If recent volatility in the stock market has you taking a closer look at your real estate portfolio, you’re not alone. Uncertainty in global equities, elections, oil and hand sanitizer are having a sweeping impact and, if you’re like us, you want to grow what’s working and do less of what’s not.
With so many concerns sweeping the market, it’s possible you could overlook the impact that property taxes, and—more specifically—property tax assessment, threatens to have on your wealth.
In the recent Minnesota Supreme Court case of Inland Edinburgh Festival, LLC v. County of Hennepin, (February 12, 2020), the court reinforced important but often overlooked property tax assessment principles, holding in favor of a savvy owner who challenged as excessive the $8.3 million assessed market value of his retail shopping center.
About two years into his appeal, but before the Tax Court decided the case, the owner sold the property for $9.6 million in a Section 1031 like-kind exchange.
Like any eligible owner under Section 1031, the owner in Inland may have been seeking the following tax and market-related benefits of the exchange:
- Swap one investment property for another, with limited or no tax due at the time of the exchange;
- Prolong tax-deferred growth, rolling capital gain into the new property;
- Pay little or no tax until you sell for cash, often many years later; and
- Swap a wide range of properties thanks to the broad interpretation of what qualifies as a “like-kind” exchange. Even bare land could generally be exchanged for an apartment building or one business for another, with exceptions.
But because of the many moving parts of Section 1031, the purchase price alone is often not the last word on the value one party receives in exchange. And that’s especially true in related party or non-arms-length transactions where the parties may agree on a higher than usual purchase price to account for other planning objectives or other market or industry related factors.
These nuances are what make Section 1031 such a valuable tool for most owners of closely held businesses. And it means assessors generally can’t rely on only the purchase price in a related-parties deal as probative of market value, especially without a clear understanding and accounting of the parties’ tax and market motives.
But that’s exactly what happened in Inland—the Tax Court rejected the owner’s appraisal and instead used his 1031 exchange sale price as its sole basis for determining the earlier assessment, applying a number of adjustments to the sale price to account for differences in time to arrive at a slightly higher adjusted value of $8.4 million! But, critically, the court did not consider the motives of the related parties for doing the Section 1031 exchange.
On appeal, the court held:
- That although the sale of the property being assessed may be “one of the most important elements to be considered,” it has never been held to be determinative;
- A recent sale of the property being assessed is only probative if the transaction is arms-length; and
- The purchase price of a sale between related parties is generally not probative of market value unless there is clear evidence that the exchange itself was at market levels.
Lacking the above elements, the Inland Court held the Tax Court’s value clearly erroneous, reversing and remanding to the Tax Court to determine the property’s market value.
If the appellant in Inland were here with us today he’d acknowledge the fact that he prevailed in the high court but we bet he’d highlight what it cost him to get there. On that note, we take the following lessons to heart:
- 1031 exchanges are convenient targets for tax assessors. Having a general idea of where your stack of closing documents can be found is not a substitute for maintaining yourself and your team in a state of audit and assessment readiness.
- Before appealing an assessment you should seek to understand the potential costs and an understanding of how the court is likely to apply the law to your unique circumstances.
- Especially in exchanges between related parties, it’s important to know how to calculate and document the non-market factors that influence the sale price, especially where an exchange is between related parties.
- The court may reject a property owner’s independent appraisal especially where it lacks a clear explanation of the methodology used by the appraiser or contains errors or lacks clarity in its computations.
- Assessors are unpredictable and may lack a uniform approach even between different assessors within the same jurisdictions or county and especially across different locations and property types. Your readiness plan should account for this factor.
One thing is for certain, we are investors living through historic economic and political times. As we look for ways to take advantage of low interest rates, diversify our portfolios and leverage our assets, we must also be prepared to square off with the tax code and the people who wield it.
Remember, it’s not enough for us to buy good properties, we must buy them well. And that means developing a team with sufficient financial competency and legal foresight that can ensure your venture and your team maintain a state of readiness, both for opportunity and for audit and assessment.
Attorneys at Lommen Abdo that can help with questions about your real estate transactions are Matt Hartranft, Keith Broady, Bob Abdo, Barry O’Neil and Creig Andreasen. Contact Matt Hartranft with questions at 612.336.9317 / email@example.com.