Understanding California Property Taxes

Posted by Rod Divelbiss

Most California property owners understand that Proposition 13 limits property tax increases. What many owners do not realize is that, despite the tax limitation of Proposition 13, many properties are overvalued, and therefore overtaxed, particularly during economic downturns. (Annual property taxes in California are imposed at approximately 1% of the assessed values.) Also, many property owners do not realize that that there is also a relatively simple method to challenge the overvaluation.

Proposition 13 limits property tax on both residential and commercial properties by (among other restraints) limiting any property value increase to no more than 2% per year. (The main exceptions are when a property changes ownership or is physically improved.) In many counties, the 2% valuation increase is automatic, which results in many properties becoming overvalued on the property tax rolls when market values for real property fall or remain stagnant, such as during a severe or extended economic downturn. Owners of both residential and commercial properties can challenge the property valuation by establishing that the value has decreased over a prior year’s valuation. To bring that challenge the property owner must file an Application for Reduced Assessment with the appropriate county. September 15 is the due date to submit the Application for Reduced Assessment. A hearing usually is not set for at least a year and, to maintain standing, the property owner must continue to pay the tax based upon the value on the roll during the pendency of the appeal.

The valuation of commercial/investment property is generally determined by an income approach - the two principal components of which are consideration of income flow and the capitalization rate. The assessor looks at income over a period of time and then applies a capitalization rate (an expected rate of return) to develop a value under an income approach. For example, a property which generates net income (there are specific rules for generating that number) of $1,000,000 per year, with a capitalization rate of 5% renders a value of $20,000,000. (It is not quite that simple, but that is the general analysis.) Under the mathematical formula of the income approach, the capitalization rate varies inversely with the final valuation figure, so the assessor will typically try to drive down the capitalization rate, which increases value. Thus, if the capitalization rate was determined to be 2.5% instead of 5% in the above example, the value would be $40,000,000 – double the final valuation above.

Of course, there are multitudes of other issue that arise in this area. To list a few: (1) change of ownership issues; (2) transfers of base year values; (3) appropriate calculation of income; (4) whether other valuation approaches are appropriate; (5) development of capitalization rates by considering comparable properties; and (6) determining if other properties are actually comparable.

Our lawyers have worked in the property tax area for over 25 years and have been associated with several reported decisions, both at the Court of Appeal level and before the California Supreme Court. In fact, we worked on the largest property tax refund case ever filed in the State of California.

Rule 8 of the California Property Tax Rules outlines the "rules" for application of the income approach to value.

Specifically, Rule 8 provides:

  • (a) The income approach to value is used in conjunction with other approaches when the property under appraisal is typically purchased in anticipation of a money income and either has an established income stream or can be attributed a real or hypothetical income stream by comparison with other properties.
  • (b) Using the income approach, an appraiser values an income property by computing the present worth of a future income stream. This present worth depends upon the size, shape, and duration of the estimated stream and upon the capitalization rate at which future income is discounted to its present worth.
  • (c) The capitalization rate may be developed by either of two means: (1) By comparing net incomes reasonably anticipated from recently sold comparable properties with their sales prices, adjusted, if necessary, to cash equivalents (the market-derived method); or (2) By deriving a weighted average of the capitalization rates for debt and for equity capital appropriate to the California money markets (the band-of-investment method).