Availability of the Welfare and Other Property Tax Exemptions in Real Property Leasing Transactions

• Publication year: 2019
• Author: Alyssa Snyder and Lysondra E. Ludwig

Availability of the Welfare and Other Property Tax Exemptions in Real Property Leasing Transactions

Alyssa Snyder and Lysondra E. Ludwig

Alyssa Snyder graduated from the University of Washington with a B.A. in Political Science. She received her law degree in 2011, and subsequently her LLM in Taxation, from Golden Gate University School of Law, and is admitted to practice in California. She is an attorney at Farella Braun & Martel LLP, where her practice focuses on advising exempt organizations, including advice with respect to real property transactions.

Lysondra E. Ludwig graduated from the University of Washington with a B.A. in English. She received her law degree from Northwestern University School of Law in 2011 and is admitted to practice in New York and California. She is an attorney at Farella Braun & Martel LLP, where she has a diverse transactional practice covering each stage of the corporate life cycle, including advising clients with significant real estate portfolios.

I. INTRODUCTION

In June 2018, the California State Board of Equalization ("BOE") issued its annual report for fiscal year 2016-2017. In that report, the BOE stated that California property tax levies for that year totaled $62.1 billion (an increase of 5.7 percent from the previous year's total of $58.7 billion) and that county-assessed property values rose $388.1 billion to reach $5.7 trillion for the 2017-2018 roll year. This increase in assessed value reflects a growing economy—both at the national level and in California—and associated increases in building activity, rising home prices, and low inflation.¹ Commensurate with this growing economy, California has experienced a dramatic decrease in office rental availability and an increase in commercial real estate costs.² Meanwhile, local taxing authorities are increasingly constrained³ and looking for new sources of revenue to fund municipal services. Nonprofit organizations are becoming tempting targets for local property taxing authorities to increase revenues, in part, due to an entrepreneurial shift in nonprofits' operations.⁴

Generally, California property tax⁵ is levied on an annual basis based on the base year value of real property (including structures and affixed fixtures).⁶ Under California's acquisition value-based system (known as Proposition 13), properties are assessed at their current market value upon acquisition, and are only reassessed thereafter upon a change in ownership or completion of new construction (the initial base year value). In addition, Proposition 13 limits annual increases in the base year value of real property to no more than two percent (2%), except when property changes ownership or undergoes new construction.

Article XIII of the California Constitution (1) provides an explicit exemption from property taxation for certain types of property, and (2) grants the Legislature authority exemptions from property tax for property used exclusively for religious, hospital, scientific, or charitable purposes.⁷ Those exemptions granted by the Legislature are set forth in the California Revenue and Taxation Code ("Code").⁸ For example, property used for free public libraries and free museums is exempted by the Constitution,⁹ and the Welfare Exemption (as defined below) may be applicable to libraries and museums that charge admission.¹⁰ This article discusses the property tax exemptions available for leasing arrangements with a primary focus on the Welfare Exemption under Code section 214 (the "Welfare Exemption"), and suggests other available exemptions in cases where the Welfare Exemption is not available.

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It is without question that significant savings (to the owner or the operator) occur when real property is owned and/or leased by a charitable organization that is eligible for property tax exemption. Many of the problems that arise in obtaining or retaining a property tax exemption are technical and can be avoided with careful planning and consideration of the unique facts and circumstances of each situation. Further, it is important for those organizations that already benefit from a property tax exemption to manage their activities in such a manner to remain in compliance.

Section II of this article discusses the general requirements of the Welfare Exemption and delves into the owner/operator qualifications, property use restrictions, and other requirements specific to the Welfare Exemptions. Section III of this article discusses the administration of the Welfare Exemption. Section IV of this article describes different leasing structures and the impact of such leasing structure on the qualification for the Welfare Exemption and, in cases where the Welfare Exemption is not available, other potential exemptions applicable under the circumstances.

II. GENERAL REQUIREMENTS OF THE WELFARE EXEMPTION

Unlike income tax exemptions, the Welfare Exemption focuses not only on the charitable character of the property owner or operator, but also on whether the property is being used exclusively for exempt purposes. In general, to be eligible for the Welfare Exemption, Code section 214 requires that property be owned and operated by an organization organized and operated for religious, hospital, scientific, or charitable purposes,¹¹ and such property must be used exclusively for those purposes. The property must be irrevocably dedicated to such purposes, and no part of the net earnings of the owner may inure to the benefit of any private shareholder or individual.¹²

A. Owned and Operated Requirement

Code section 214 requires that both the owner and the operator of a property meet specific requirements to be eligible for the Welfare Exemption. A nonprofit organization claiming the Welfare Exemption for its property must be a community chest, fund, foundation, or corporation,¹³ and be organized and operated for exempt purposes (as described below in Section II.B of this article). The operation of the organization for exempt purposes is determined by its activities and the use of the property. The owner and operator need not be the same legal entity, but to be eligible for the Welfare Exemption, the operator must also satisfy all of the requirements of Code section 214.¹⁴

B. Organized and Operated for Exempt Purposes Requirement

It is critical to evaluate that the owner's (and operator's) eligibility for any particular exemption(s) before formation of an entity formed specifically for purposes of holding and/or leasing real property that could benefit from a property tax exemption. However, a deep dive into the parameters of what separately constitutes a religious, hospital, scientific, or charitable purpose is outside the scope of this article. "Charitable purpose" is not defined by the California Constitution nor Code section 214; thus, it has been construed by the judiciary. The California State Supreme Court has broadly construed what constitutes a "charitable" purpose for purposes of the Welfare Exemption, which includes a "wide range of activities beneficial to the community."¹⁵ Whether the organization is organized and operated for exempt purposes is typically first evaluated by the local taxing authority when the organization is formed and seeks federal and/or state tax-exempt status. But, exempt purposes under the Welfare Exemption or other California property tax exemptions are not always defined consistently with definitions under federal or state income tax law.

C. Exclusive Use Requirement

With respect to the use of the property, nonprofit organizations claiming exemption under Code section 214 must use the property exclusively for exemption purposes. California courts have defined "used exclusively" because the statute does not provide a definition. In Cedars of Lebanon Hospital v. County of Los Angeles, the California Supreme Court held that "used exclusively" for exempt purposes includes any property which is used exclusively for any facility which is "incidental to and reasonably necessary for the accomplishment of the exempt purpose."¹⁶ In that case, the Supreme Court held that facilities, including tennis courts, used for training nurses, doctors, and other essential employees, were uses reasonably necessary for the accomplishment of hospital purposes.¹⁷ Subsequently, courts have applied this test to find, for example, that dormitory rooms maintained and rented to young men by a YMCA were incidental to its charitable purpose of promoting the welfare of young men and boys, even where a moderate charge was made for the accommodations.¹⁸ Similarly, the courts held a bar maintained within a theater and open only to persons admitted to performances was reasonably necessary for the fulfillment of a generally recognized function of a complete and modern theater.¹⁹

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Conversely, the courts have held that running a thrift shop was not deemed incidental to and reasonably necessary for the accomplishment of a hospital's exempt purposes.²⁰ Additionally, the courts have held that portions of YMCA property open to the public, in addition to YMCA members, and devoted to a restaurant, barbershop, valet shop, and a gym store were largely commercial in nature and not reasonably necessary for the accomplishment of exempt purposes.²¹

Under the exclusive use requirement, the exemption is only allowed for that portion of the property used for the actual operation of the exempt activity. Any amount of property in excess of what is reasonably necessary to accomplish the exempt purpose is subject to tax.²² Thus, property or portions of property that are unused are not eligible for the exemption. However, the Welfare Exemption has been extended to property that is not physically used in the actual operation of the exempt activity under certain circumstances.²³ For example, the California Court of Appeals held that the portions of a religious retreat property, which included the passive use of...