Prevent Post-Lease Tax Law Changes from Tapping You Out

Texas is experiencing a tug-of-war over whether the state's commercial property owners or tenants should bear the brunt of changes to the state's franchise tax law. The controversy serves as a reminder to commercial property owners and managers everywhere: Make sure your lease establishes the broadest possible definition of “property taxes”—that is, taxes for which the tenant, not the owner, is responsible.

The controversy in Texas concerns the state legislature's move to broaden the applicability of the Texas franchise tax—a tax that, before the recent changes, was not usually passed through to tenants. Because the revised franchise tax reduces local school property tax rates in Texas, commercial property owners in the throes of lease negotiations in that state are maintaining that tenants should now be responsible for the tax, explains Steve Kuntz, a partner in the Houston office of Fulbright & Jaworski.

“Owners are arguing, ‘this is just a substitute for property taxes, we've always passed through property taxes, and therefore we've got to pass this through to tenants, too,’” Kuntz says.

The issue is on the minds of the Lone Star State's commercial property owners and tenants because changes to the law at issue—Chapter 171 of the Texas Tax Code—are legally effective as of Jan. 1, 2008. Moreover, it's economically effective now, Kuntz explains. “That's because taxpayers' 2008 returns will be based on 2007 activity,” he says.

Kuntz says that many owners are trying to negotiate lease clauses that explicitly state that the so-called margin tax created under revised Chapter 171 of the Texas Tax Code will pass through to the tenant. In fact, when negotiating leases, commercial property owners in every state should anticipate unforeseen changes to the tax law.

Not Just a Local Concern

“It can happen anywhere,” says George Bernhardt, real estate counsel at Baker Hughes Inc., a Houston-based natural resources product and services provider. ”You never know when a state is going to change its tax system.” Bernhardt suggests adapting and using the Model Lease Language on p. 4 to make tenants responsible for taxes passed “in lieu of” property taxes.

Of course, while owners should fight to get these clauses included in their leases, they may not get their way. “In the long run, I expect that a ‘market’ approach to handling the revised Texas franchise tax will emerge, and it may be that the tax will not be passed through to tenants—instead, rents may just increase to cover it,” Kuntz predicts.

CLLI Sources

George Bernhardt, Esq.: Real estate counsel, Baker Hughes Inc., Houston, TX

Stephen Kuntz, Esq.: Partner, Fulbright & Jaworski, Houston, TX