The California Court of Appeal (Second Appellate District) published a landmark decision on April 7, 2023, that may have significant implications for the property tax assessments of qualifying California hospitality assets such as hotels. If you own a hospitality asset in California, you may be eligible for a reduction in your asset’s assessed property tax valuation.
In California, tax assessors often appraise commercial properties, including hospitality assets, using the “income method” (a discounted cash flow analysis), calculating the property’s assessed value by taking the net present value of the expected future income stream of the property. This method requires assessors to exclude income fairly ascribed to certain intangible assets (versus real property and tangible personal property), including those “directly necessary to the productive use of the property.” Hospitality assets typically derive income from clear use of the real estate (e.g., rental of rooms) and from the operation of the property as a going concern involving various components, such as intangible assets.
In Olympic and Georgia Partners, LLC v. County of Los Angeles, the court determined that in appraising the value of a hotel property, the county assessor erroneously included income from the following intangible assets: (1) a rebate of transient occupancy taxes (TOT) collected by the City of Los Angeles (the City) from hotel guests; (2) a “key money” payment; and (3) certain hotel “enterprise assets” related to the operation of the hotel. Any owner of a hospitality asset in California that has been valued with these and perhaps similar intangible assets should examine whether this decision may support a property tax appeal to reduce the assessment of its asset.
Background
Olympic and Georgia Partners, LLC (Hotel Owner), owns the subject property, the Ritz-Carlton and JW Marriott Hotels (collectively, the Hotel) in downtown Los Angeles. After completion of construction, the Hotel was reassessed by the Los Angeles County Assessor’s Office (the County), and property taxes on the Hotel were thereafter based on the new valuation. Hotel Owner asserted that the County should have subtracted from the Hotel’s assessed valuation (1) a rebate agreed to by the City of TOT, having a present value of $80 million (which the court characterized as the Tax Subsidy); (2) a one-time key money payment from Ritz-Carlton and Marriott (collectively, the Hotel Managers) to Hotel Owner (the Key Money Payment) in the amount of $36 million; and (3) other enterprise assets of the Hotel, characterized as “flag and franchise,” “food and beverage,” and “assembled workforce” assets, which the court called the Hotel Enterprise Assets, in the amount of $34 million. Hotel Owner did not have any success in these arguments with the County, with the Los Angeles County Assessment Appeals Board (the Board), or at the lower court level (except with respect to the Hotel Enterprise Assets).
The Decision and the Rationale
After discussing certain precedents in California law for excluding certain intangible assets from the valuation of commercial properties for real property tax purposes,[1] the court stated that the relevant test for determining whether to exclude the value of a particular asset from the assessed valuation of a property is (i) whether that asset is intangible; (ii) whether that intangible asset is capable of valuation; and (iii) whether that intangible asset is necessary to the productive use of the property.
Regarding the Tax Subsidy,[2] the court focused on Hotel Owner’s arguments that the City’s desire to make its downtown convention center competitive in the national market prompted the City to provide the TOT rebates, payable on a monthly basis over the course of 25 years, to incentivize the development of the Hotel, which would increase the use of the nearby convention center. The court further accepted Hotel Owner’s arguments that while development of the Hotel would be publicly beneficial, it would not have been economical to develop the Hotel without this rebate. Applying the test referenced above, the court held that the value of the Tax Subsidy must be deducted from the Hotel’s valuation because it was (i) intangible (since it is “not something tangible you can touch”); (ii) capable of valuation (since the parties agreed it had a present value of $80 million); and (iii) necessary to the productive use of the property (since the Hotel would not have been built without it).
Regarding the Key Money Payment, the court described how in engaging the Hotel Managers to serve as the managers of the Hotel, Hotel Owner agreed to pay a hotel management fee calculated as a percentage of the Hotel’s gross revenue. As part of that agreement, the Hotel Managers agreed to make the Key Money Payment to Hotel Owner. The court viewed the Key Money Payment as a “discount” of the management fees that Hotel Owner was obligated to pay the Hotel Managers over the term of the 50-year hotel management agreement, bestowed by the Hotel Managers to secure their arrangement with Hotel Owner. The court further reasoned that since “discounts” (such as when getting a price break in buying a car) are not “income,” the $36 million Key Money Payment should not have been counted as income of the property for purposes of assessment (and therefore should be excluded from the Hotel’s valuation).
Finally, regarding the Hotel Enterprise Assets, in response to the Board’s argument that the flag and franchise and workforce were the property of Ritz Carlton and Marriott (and not Hotel Owner), the court stated that no California law allows an assessor to require a taxpayer to pay property taxes on intangibles so long as the taxpayer does not own the intangibles. Further, the court stated that the Board improperly failed to address Hotel Owner’s extensive expert analysis of the valuation of the Hotel Enterprise Assets. The court did not accept the County’s argument that its assessment “identified and completely removed” the value of the Hotel Managers’ franchises and workforces by simply deducting the franchise fees from the valuation, stating that if a franchise fee were so high as to account completely for all intangible benefits to a hotel owner, the owner would have no reason to agree to the franchise. The court remanded the question of the valuation of the Hotel Enterprise Assets to the Board and held that such valuation must be deducted from the Hotel’s valuation.
The Dissent
A dissent from the majority’s holding criticized the majority’s opinion, especially in characterizing the TOT rebate as a “monthly subsidy to build” the Hotel and the “key money” payment as a “discount.” The arguments and analysis provided by the dissent may be instructive in future appeals of this case or in similar cases.
The dissent argued that TOT rebates are income generated by the use of the taxable property (the Hotel), not by an intangible asset (i.e., the value of the Tax Subsidy derives directly from Hotel Owner’s use of the Hotel, similar to lease payments being derived from the use of a property, not just from the lease agreement itself). The dissent further asserted that as part of the calculation of the overall return on investment for Hotel Owner, the rebate of TOT should be included as taxable income for purposes of property tax assessment.
The dissent also rejected the characterization of the Key Money Payment as a “discount” and instead likened it to prepaid rent under a commercial lease.[] The dissent reasoned that since the key money was paid in exchange for the right to use and control the Hotel over an agreed amount of time (similar to rent under a lease) and must be returned upon an early termination of the hotel management agreement by Hotel Owner, the Key Money Payment also should be counted as taxable income for purposes of property tax assessment.
Conclusion
Given this decision, owners of hospitality assets in California would be wise to examine whether the assessed valuations of their hospitality assets may include values ascribed to the types of intangible assets described above (and perhaps other similar intangible assets) and consider whether an appeal to reduce the assessment of any such hospitality assets may be available.
For questions related to this case or California property taxes, please contact any of the authors.
[1] Referencing certain precedents in California law, the court stated that the only forms of intangible property that may be subject to property taxation are: (1) notes, (2) debentures, (3) shares of capital stock, (4) bonds, (5) solvent credits, (6) deeds of trust, and (7) mortgages.
[2] The Tax Subsidy arises from an agreement between the City and the Hotel’s original developer, L.A. Arena Land Company, LLC. Hotel Owner is the successor to the original developer.
[3] The dissent also likened the hotel management agreement to a commercial lease for the purpose of carrying on a business, a characterization expressly rejected in the majority’s decision.
Contacts
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Chauncey M. Swalwell
Partner