In 2020, California voters will get a chance to decide whether to change Prop. 13, the landmark 1978 Ballot Measure that capped California property taxes. For more than 40 years, Prop. 13 has been deemed sacrosanct. No one could touch it or change it. And for good reason. 

The measure has been incredibly popular with Californians since it was implemented — so much so, that it is often called the “Third Rail” of California politics. But the electorate in California has changed since 1978 and critics of Prop. 13 are hopeful the 2020 election will finally crack the “Third Rail.” 

The California Schools and Local Community Funding Act of 2018 (“CSLCFA”), the constitutional amendment that seeks to change Prop. 13, has now qualified for the November 2020 ballot. The implications of such a change are important for California real estate investors to consider due to the adverse effect such a change could have on the value and profitability of investment properties in California. 

What is Prop. 13? 

Passed in 1978 by an overwhelming majority, Proposition 13 limits state property taxes to 1% of the property’s purchase price with an annual increase of no more than 2%. When it was passed, California home prices were appreciating rapidly, a whopping 120% between 1974 and 1978 (Hoover Institute). 

Many homeowners could not afford their ever-increasing property taxes. Proponents of the measure argued that it was needed to protect homeowners from being taxed out of their homes. 

However, the measure also applied to commercial properties. Consequently, real estate investors in California also enjoy the benefits of Prop. 13. For long term owners of commercial property, the benefits are huge. 

For instance, while a rental property purchased 20 years ago may have quadrupled in value (a not unlikely occurrence in CA), the owner’s tax payments would only have increased by 48.5%. Without Prop. 13, the property tax would have increased by 300%. And while property taxes remained stable at a 2% increase each year, rental rates in the state soared. Bottom line: long term California real estate investors receive a much higher net return on their properties, thanks to Prop. 13. 

But lower taxes are not the only benefits of Prop. 13. By capping property tax increases, Prop. 13 encouraged property owners to hold their properties longer, thereby reducing inventory and increasing prices. Without Prop. 13, many would be unable to pay taxes at current market values and be forced to sell, increasing inventory and depressing prices. (Property Taxes and Tax Revolts, The Legacy of Proposition 13, O’Sullivan, et al.) 

Proposition 13 still remains popular with California voters — 65% still support the measure based on a recent Public Policy Institute of California (PPIC) poll. However, when it comes to commercial properties, the electorate is more evenly split. And this is the basis of the proposed changes. 

How Does the Proposed Reform Measure Change Prop. 13? 

The CSLCFA would increase property taxes by reassessing commercial property at current market values every three years. The property owner in our example above would see their property tax increase by almost three times their current amount. Others could see an even bigger increase depending on how long they have owned their properties. 

The measure is limited to commercial properties owned by businesses of 50 or more employees. In addition, business owners with less than $2 million in California property are exempt. 

The measure is supported by a coalition of affordable housing advocates, teachers’ unions, labor groups, and social justice organizations who say that it will raise between $6.5 billion and $10.5 billion a year. Opponents claim that amount is unrealistic, especially given the adverse impacts on jobs and state GDP caused by the tax increase. 

The International Council of Shopping Centers (ICSC), along with the California Business Properties Association (CBPA), and other commercial real estate associations in California have opposed these efforts for a number of years. “Creating split roll property tax could put thousands of tenants out of business, resulting in higher taxes, and create uncertainty leading to the devaluation of all property values,” said CBPA Vice-Chairman Doug Wiele (International Council of Shopping Centers, California Split Roll Tax Measure Challenges Prop 13, 2018). 

What are the Implications for California Real Estate Investors? 

Since the proposed measure is limited to businesses with 50 or more employees, most California real estate investors are excluded from the changes. However, the indirect effects could be enormous. 

A tax increase, any increase, tends to reduce GDP. Jobs could be lost if businesses decide to move out of state to avoid the tax increase. Many businesses may decide to sell their properties rather than pay the tax increase, thereby flooding the market with new inventory and depressing prices. These are changes that affect all California investment properties. 

Also, while the proposed measure is limited in scope, subsequent measures may expand the changes to include all landlords. The potential for additional tax revenue may be too difficult for the state to resist. After all, once a governing body discovers a source of income, they tend to expand it. 

Proponents of the ballot measure claim that the tax increase is fair given the wealth of businesses in the state that owns over $2 million in property. They argue that businesses need to pay more to help the state house the homeless, fund schools, build roads, and pay for all of the other social needs of the citizens. They argue that greedy corporations are not paying enough. 

Raising taxes on all landlords falls in line with the very argument proponents are using to support the current ballot measure. Rising rents and unaffordable housing are a top issue. Increasing rents are unfair to the average worker. Why should landlords benefit from a measure that was only intended to keep average homeowners from being taxed out of their home? With skyrocketing rents, landlords can afford to pay more in property taxes to benefit all Californians. 

It is unlikely that the proposed changes would eventually be extended to homeowners since homeowners are still a majority of the electorate in California and are unlikely to voluntarily pass such a large tax increase on themselves. Plus, no politician will want to vote in favor of such a tax increase. 

But landlords are very much in the minority. It is predictable that the majority of voters may decide that landlords should not be allowed to raise rents at market rates while enjoying a cap on their property taxes. Plus, the potential income from applying the proposed changes to all real estate investments will be much higher than those under the proposed measure. The state may decide that the changes did not go far enough and that more money is needed. 

So, while today it may just be businesses with 50 or more employees that get stuck with the tax increase, tomorrow it may be all landlords. If so, many real estate investors may decide to sell or be forced to sell, because of the tax increase. In that situation, the flood of inventory on the market would depress prices even further. 

The implications discussed above are a worst-case scenario. We do not know if the CSLCFA will even pass. And even if it does, the state may decide to not extend it to other real estate owners. 

But all California real estate investors should be concerned with the changing political atmosphere in the state. In fact, the California Senate just advanced a rent control bill, called Assembly Bill 1482, to prohibit landlords from raising the rent more than 5% per year plus inflation. The bill also increases protections for tenants by enacting stronger “just cause” eviction policies. The bill now advances to the Assembly where it is predicted to pass. Governor Newsome has also indicated that he will sign the bill into law.

California’s rent control, property tax increases, and eviction restrictions are all part of an attempt to address California’s the state’s high cost of living, homelessness and underfunded state budgets. These problems are only getting worse. And in desperate times, the state may turn to desperate measures to solve them. 

What Can California Real Estate Investors Do? 

Given the changes taking place in California, real estate investors may want to consider diversifying some of their equity into other states. Many states, particularly those that are tax-free, are benefiting from the exodus of businesses and jobs moving out of high tax coastal states like California. 

A more business-friendly environment in these states also means it is less likely that rent control and restrictive tenant protections will be enacted. Having at least some of your investment real estate outside of California may be a prudent way to protect your net worth and future income from the changes coming to California. 

One way to do this is to sell some of your California properties and exchange them through an IRC section 1031 tax-deferred exchange (1031 Exchange) into out-of-state properties. For those who are not familiar, a 1031 Exchange allows accredited investment property owners to sell a property and indefinitely defer the taxes due on the sale by exchanging their sales proceeds into a property of equal or greater value. 

Accredited investors are defined as an individual with a net worth, or joint net worth with their spouse that exceeds $1 million at the time of the purchase; or an individual with income exceeding $200,000 in the last two years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same in the current year; or a trust with assets in excess of $5 million, not formed to acquire the securities offered, whose purchases a sophisticated person makes. (For a more thorough discussion of 1031 Exchanges, visit: www.IPA1031Group.com/1031-dst-properties/). Ultimately, it’s worth considering that out of state real estate investing could be beneficial based on the unique circumstances surrounding the current climate of property management.

Of course, investing in out-of-state property poses its own problems as well. It is difficult to manage properties that are hundreds or even thousands of miles away. Plus, you may not be familiar with the market, making it difficult to find value.

One way to overcome these issues is to invest in properties structured under a Delaware Statutory Trust (DST). DST properties offer several advantages to real estate investors looking to get out of California that other properties do not. 

First, DST properties are completely management free. DST properties are managed by professional, in-place management companies with a vested interest in the successful performance of the property. DST investors no longer need to deal with the “5 T’s” of real estate ownership: tenants, toilets, trash, telephone calls, and time commitments. The day-to-day supervision of the property is handled by an experienced real estate company with the staff and the necessary resources to provide better and more efficient management. This is a huge benefit for California investors looking to own out-of-state properties. 

Second, investing in DSTs allows you to diversify your equity into multiple properties. Diversification is a prudent investment goal, but purchasing a commercial property requires a substantial amount of equity, forcing real estate investors to put a lot of their “eggs in one basket.” 

DSTs offer a solution to this problem because they can be purchased for as little as $100,000. Even smaller exchanges can be diversified. For example, an investor with a $360,000 exchange could purchase three DSTs (by investing $120,000 into each property) in different locations and asset types across the country. 

Finally, DSTs are syndicated by large institutional real estate companies with research and acquisition departments that perform a higher level of due diligence that individual investors simply are not equipped to replicate. They research the markets and properties thoroughly before structuring any property into a DST. 

Also, due to their financial strength, negotiating power, and high purchase volume, investors can frequently purchase properties with better terms and financing than those available to individual buyers. So even if you are unfamiliar with an out-of-state market, you can still benefit from the exhaustive research and analysis conducted by a reputable DST sponsor. 

The changes in store for California Real Estate investors may be disconcerting, but you can protect yourself and the equity you worked so hard to build by selling some of your California properties and exchanging them through 1031 into DST properties located in more investor-friendly states. 

Contact us to speak to one of our partners and find out more information about how a DST could benefit you.