The Dark Store Theory and Other Lies the Government Told

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Tax Policy

Dark stores are closed and vacant commercial buildings. Big-box retailers have argued that dark stores can be considered when valuing their property. Assessors and appraisers have argued that dark stores are not comparable to open and operating stores, and shouldn't be used for property tax valuation. In this article, Fredrikson & Byron, P.A.'s Judy Engel and Lynn Linné discuss the dark stores theory and why using vacant stores in property valuation is an acceptable appraisal practice.

Judy S. Engel Lynn S. Linne

By Judy S. Engel and Lynn S. Linné

Judy S. Engel is a shareholder with and co-chair of the property tax appeals group at Fredrikson & Byron, P.A. Judy focuses primarily on retail, office and multi-family residential real estate appraisals, but also has extensive experience handling tax appeals involving industrial, mixed use, and medical buildings. Lynn S. Linné is an associate with Fredrikson & Byron, P.A. Lynn focuses her practice on tax appeals of commercial and industrial properties. Before joining Fredrikson & Byron, she served as a judicial law clerk to the Minnesota Tax Court.

The “Dark Store Theory” was initially developed by a handful of activist assessors and appraisers in an attempt to tax big box retail stores based on above-market built-to-suit leases as opposed to their fee simple fair market values in order to increase local tax bases. These activist assessors and appraisers have creatively spun the theory as a “tax loophole” used by large corporations seeking to avoid paying their “fair share” of local property taxes. Proponents of the theory argue that big box retailers want their operating stores valued as if they were empty and abandoned – i.e. like a “dark” store.

Our opinion? The theory is nothing more than a populist propaganda tool being used to blame those perceived as outsiders for shortfalls in local governmental budgets. The reality is that there is no such thing as the “Dark Store Theory.” There are only generally accepted appraisal practices used to properly identify the fee simple market value of real estate – the measure for real property taxation in most states.

Valuing the Fee Simple, Generally Accepted Appraisal Practices

Most states' constitutions require taxes to be levied against real property in a uniform manner. These provisions typically require that similar properties be treated similarly. In a nutshell, this requirement prohibits the government from taxing you twice as much as your next door neighbor with an identical house.

One way to help assure that property is taxed uniformly is to require real property to be valued in the fee simple using generally accepted appraisal practices. Fee simple is defined as “absolute ownership unencumbered by any other interest or estate, subject only to the limitations imposed by the governmental powers of taxation, eminent domain, police power, and escheat.” [ Fee simple estate, Dictionary of Real Estate Appraisal, 90 (6th ed. 2015).]

A property subject to a lease is encumbered by what is known as a leasehold estate – i.e.: the estate held by the lessee. A property sold subject to a lease is not sold in the fee simple. Instead, it is sold in what is commonly referred to as the leased fee.

That leased fee interest can have a positive or negative value depending on the terms of the lease. In the most basic terms, if the property is leased at a rate below current market levels, the lease generally impairs the value of the property and a buyer purchasing the real estate will pay less for the property than it would be willing to pay if the lease was at market levels. Conversely, if the property is leased at a rate above current market levels, the leased fee value is generally positive and a buyer purchasing the real estate will pay more for the property. The key, however, is that the buyer is buying more than the real estate alone – they are also buying the contractual income stream associated with the real estate. The contractual right to this income stream is an intangible asset, not real property.

This is why generally accepted appraisal practices permit sales of leased fee properties to be considered only when the value of the leased fee can be identified and removed from the sale price. Identifying and valuing the leased fee interest of a property, however, can be difficult—if not impossible—since it requires the analysis of facts and details that are generally not publicly available. As a result, for purposes of a fee simple valuation, the most accurate method for valuing real property under the sales comparison approach often is to compare it to similar properties that have sold in the fee simple. In most cases, properties sold in the fee simple are vacated by the prior occupant before the sale.

The “Lie”

For many years, these basic tenets of real estate valuation were undisputed. However, a number of opportunistic assessors recently began to attack these core valuation principles in an effort to increase their local tax bases. They have largely focused on big box retail properties, which are commonly purchased subject to long term above-market rate leases entered into as part of the financing structure for their original construction. These properties generally sell at values significantly higher than their fee simple counterparts because the leased fee sales include the value of the contractual income stream associated with the long term above-market rate leases.

In order to capture and tax the increased value of these leased fee estates, a number of inventive assessors began peddling the “Dark Store Theory.” They allege that national big box retailers are trying to avoid paying their fair share of local taxes by seeking to exclude leased fee sales and include only sales of “failed” or “dark” stores.

The argument, as with most populist arguments, has broad appeal. It pits the large corporate outsider against the small local underdog, creating an “us verses them” dichotomy that tends to sell more newspapers and get more votes. The problem is that the theory directly contradicts long standing generally accepted appraisal practices as espoused for many years by preeminent professional appraisal organizations such as the Appraisal Institute. Adding the value of an intangible asset into real property taxation will ultimately lead to non-uniformity in taxation in violation of most states' constitutions and will create the “unfairness” in taxation which most assessors are statutorily required to avoid.

Closing the “Loophole”

Assessors and local government officials recently began arguing the Dark Store Theory in a number of court cases, achieving mixed results.

Several courts have accepted the Dark Store Theory argument. For example, the New York Supreme Court, Appellate Division, held in Rite Aid Corporation v. Huseby that the taxpayer, a national drugstore company, improperly failed to consider a recent sale-leaseback of the property as well as the sales of other drugstore properties subject to built-to-suit leases. [ Rite Aid Corp. v. Huseby130 A.D.3d 1518 , 13 N.Y.S.3d 753 (2015).] The Court based its decision on the existence of what it characterized as a “submarket” consisting of built-to-suit net lease sales of national chain drugstores, which the court concluded were a better indicator of value for the property than what it characterized as unoccupied and vacant stores.

Other courts have rejected the theory, finding that it conflicts with generally accepted appraisal practices. For example, in Walgreen Company v. City of Madison, the Wisconsin Supreme Court held that generally accepted appraisal practices require the fair market value of a fee simple interest to be based on market rents rather than contract rents. [ Walgreen Co. v. City of Madison, 2008 WI 80, 311 Wis. 2d 158, 752 N.W.2d 687 (2008).] The Court explained that contract rents, particularly those resulting from sale-leaseback and built-to-suit transactions, often reflect “artificially increased sales prices caused by unusual financing arrangements.”

The dispute over the Dark Store Theory was quickly picked up by the media. Journalists throughout the country began to spin this theory as a corporate “tax loophole” targeted to undercut the funding of small towns and local governments.

Most recently, politicians have also gotten involved by proposing new legislation on the issue. Legislators in Indiana, Michigan, Texas and Wisconsin have been particularly active in their attempt to close what has been characterized as the “dark store” loophole.

In 2015, Indiana successfully passed legislation that required first generation big-box retail properties with an effective age of 10 years or less to be valued under the cost approach. It also limited the types of sales comparables that could be used in assessing commercial non-income-producing real property with an effective age of 10 years or less. Taxpayers were prohibited from using comparables that were vacant for more than one year or that had a significant restriction placed on the use of the property. These provisions were subsequently repealed one year after their adoption, presumably due to constitutionality concerns regarding uniformity in taxation. However, in 2016, Indiana adopted replacement legislation requiring property to be classified on the basis of market segmentation, which prohibits the consideration of comparable sales in a different market or submarket than the current use of the subject property. The legislation also specifies, however, that true tax value does not mean the value of the property to the current user.

In the past several years, legislators in Michigan, Texas, and Wisconsin have also attempted to pass similar legislation intended to prevent big box retailers from considering vacant or “dark” stores when valuing properties. The proposed legislation also focused on related issues, such as the consideration of deed restrictions and the use of contract rents instead of market rents when valuing income producing properties. Although these additional legislative attempts have gained momentum in recent years, they have (thus far) been unsuccessful.

Will it Work? Can it Last?

Will the attempt to create new valuation rules that single out big box retailers work? If it does, the more important question is, can it last?

The short answer to the first question is apparently yes—the activist assessors and appraisers have been able to get some courts and legislators to drink the Dark Store Theory punch. Populist arguments such as the Dark Store Theory are gaining ground not only in America, but around the world. Blaming the outsider is easy and politically expedient at the moment. Moreover, selling a tax policy that “taxes the rich” and makes them “pay their fair share” is always easy.

The answer to the second question, however, is not so clear. The problem is that the entire theory is based on a lie. It is not supported by generally accepted appraisal practices and will ultimately lead to constitutional violations of the requirement of uniformity in taxation. Thus, any legislation attempting to single out one type of property and to tax it differently from all others will always be subject to a legitimate legal challenge.

Perhaps more importantly, the long term sustainability of any taxing scheme that taxes big box retailers differently from everyone else is questionable. The retail markets are currently experiencing a period of dramatic and swift change. The growth of online retailers such as Amazon are putting a strain on the brick and mortar retailers like never before. Retailers, including those often occupying big box properties such as Sears, Kmart, Gordman's, HH Greg, Sportmart, J.C. Penney, Macy's, and Gander Mountain, are filing for bankruptcy and closing stores at a record pace.

Assessors, appraisers and legislators advocating the Dark Store Theory don't seem to understand that targeting big box retailers by imposing disproportionally higher property taxes on them may harm the very constituents they seeks to benefit. For brick and mortar retailers, real estate taxes are often one of the largest expense items on the profit and loss balance sheet. In today's hyper-competitive and continually shrinking brick and mortar retail market, retailors are being forced to close their less profitable stores. As one of the largest expenses, a store's tax burden may be one of the first factors a retailer will consider in deciding which stores to close.

When these retailers shutter their brick and mortar locations—everyone loses, especially the local communities that depend on these stores not only for their property tax revenues, but for the jobs they provide and the goods they sell. Perhaps only then will proponents of the Dark Store Theory realize that big box retailers are not outsiders—they are friends, family and neighbors, and application of the Dark Store Theory may ultimately only lead to more “dark” stores.

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