California Real Property Valuation Excludes Intangible Assets: SHC Half Moon Bay v. County of San Mateo

California Real Property Valuation Excludes Intangible Assets:  SHC Half Moon Bay v. County of San Mateo

©  Mark Muntean[1]

§ 1.01  Introduction

In a landmark decision guaranteed to effect the  assessed real property value of large segments of commercial property, especially hotel and motel properties, the California of Appeal following the lead of the California Supreme Court, invalidated a decades old method for value income real property and held real property assessed value must exclude all intangible assets from their respective values.

[1]        Background. 

In SHC Half Moon Bay v. County of San Mateo,[2] the California Court of Appeal heard an appeal that arose from a dispute regarding the real property tax assessment of the Ritz Carlton hotel in Half Moon Bay, California. The court was presented with the issue of how to properly value taxable real property, with associated intangible assets, at fair market value.  The Court of Appeals sought to implement the California Supreme Court’s recent decision in Elk Hills Power, LLC v. Board of Equalization (“Elk Hills” ).[3]

                        In Elk Hills the California Supreme Court held that in valuing real property, the real property assessment may not include the value of intangible assets, in that case valuing a taxable power plant property.  The California Supreme Court’s decision drew a bright line in valuing nearly any real property in California that all intangible assets must be excluded in valuing real property for property tax purposes under California law.[4]

[2]        California Supreme Court Sets Precedent.

More specifically, in Elk Hills the Supreme Court held that: “[T]he California Constitution requires generally the assessment of property at ‘fair market value’. [A]ssessors have a constitutional mandate to tax all property at fair market value if not exempt under federal or state law.”[5]  Further, in Elk Hills, the Court clarified that intangible assets and rights have

                        “a quantifiable fair market value that must be deducted from an

                        income stream analysis prior to taxation” pursuant to [Cal. Rev.

                        & Tax. Code S]ections 110 and 212. … “[I]ntangible assets like

                        The goodwill of a business, customer base, and favorable franchise

                        terms or operating contracts all make a direct contribution to the

                        going concern value of the business as reflected in an income stream

                        analysis” and have “a quantifiable fair market value that must be

                        deducted from an income stream analysis prior to taxation.” [6]

Under the California Revenue and Taxation Code (“Cal. Rev. & Tax. Code”), “[i]ntangible assets and rights are exempt from taxation and shall not enhance or be reflected in the value of taxable property.”[7]  Cal. Rev. & Tax. Code Section 110(d) prevents the direct taxation of “intangible rights and assets relating to the going concern value of a business” and mandates the “value of intangibles that directly enhance that income stream cannot be subsumed in the valuation of taxable property and must be deducted from an income stream analysis prior to taxation.” [8]

§ 1.02  SHC Half Moon Bay v. County of San Mateo

In SHC Half Moon Bay the hotel owner (“SHC”) claimed the assessment conducted by the San Mateo County Assessor (“Assessor”), and approved by the San Mateo County Assessment Appeals Board, erroneously inflated the value of the hotel by including $16,850,000 in nontaxable intangible assets.   SHC's argued that the income approach used by the Assessor violated California law by failing to identify and remove the value of intangible assets.

[1]        Ritz Carlton, Half Moon Bay’s Property Tax Assessment.

SHC purchased the Ritz Carlton hotel for $124,350,000 in 2004.   The purchase price included the real property, the personal property (e.g., furniture, fixture and equipment), and intangible assets and rights.   At the time of sale, the Ritz Carlton Hotel Company, LLC managed the fully-operational hotel pursuant to a long-term management agreement.   In 2004, the Assessor assessed the hotel pursuant to Proposition 13, at its purchase price of $124,350,000, and the Assessor properly deducted the value of personal property, for a total value of $116,980,000.  

                        Using the income approach, the Assessor derived a stabilized income stream for the hotel and then estimated the hotel's stabilized occupancy rate of 71 percent with net revenue per room of $330 at 3 percent.  After reducing the projected income for fixed expenses such as insurance, subtracting $1.6 million in management and franchise fees, and deducting for reserves and taxes, the Assessor estimated the hotel's net operating income to be 18 percent.   Utilizing a capitalization rate of 6.5 percent, the Assessor concluded the fair market value of the hotel was $129,700,000 (which was greater than the purchase price SHC paid by more than $5 million).  

                        The Assessor then deducted $7,340,000 in personal property and determined the value of the hotel was $122.3 million, a value within five percent of the roll value of $116,980,000.  The Assessor enrolled the hotel at its purchase price of $124,350,000 because the appraised value was within five percent of the purchase price.  The income method rests upon the assumption that in an open market a willing buyer of the property would pay a willing seller an amount approximately equal to the present value of the future income to be derived from the property.[9]

[2]        SHC Challenge to the Assessment. 

SHC challenged the 2004 property tax assessment, claiming it erroneously included the value of $16,850,000 in nontaxable intangible assets, specifically:  (1) the hotel's workforce;  (2) the hotel's leasehold interest in the employee parking lot;  (3) the hotel's agreement with the golf course operator;  and (4) goodwill.   SHC claimed the income approach was “not appropriate for California property tax purposes” because it failed to identify and exclude intangible assets.  The  Supreme Court held, “goodwill of a business” is an intangible asset “that must be deducted from an income stream analysis prior to taxation.”[10]

                        The County argued that SHC's “assumptions and methodology did not reflect the realities of the hotel market.   According to the assessor, the method used by the Assessor (the Rushmore Method) better recognizes those realities.[11]

[3]        Review of the Assessment.

The San Mateo County Assessment Appeals Board affirmed the Assessor’s value of $116,980,000, and the trial court affirmed the Board’s decision relying on EHP Glendale, LLC v. County of Los Angeles.[12]  

[4]        Court of Appeal’s Holding.

The Court of Appeal reversed, directing the trial court to enter a new and different judgment in favor of SHC and against the County, determining the method used by the Assessor and approved by the San Mateo County Assessment Appeals Board to calculate the value of the property violated the standards prescribed by law because it failed to identify, value, and remove the value of the following intangible assets and rights from the hotel's income stream prior to taxation:  (1) the hotel's workforce;  (2) the hotel's leasehold interest in the employee parking lot;  and (3) the hotel's agreement with the golf course operator.  

                        The Court of Appeal applied a de novo standard of review, and concluded that the income approach used by the Assessor and approved by the San Mateo County Assessment Appeals Board to assess the hotel violated California law because it “failed to attribute a portion of [the hotel's] income stream to the enterprise activity that was directly attributable to the value of intangible assets, and deduct that value prior to assessment.”[13]   The Assessor failed to remove the value of the hotel's workforce, the hotel's leasehold interest in the employee parking lot, and the hotel's agreement with the golf course operator prior to the assessment. 

                        In so holding, the Court of Appeal reaffirmed the property tax exemption for intangibles and ruled that the Rushmore Approach, failed to remove the value of the taxpayer’s intangibles when performing an income approach to value.  The Court of Appeal quoted from the California State Board of Equalization’s Assessors’ Handbook noting that the handbook rejects the Rushmore Approach since that approach allows only a return of the investment in the intangibles and not a return on the intangibles.  The California Supreme Court cited the Assessors' Handbook with approval in Elk Hills.[14]

                        The court did not allow SHC to exclude any amount for goodwill in this case because it’s held SHC failed to provide to present substantial evidence that a deduction of the management and franchise fee did not capture the intangible asset of goodwill.

§ 1.03  Application to Other Taxpayers.

The Court of Appeal’s decision in SHC is an application of the Supreme Court’s holding in Elk Hills to the assessment of a hotel property.  The Supreme Court’s holding in Elk Hills is mandatory precedent through-out California in the assessment of real property in California.  Local Assessors cannot choose to ignore it.  It is a landmark decision applicable to any real property with intangibles assets associated with the real property, especially hotel properties in that the use of the Rushmore Approach has been categorically rejected.  However, the holding in this case can easily be applied to golf course properties, restaurants buildings (especially a Chipotle’s or McDonalds), a refinery; oil and gas property; or any property with the presence of intangible assets.

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[1] Mark Muntean, J.D. LL.M. Taxation (Georgetown) is a business and tax lawyer in the San Francisco/Bay Area  of California with over 30 years’ experience in federal, state and international tax matters.  He represents clients in connection with federal and state income and excise tax matters; corporate, real estate, mergers and acquisitions, private equity, and business law matters; and criminal tax issues.

[2] (2014) 226 Cal. App. 4th 471.

[3] (2013) 57 Cal. 4th 593.

[4] Id.

[5] 57 Cal. 4th 593 at 606–607

[6] Elk Hills at 618-619.  In Elk Hills the taxpayer claimed that the State Board of Equalization improperly taxed intangible assets and rights, including emission reduction credits (ERCs), when it assessed the taxpayer's electric power plant.  Elk Hills, 57 Cal. 4th at 601–602.   The Elk Hills court explained, “[b]ecause Elk Hills challenged the Board's methodology that includes the value of the ERCs in its unitary valuation of the power plant, the issue here is a question of law.”  Id. at 606.  In SHC, Sky River and Elk Hills, each taxpayer challenged the Assessor's methodology that includes the value of intangible assets in its valuation of the property.  

[7] Rev. & Tax. Code, § 212(c)(1).

[8] Elk Hills, 57 Cal. 4th at 618–619.).

[9] Olen Commercial Realty Corp. v. County of Orange (2005) 126 Cal. App. 4th 1441, 1446.  See also De Luz Homes v. County of San Diego (1955) 45 Cal.2d 546 (property's value under the income method is the sum of anticipated future installments of net income from the property, less an allowance for interest and the risk of partial or no receipt).

[10] Elk Hills, 57 Cal.4th at 618–619; GTE Sprint Communications Corp. v. County of Alameda (1994) 26 Cal. App. 4th at 1004.

[11] The Rushmore Method or Rushmore Approach, a species of the income method, is a model of hotel valuation recognized in Marriott Corp. v. Bd. of County Com'rs (Kan.App.1999) 972 P.2d 793, 796.  The Rushmore Method allocates a hotel's value among the real, business, and personal property components:  it separates the business component by deducting management and franchise fees from the hotel's stabilized net income and handles the tangible personal property component by deducting a reserve for replacement along with the actual value of the personal property in place. Chesapeake Hotel LP v. Saddle Brook Township (N.J. Tax 2005) 22 N.J. Tax 525.

[12] (2011) 193 Cal.App.4th 262, 272.  EHP Glendale is distinguishable because it concerned an appeal from the grant of summary judgment, which as the court itself explained, “call[s] for the weighing of facts[.]”  EHP Glendale, supra, 193 Cal.App.4th at 273.)   As such, the EHP Glendale court's holding was limited to whether summary judgment was appropriate where an incomplete record suggested there were triable issues of fact;  the court's statement regarding the validity of the income approach is dicta.  Dammann v. Golden Gate Bridge, Highway & Transportation Dist. (2012) 212 Cal.App.4th 335, 354.   We have no quarrel with EHP Glendale 's statement that “the income approach is a valid methodology for determining full cash value” but we are not bound by that court's summary conclusion that the assessor's failure to deduct intangibles in that case “present[ed] a question of fact.”  EHP Glendale, supra, 193 Cal.App.4th at 272. EHP Glendale, LLC v. County of Los Angeles, has since been depublished by the California Supreme Court after the county filed its brief in SHC. (ordered nonpub. Dec. 18, 2013 (S214290)).

[13] SHC Half Moon Bay v. County of San Mateo (2014) 226 Cal. App. 4th 471, citing, Elk Hills at 618;  Cal. Rev. & Tax Code §§ 110(d), and 212(c);  Sky River LLC v. County of Kern (2013) 214 Cal. App. 4th 720, 735. 

[14] 57 Cal. 4th at 616 and 620-621.