Tax Prorations and “Cash-Basis” Leases
January 1, 2001
Every real estate purchase and sale transaction involves the proration of real estate taxes. Disputes often arise involving the method to be used to calculate these prorations. Recently, while I was representing a seller on the sale of a $100 million mixed-use project in a Chicago suburb, an issue arose, the resolution of which involved an adjustment to the purchase price of almost $3 million.
The facts that led to the dispute are fairly common in commercial real estate sale transactions. The 1999 taxes assessed against the property, like all Illinois real estate taxes, were payable in arrears, in the year 2000. The total 1999 taxes were approximately $3 million. The property was fully occupied and the tenants all reimbursed the landlord for their full proportionate shares of the real estate taxes assessed against the property (i.e., all of the leases were "triple net leases"). The closing occurred on December 31, 1999. The key fact causing the dispute was the language of each lease that provided that the tenant was required to reimburse the landlord for the tenant’s share of taxes "payable each year during the term of the lease." Many real estate professionals refer to these types of provisions as "cash-basis" tax reimbursements and to these types of leases as "cash-basis leases."
Almost universally in Illinois real estate transactions, the parties concede that the seller is responsible for the real estate taxes accruing before the closing and payable after the closing, and the buyer should be entitled to a proration credit from the seller for these amounts. Therefore, the issue in dispute on purchase and sale transactions involving cash-basis leases is: should the tax reimbursement payments to be made by the tenants to the buyer after the closing be credited against the taxes accruing before the closing, thereby reducing the tax proration credit to the buyer?
Obviously, the seller will argue that the payments by the tenants after the closing should be credited against the taxes accruing before the closing. The logic behind this argument is that these payments are clearly stated in the lease to be reimbursement for the taxes payable in a particular year, which, in Illinois, means they apply to the taxes accruing in the prior year. For instance, in the case of the transaction described above, the seller argued that the tenants’ payments to the buyer in the year 2000, after the closing, were clearly reimbursement for the 1999 taxes (payable in 2000) and, therefore, the buyer would be fully reimbursed for those taxes without any proration credit. If the seller wins the argument, the seller eliminates the entire 1999 tax proration credit otherwise payable to the buyer, and thereby saves the payment of a full year of taxes — $3 million.
The buyer refutes this argument with a battery of responses. Most of these responses are based on the premise that because taxes are payable in arrears, and taxes are customarily prorated in the buyer’s favor in Illinois, the timing of tax reimbursements under the leases should not impact the method of prorating the taxes. The buyer argues against the seller’s "cash-basis" position: "That's not custom and practice in Illinois," or "When I go to sell the property, I will need to give the credit to my buyer," or "My lender is requiring that I escrow those taxes," or "If the property burns down or eventually is put out of use, I will be short the money to pay the taxes applicable to the final year in which the property is used." If the buyer wins the argument, the buyer will be entitled to a proration credit, reducing the net purchase price by the amount of a full additional year of real estate taxes. In the case of the transaction described above, the reduction would be $3 million.
So who is correct, the buyer or seller?
Both parties have defensible positions. There is no one right answer. Whatever the parties negotiate on a deal-by-deal basis is acceptable. The key factor for each party is understanding the ultimate economic ramification of their agreement, namely, how it affects the bottom line of the closing statement. In the transaction mentioned above, the seller prevailed and kept its $3 million. Obviously, the buyer was willing to pay the full price without the proration credit, or the deal could not have been made.
This article was first printed in "Legal Advisor" section of the January 2001 edition of Real Estate Chicago magazine.