of the lien for unpaid property taxes, the issue is not whether the government will collect the taxes—and applicable penalties—but when collection will occur. And that same priority provides the tax collector with little incentive to compromise its claim for unpaid taxes and penalties. A lender who recognizes this reality must act early and aggressively to minimize the financial impact of these additional out of pocket costs associated with most distressed loans.

About the Author

Theodore F. Bayer is a graduate of Lehigh University and Golden Gate University School of Law. His practice specializes in transactional real estate matters, with a focus on property taxation, commercial leasing and commercial property sales. Mr. Bayer is also a Principal in the San Francisco-based property tax consulting firm, Ad Valorem Solutions, LLC (AVS). AVS represents owners of office, industrial, retail, multi-family residential and R&D properties, including numerous publicly-traded REITs. He has been a speaker at event sponsored by IREM, the San Francisco Bar Association, the State Bar of California Real Property Law Section and the California Assessors’ Association and has authored numerous articles concerning property taxation.

Ted Bayer, Esq.
Paradigm Tax Group
P: 415-951-6204
E: tbayer@paradigmtax.com
W: www.paradigmtax.com
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