Understanding Your Commercial Lease: Taxes
Taxes are another important consideration when working towards understanding your commercial lease. The tax provisions of your lease will detail what taxes are required to be paid by the tenant and what taxes are required to be paid by the landlord. The tax provisions will also detail how and when all taxes must be paid. To understand the true costs of your lease, you must understand what taxes you are required to pay and who takes on the risk that tax rates rise or additional taxes are levied.
What taxes will you be required to pay under your commercial lease?
The taxes you are required to pay are generally described in the definition of “Taxes” in the lease. How the definition will be written and integrated with the rest of the lease will be at least in part determined by the type of commercial lease structure.
The tax definition in your commercial lease may be broken into two sections. One section will detail what taxes will be the tenant’s responsibility, and another section will detail what taxes are the landlord’s responsibility. This approach is more typical in a gross lease, as a gross lease incentivizes the landlord to be primarily concerned with defining the tenant’s “separate taxes” (e.g. tenant personal property taxes) rather than allocating all the landlord’s tax risk to the tenant.
In triple net and base year lease structures, you will see the tax section written so that all taxes are the tenant’s responsibility with a few limited exceptions. Those exceptions generally include a description along the lines of “taxes levied on the net income of the landlord,” but the exceptions listed should also generally include franchise, estate, inheritance, net income, gift, corporate, and excess profit taxes. Here is a comprehensive (if wordy) example of a negotiated tax description from a triple net lease:
“Taxes” means, collectively, any and all general and special taxes and impositions of every kind and nature whatsoever imposed upon, or with respect to the Building and Real Property, any leasehold improvements, fixtures, installations, additions, and equipment, whether owned by Landlord or Tenant, or either because of or in connection with Landlord’s ownership, leasing and operation of the Building and Real Property, including, without limitation, real estate taxes, personal property taxes, transit taxes, sewer rents, water rents, general or special assessments, duties or levies assessed against the Building and Real Property and related personal property, transit taxes, all reasonable costs and expenses (including legal fees and court costs) charged for the protest or reduction of property taxes or assessments in connection with the Building and Real Property, or any tax or excise on rent or any other tax (however described) on account of rental received for use and occupancy of any or all of the Building or Real Property, whether any such taxes are imposed by any federal, state, or local governmental municipality, authority, or agency or any political subdivision of any thereof; provided, however, Taxes shall not include franchise, estate, inheritance, income, gift, corporate and excess profit taxes.
Savvy tenants will bargain for more (or clearer) exceptions and ensure the risk of tax increases is properly considered in the context of the base rent rate, free rent, tenant improvement allowances, and operating expenses. That is, can the tenant still afford the space even if tax rates go up?
How are taxes paid and who actually pays them?
Most leases will provide that the tenant will pay on-time all taxes owed by the tenant. In a lease where the landlord will pass through the taxes to the tenant (most leases that are not true gross leases), the tax provisions will also specifically provide for how the tenant will pay taxes owed by the landlord. This is usually accomplished by including taxes in the definition of “additional rent” when detailing how common area maintenance and other pass through expenses will be handled. This means the cost of taxes levied on the building will be paid by the tenant to the landlord in an amount that is an estimate every month. The estimates would then be reconciled at the end of the year and the tenant would pay their actual share of taxes. The tenant will almost always pay general property taxes to the landlord as a reimbursement and tenant specific taxes (e.g. personal property and income taxes) directly to the taxing authority.
Tenants should note whether the landlord has the right to pay taxes on the tenant’s behalf if not timely paid, and what costs and fees the landlord may charge the tenant if it pays taxes on the tenant’s behalf.
Who can dispute taxes and who pays for the costs of any dispute?
Generally, landlords will retain all rights to protest tax assessments and may do so (or not do so) at their discretion, though tenants with bargaining power may also negotiate for a right to protest if the landlord declines to do so on their own. Many leases will require the tenant to pay the cost of disputes regardless of whether the landlord wins, but a tenant with bargaining power may be able to negotiate for the landlord to pay costs if initiating the dispute was unreasonable.
What are “special taxes” and why should I care?
“Special taxes” generally refer to the category of taxes that are levied specifically on a small group of taxpayers who (at least ostensibly) will benefit more than the general population from how the money collected through the tax is spent. Special taxes are given many names (so any politician can avoid having to say “special taxes” out loud), including “special assessments,” and in Seattle “local improvement districts” or “LIDs”. Special taxes are usually the responsibility of the tenant, and many tenants are surprised to find out they are expected to pay for this type of cost.
Special taxes can be costly (even if they are relatively rare). Especially for retail tenants, these taxes may increase costs at a time when the business may also be experiencing revenue declines. For instance, if a public improvement project impacts traffic near a certain set of buildings, those building owners (and by extension you as the tenant) may be asked to pay for the project at the same time that the project is blocking and thus slowing customer traffic. Special taxes may also loom for long periods of time, which can affect a tenant’s budgeting, as the tenant must expect the tax and consistently update their budget as the tax proposal moves through the legislative process.
Depending on the nature of the tax and how well the tenant can see that it is coming before signing the lease, a tenant with bargaining power may be able to get the landlord to take on the risk of a special tax. The landlord will also have access to information that may not be in the public domain. So a savvy tenant will ask the landlord to share that information and potentially represent in the lease certain facts the landlord may know about a pending special tax.
Tax provisions in commercial leases are generally standardized and will require only minimal negotiation, but that negotiation can be important. Consider the tax provisions of your lease in detail, as every tax provision could impact your business significantly.