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California Clarifies Valuation of Taxable
Possessory Interests

by Scott Donald, Irvine, April 2014


There has been an ongoing inconsistency in the way taxable possessory interests (TPI) are valued for property tax purposes in California.


A TPI is created when a private party is granted the use of real property owned by a non-taxable entity, such as a pension fund like the State Teachers Retirement System (STRS).


In the wake of a test case in the courts, the State Board of Equalization issued an advisory letter to assessors to provide guidance on the issue.


Court Case


The TPI valuation model was challenged in California State Teachers Retirement System v. County of Los Angeles. Since, STRS is a unit of state government, property it owns is exempt from property taxes. However, the private lessees of real property owned by STRS are subject to property tax based on the lessees' possessory interest.


The case concerned an office building owned by STRS. Dong Eil Kim and Chang Nim Kim, doing business as Mail Boxes, Etc., entered into a five-year lease with STRS for retail space in the building. They later extended the lease for an additional five years.


In valuing the leasehold interest, the county assessor multiplied the fully allocated trended base value of the retail space in the building by 3.3%, representing the Kim’s share of the total retail space.


The Court of Appeals ruled there are constitutional defects in the law's valuation methodology. The opinion stated:


"Section 7510, subdivision (b)(1), is facially unconstitutional insofar as it bases a lessee's assessment on the lessee's allocable share of the full cash value of the property, based on the lessee's percentage of the total leasable square feet of the property. Under the statute, the exempt remainder or reversionary interest, belonging to the public retirement system owner, is included in the assessment of the lessee's possessory interest. Consequently, the statute violates the prohibition against assessing property taxes on publicly owned real property as well as the prohibition against assessing property in excess of its fair market value."


Guidance for Assessors


The State Board of Equalization recently issued a Letter to Assessors (LTA) regarding the valuation of a TPI following the court case. It reaffirms the definition of who can file appeals. Because STRS, not Kim paid the tax, only STRS has equal standing with the affected party (Kim) to appeal.


The LTA also points out the importance of considering the stated term of possession in the valuation of a TPI. All else being equal, the longer the term of possession, the higher the value of the possessory interest.


The State Board of Equalization went on further to reaffirm that both the assessor and taxpayer need to utilize a reasonable and documented term period in their valuation when it is either month-to- month, or one-year, or less. Just because a tenant has leased the existing site for an elongated period of time, does not mean they will continue to do so.