Are You Buried in Your Ground Lease? Issues in Entering into, Transferring and Financing Ground Leases, and Redeveloping Ground Leased Property

When real estate professionals refer to a ground lease, they generally mean a long term (usually 30-99 years, including options to extend) lease pursuant to which a property owner leases land (but not improvements) to a tenant, and the tenant is permitted to build a building on the land during the lease term. During the ground lease term, the tenant will typically own and depreciate the improvements. At the end of the term, ownership of the improvements generally transfers to the property owner, or the ground lease may require the ground tenant to remove them.  Ground lease landlords and tenants can each reap benefits from the arrangement; however, flexibility is not typical of ground leases.

They Can Tax That?

A few states, counties and municipalities around the country tax the transfer or assignment of a tenant’s interest in a ground lease. Now, however, thanks to some recent rulings by the City of Chicago Department of Finance, in Chicago, you’ll be paying early and often for the privilege of not just transferring a ground lease, but entering into one.

The State Gets Its Piece of the Pie (or Dirt)

The State of Illinois, like many states, imposes a tax on the “privilege of transferring  . . . a beneficial interest in real property located in Illinois, at the rate of 50¢ for each $500 of value or fraction of $500 stated in the declaration”. (35 Ill. Comp. Stat. 200/31-5 and 200/31-10) A beneficial interest" includes “the lessee interest in a ground lease (including any interest of the lessee in the related improvements) that provides for a term of 30 years or more years when all options to renew or extend are included whether or not any portion of the term has expired.” (35 Ill. Comp. Stat. 200/31-5.) The Illinois Department of Revenue holds that the transfer tax applies to the assignment of the ground lease by a tenant, but not to the issuance or creation of ground leases… so at least you are not taxed from the start. 

The City of Big Shoulders Gets a Bigger Piece of the Pie (or Dirt)

Chicago also taxes the “the privilege of transferring title to, or beneficial interest in, real property located in the city, whether or not the agreement or contract providing for the transfer is entered into the city”, and, like the State, Chicago defines a beneficial interest in real property as “the lessee interest in a ground lease (including any interest of the lessee in the related improvements) that provides for a term of 30 years or more years when all options to renew or extend are included, whether or not any portion of the term has expired” (Chicago Municipal Code §3-33-020(A)(2)). However, as the City of Chicago’s financial situation has deteriorated, Chicago has taken an increasingly broad view of both what constitutes a ground lease and when the tax on a ground lease is due. On December 16, 2014, the City of Chicago Department of Finance issued Real Property Tax Ruling #5, which provides that by the mere act of granting a tenant the right to use real property under a long-term ground lease, a landlord is transferring a taxable “beneficial interest in real property” within the meaning of the Chicago Municipal Code. In short, you have to pay a transfer tax for the creation of a ground lease, and not just the assignment of a tenant’s interest in a ground lease. Moreover, on January 19, 2020, the City of Chicago Department of Finance issued Real Property Tax Ruling #6 which provides that, in the eyes of the City, the fact that the lease includes not only the land but also a building does not prevent the lease from being considered a ground lease (interested to see what the City does not consider to be a ground lease…).  

So What’s the Damage?

So now that we know that, at least in Chicago, both the creation of a ground lease and the transfer of a tenant’s interest in a type of lease that most real estate professionals would not consider a traditional ground lease are taxed, how do we know when the tax is due and how much it is? Chicago’s City Code tells us that the taxable transfer price is “the consideration furnished for the transfer of title to, or beneficial interest in, real property, valued in money, whether paid in money or otherwise, including cash, credits and property, determined without any deduction for mortgages, liens or encumbrances . . .”. According to Ruling #6, if the consideration furnished includes amounts that are not for the lessee’s interest in real property then those amounts may be deducted for purposes of calculating the taxable transfer price. But what does this mean with respect to a lease? Ruling #6 provides guidance.

For an existing taxable ground lease, the transfer price is the consideration paid to the original lessee, by the new lessee, for the transfer of the remainder of the lease.

On the other hand, when a new taxable ground lease is being created, the transfer price is the lump sum that represents the present economic equivalent of the lease payments to be made during the term (excluding any option periods that have not yet been exercised). A discount rate of 110% of the Long-term Applicable Federal Rate (AFR), based on monthly compounding for purposes of Section 1274(d) of the Internal Revenue Code that is in effect for the calendar month in which the transfer occurs, is used to accomplish this.

Because calculating the present value of future lease payments can sometimes involve uncertainty – for instance, if the amounts of those payments will depend on future events, such as gross revenues or other variable performance measures -- Chicago allows taxpayers the option of deferring payment of the tax until the corresponding lease payments are made. Alternatively, a taxpayer can pay tax based on a transfer price equal to the estimated fair market value of the real property to be leased (as most recently certified by the Cook County Board of Review).

If the lease requires the lessor to add improvements after the time of the transfer, it gets even more complicated. The City allows the taxpayer to: (a) pay tax at the time of the transfer based on the estimated FMV of the land plus the lessor's estimated cost of supplying the additional improvements (note, though that this estimate is subject to audit, and if the actual cost varies 10% or more from the estimate, then the taxpayer and the City reconcile), or (b) pay tax based on the estimated FMV of the land as unimproved and then, after the improvements are added, file a supplemental declaration and pay any additional amount due.

Financing a Ground Lease Interest – You Can Mortgage That?

Financing a tenant’s ground lease interest raises a number of complex questions, the primary of which is whether the lease allows for a leasehold mortgage and whether the ground landlord must subordinate its interest in the ground lease to a tenant’s leasehold mortgage. When markets retract, the ground landlord may be willing to allow the subordination of its interest for the property’s redevelopment. If the lending market requires a mortgage on the landlord’s fee interest in the land, perhaps the tenant can grant the landlord a participating interest in the project? Or, the ground landlord could agree to the encumbrance of the land with a mortgage if the ground tenant can provide equity or the lender limits the maximum lien exposure to the land. With a motivated ground tenant and ground landlord, there is more than one way to finance a ground lease deal.

Being Flexible – Can I Build That?

If there are construction provisions in the ground lease and construction is complete, the provisions likely contemplated the construction of the project’s current structure—and limited the ground tenant’s ability to build anything different. For tenants, the hope is that the ground lease contains a mechanism by which a ground tenant can start ‘from the ground up’ and redevelop the property with the landlord’s reasonable consent as a matter of right under the ground lease. 

But even if financing and the ground tenant’s ability to rebuild the improvements on the property are not at issue, some ground leases include use restrictions that could inhibit the ground tenant’s plans to redevelop. The ground landlord may own adjacent land and want to keep some or all of the use restrictions set forth in the ground lease in place. If the highest and best use of the property contravenes the use restrictions set forth in the ground lease, or more importantly, the ground landlord’s interests in operating its adjacent property, the ground tenant could be stuck in the mud. It is in the ground landlord’s interest to effectuate a reuse of the property, though, as any improvements to the project are likely to revert to the ground landlord at the end of the ground lease. 

If issues with use restrictions can be overcome, sufficient term on the ground lease remains and financing is available, either through a leasehold mortgage or pseudo joint venture with the ground landlord, a tenant’s ground lease can be redeveloped. However, if a ground tenant tries to assign its leasehold interest to off-load space in the wake of the COVID-19 pandemic or for any other market downturn, as the State of Illinois’ financial straits grow increasingly dire, it will be interesting to see whether the State follows the lead of its largest city and broadens its scope of which leases it taxes to include the creation of a ground lease. and at what points in the life of those leases it taxes them. Let us hope not.