Triple Net Leases: Allocating Taxes Among Tenants

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If you’re going to be the landlord’s sole renter, it won’t be hard to allocate the tax burden between the two of you. Depending on who has the superior bargaining position, either you’ll get stuck with the entire bill, a portion of the entire bill (the landlord pays the rest), or all or a portion of any increase. The situation can get a bit trickier, however, if you’re going to occupy space in a multitenant building, where many tenants share the tax burden. Keep these two important issues in mind as you head into lease negotiations:

  • is your portion of the tax bill based on the total rentable space of the property, or on the space that is, in fact, rented (see Triple Net Leases – Taxes) and
  • have other tenants’ improvements caused the tax bill to grow—and are you indirectly paying for the consequences of these fancy improvements? If this describes your situation, read on.

Other Tenants’ Improvements

In a multitenant property, you may have neighbors who have put in expensive, value-adding improvements, such as equipment for a restaurant, fancy décor, or extensive computer wiring for an office suite. (Improvements are permanent additions to the landlord’s property, as opposed to trade fixtures that tenants usually remove when the tenancy ends.) You, on the other hand, may end up adding little or nothing to the value of the property when you move in, asking only for a new carpet, paint, and some special lighting. What’s the problem? Your landlord’s real estate tax bill is based on the taxable value of the entire property, which is computed by considering the sum of all tenants’ improvements. If your tax obligation is based on your pro rata share of the rentable space, without taking into consideration the fact that your neighbors’ valuable improvements have upped the tax bill significantly, you’ll be paying more than your fair share.

One way to even things out is to bargain for your tax obligations to be based on your pro rata share of the taxable value of the entire property, instead of your pro rata share of the entire rentable space. That way, you pay according to the value of your space.

It’s unlikely that you can get the tax assessor to separately value individual tenants’ spaces in a commercial building. The best way to estimate your fair share of taxable value is to assume that the cost to rebuild the entire property, with each tenant’s improvements as they are now, is roughly equivalent to the taxable value of the property (if the tax assessors have been doing their job, these figures should be close). Next, assume that your share of the rebuilding costs (expressed as a percent, by dividing the cost of rebuilding your space by the cost of rebuilding the entire -property) will be the same as your share of the taxable value of the property. That’s the percentage multiplier that you apply to the tax bill to compute your fair share.

Example: A small strip mall in Pacific Cove has three commercial spaces and 10,000 square feet available.

Tenant A leased 2,000 square feet for an auto repair shop, adding a hoist, automatic garage doors, a heavy-duty ventilation system, and extensive electrical wiring, all of which became permanent improvements. Rebuilding this space would cost $150 per square foot.

Tenant B leased 5,000 square feet to use as a distribution center for dry goods. B added nothing to the bare space when he moved in. To rebuild would cost $50 per square foot.

Tenant C leased the remaining 3,000 square feet and added interior walls and some lights for use in its telemarketing business. Rebuilding costs for this space would be $65 per square foot.

The tenants all have net leases, which are all up for renegotiation.

Table 1, below, shows what happens to each tenant’s tax obligation if it is figured on the basis of that tenant’s portion of the rentable space only. Table 2 shows what happens to each tenant’s taxable share when the landlord figures it according to the value of each tenant’s rented space. After computing the replacement cost of the property and each tenant’s share, the landlord applies that percentage to the tax bill, too.

Table 1: Allocating Taxes According to Rentable Space

 

Tenant

Rented space (square feet)

Rentable space

Ratio (rented space/rentable space)

Tenant’s share of the taxes

A (extensive improvements)

2,000

10,000

20%

20% of the total

B (added nothing)

5,000

10,000

50%

50% of the total

C (moderate improvements)

3,000

10,000

30%

30% of the total



Table 2: Allocating Taxes According to Replacement Value

 

Tenant

Replace-ment cost per square foot

Rented space, square feet

Cost to replace own space

Replacement cost of entire property

Tenant’s share of replacement costs

Tenant’s share of the taxes

A (extensive improvements)

$150

2,000

$300,000

$745,000

40.3%

40.3%

B (added nothing)

$50

5,000

$250,000

$745,000

33.6%

33.6%

C (moderate improvements)

$65

3,000

$195,000

$745,000

26.1%

26.1%

 

As you can see from comparing the results of Tables 1 and 2, the tax burdens on A, B, and C will be quite different if the landlord allocates them according to the value each has brought to the property, instead of the size alone of their rentals. Tenant A in particular, who brought in many expensive improvements, will pay twice as much according to the replacement value method. If you happen to be Tenant A, no doubt you’ll prefer the system shown in Table 1—but it wouldn’t be the fairest way of dividing the tax burdens.

When you negotiate with the landlord over how taxes are allocated among tenants, remember that it must be the same for all tenants in the building. The landlord will be constrained by the terms of the leases already in place with other tenants. If, for example, Tenants A and B are already renting under leases that allocate taxes according to the size alone of their spaces, Tenant C won’t be able to press for a different system unless C can get the landlord and A and B to rewrite A’s and B’s leases. Absent some extraordinary clout on your part, it’s unlikely you’ll be able to accomplish this.

However, there’s no reason why the system has to remain the same forever. If you have a lease that’s longer than other tenants in the building, press for a planned switch to a value-based method when all existing tenants are out. Negotiate for a promise from the landlord that all new -tenants will be given space-based tax obligations only until all space-based -tenants have left. At that point, all of you will convert to a value-based system.

This article was excerpted from Negotiate the Best Lease for Your Business by Janet Portman

by: , Attorney

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