HABITAT

LEGAL/FINANCIAL

Tax Escalation Clauses Save Money

Howard Schechter in Legal/Financial

New York City

Want to maximize commercial rents without affecting your tax status? Until the end of 2007, the so-called “80/20 rule“ of the federal tax code limited the rents that many cooperatives could collect for commercial space (only 20 percent of a co-op’s income could be non-shareholder). When the 80/20 rule was liberalized in 2007, it was suddenly possible for many cooperatives to adopt new techniques used by commercial landlords to collect more rent.

A real estate tax escalation clause is just such a technique. It imposes increases in rent each time the property¹s real estate taxes rise. Since these taxes are the cooperative’s largest variable expense, increases in commercial rents should be proportionate to increases in real estate taxes. These rent increases insulate the co-op against reductions in net commercial rental income.

Skillful drafting is key to maximizing the income generated from tax escalation clauses and avoiding disputes with tenants over their implementation. Here are items that should be written into a strong tax escalation clause:

Carefully define the critical concepts used in the clause. How are the real estate taxes determined: is it the amount billed, the amount actually paid, the tax rate multiplied by the assessment? It is important to include all taxes that are imposed regardless of how they are designated. It can be a mistake to omit business improvement district charges if the property is in such a district, or to make clear that future impositions that don¹t exist when the lease is written are included. How are abatements to be handled?

Aside from the co-op abatement, there may be J-51, 421-a and other abatements affecting the property. Particularly those that burn off over time need to be considered and clearly addressed in the clause.

Pick the right variables. You can set or negotiate the percentage of the property attributed to the commercial space and the base tax year. The percentage is used to determine what portion of the increase in taxes is payable by the tenant. Cooperatives are often lax in determining the fair proportion of tax increases to be paid by a tenant. If the tenant is deemed to be responsible for 5% of increases, the amount generated by the clause will be twice as high as if the tenant is responsible for only 2.5%. The base tax year is also crucial. Since the clause provides for increased rent when the taxes increase, there must be a base tax against which increases are measured. Choose the base tax year that will assure that increases in cost are captured. If you do the calculations, you will see that over time even choosing a base year that starts one year later reduces the increase in every subsequent year.

Many areas of potential dispute are predictable. The clause should address these issues. What happens if the base year taxes are reduced after the lease is signed? Are the original or the reduced taxes used as the base? If there is a tax reduction caused by a landlord challenge, does the tenant benefit, and if so is the landlord compensated for the costs of obtaining the reduction? Does the rent go down if the taxes go down or can it only go up under the clause? Are the increases compounded or does each year stand alone as compared to the base year? Is there a time limit for the tenant to challenge the landlord¹s calculation of the tax increase?

Finally, boards should be vigilant to assure that the managing agent is aware of the various provisions of the commercial leases and that the charges due under the tax escalation are timely billed and collected.

Howard Schechter has been representing cooperatives and condominiums for over 40 years. He is a founding partner of Schechter & Brucker, P.C., a New York City law firm that is general counsel to over 200 housing cooperatives and condominiums. He is a co-drafter of the Code of Ethics adopted by the New York Association of Realty Managers and has taught the mandatory ethics course for that organization's manager certification course. His articles on subjects of interest to the cooperative/condominium bar have been published by the New York Law Journal and he is a frequent speaker at industry and bar conferences and continuing legal education seminars for practicing lawyers.

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