Many state statutes recognize that a recent sale represents the best evidence of market value for real estate tax assessment purposes. Given the record number of real estate acquisitions over the past few years, assessors have accumulated evidence to support across-the-board increases in assessed values.

Recent financial reporting rules would suggest, however, that reliance on unadjusted sale prices often results in an inflated assessment. With the recent requirement by the Financial Accounting Standards Board (FASB) for disclosure of certain intangible assets, commonly referred to as “FAS 141,” investors have the opportunity to use this information to support lower real estate tax assessments.

Unlike tangible assets, intangible assets such as contracts, license agreements, permits and operating rights are generally not taxed in most states. However, to the extent that these intangibles are reflected in the sale price of real estate transactions, assessors are inadvertently including them when reassessing property based on the reported sale price.

Opportunity for clarity

FASB is the designated private-sector body that establishes standards for financial accounting and reporting. The Securities and Exchange Commission (SEC) and the American Institute of Certified Public Accountants recognize FASB standards as authoritative.

In a series of standards (FAS 141-144) that went into effect in 2001, FASB now requires that certain intangibles — namely lease intangibles and customer relationships — be quantified and disclosed in connection with the financial reporting for real estate acquisitions.

The allocation methodology of FAS 141 for real estate acquisitions requires an analysis and allocation of a sale price into the following asset categories:

• the value of land, buildings and tenant improvements as if they were vacant;

• above- and below-market leases, determined on a lease-by-lease basis;

• in-place leases;

• customer relationships

FAS 141-144 grew out of FASB's finding that intangible assets are an increasingly larger component of business enterprises in terms of value and importance. With real estate acquisitions now subject to these standards, investors will find that their FAS 141 allocations identify and quantify intangibles that should not be included in assessed values.

Old habits die hard

Although FAS 141 was originally intended to eliminate the disparity in accounting methods for mergers, the SEC extended its application to real estate acquisitions. This was particularly significant because historically real estate investors had rarely gone beyond land and building allocations in their financial reports.

Most state realty transfer tax returns and real estate sales validation questionnaires allow for the deduction of personal property — both tangible and intangible — from a reported sale price. Historically, real estate investors have not taken advantage of this deduction because allocations have not been deemed to be of critical importance to determining a purchase price or closing the deal.

Tax authorities accept the practice of characterizing the entire sale price as real estate because it allows them to collect the incremental transfer and property taxes. Unfortunately, this also reinforces the false notion that intangibles are not included with the transfer of real property.

Real-world applications

Increasingly, sophisticated investors are rethinking their due diligence and closing processes to address this situation. By performing FAS 141 allocations before closing, rather than after, investors can provide their transaction attorneys with the information they need to declare personal property deductions on transfer tax returns and related transfer documents.

For example: A partnership acquires a shopping center for $5 million. It prepares a FAS 141 allocation as described above. It assigns $4.5 million to the land, building and tenant improvements and $500,000 to the intangible assets (in-place leases and customer relationships). By virtue of the FAS 141 allocation, the partnership can reduce its real estate tax assessment and, therefore, its real estate taxes by 10%. Recent experience has shown that intangibles represent anywhere from 10% to 20% of sale prices.

This allocation disclosure becomes especially relevant in light of a growing body of case law that permits assessors to rely solely on a reported sale price without consideration of other factors. Therefore, when investors perform FAS 141 or other purchase price allocations after a deal has closed (and the deed filed), the case law permits assessors to disregard them since they were not incorporated into the official transfer documents.

By utilizing the intangible asset analysis required by FAS 141, investors take a proactive approach to minimizing the impact of assessors and school districts chasing the sale.

Ken Rogers is the director of real estate analysis at Fisk Kart Katz and Regan Ltd., the Illinois member of American Property Tax Counsel. He can be reached at krogers@proptax.com.