April 1, 2003

Real estate owners should understand the ramifications of applying escrows on a cash or accrual basis.

Many counties throughout the country bill real estate taxes in arrears—in other words, a bill is issued in a calendar year for taxes that accrued the prior calendar year. For owners of multi-tenant retail, office and industrial properties, this payment method may bring confusion to the management process and headaches if the property is sold. Without diligent oversight by management and clearly stated lease provisions uniformly implemented, the costs to real estate owners can be substantial.

Most leases provide that a tenant pay its pro rata share of taxes by making monthly deposits with the owner of estimated amounts to be held in escrow. In counties where taxes are billed in arrears, owners must be certain that lease language is clear on how escrows will be applied. The owner will generally apply escrows in one of two methods—on a cash or accrual basis.

Applying escrows on a cash basis means that the owner will use the escrows to pay tax bills issued in each year irrespective of the year the bill relates to. This option results in the tenant paying for taxes that are billed during years that it occupies the premises. Applying escrows on an accrual basis means that the owner will use the escrows to pay tax bills issued for the year that the owner actually collected them. This option results in the tenant paying for taxes that accrue during the years it occupies the premises.

Most owners prefer applying escrows on a cash basis because:

  • Owners do not like spending their own money. For example, if a lease began on January 1, 2003, the owner wants to apply the escrows to those bills issued during 2003 and not wait to apply the escrows until the 2003 bills are issued in 2004; and

  • Owners do not like the risk of having to chase a tenant after the expiration of a lease term to be reimbursed for additional amounts owed by them. If the owner does not properly estimate the taxes that will accrue during the tenant's last lease year, the owner will need to obtain a reimbursement from the tenant as far as 1 year after it vacated the premises.

Most owners should apply escrows on an accrual basis because:

  • A tenant should be paying for taxes that accrue during its period of occupancy;

  • If the property is a new construction, the bills issued during the initial lease year will most likely be based upon vacant or unoccupied land and a tenant should not obtain the benefit of a reduced tax bill; and

  • When the owner sells the property, the owner can easily credit the purchaser with the escrows being held for taxes that have accrued but are not yet due and payable.

Whatever method an owner applies, the lease language should provide the owner with the freedom of using either method, so long as it is done uniformly. To avoid a management and accounting nightmare for the owner, the owner should apply the escrows collected for all tenants in a consistent manner.

Once the owner decides to sell the property, the issue of how the owner has been applying escrows will likely become a hot topic of discussion and negotiation between the owner's and purchaser's lawyers. In theory, neither party should obtain a windfall in connection with the proration of taxes. Ultimately, each party should pay exactly what it owed during its period of ownership. Accordingly, the parties should agree on a proration method for the taxes and provide for a reproration to take place within 30 days after the final bills are issued. However, a vast majority of owners would prefer not to revisit the proration of taxes several months, even a year, after the closing. Instead, they prefer to distribute the net profits, close the books and move on to the next project.

Whether or not the parties agree to reprorate the taxes, it is of utmost importance for the purchaser (and its attorneys and accountants) to carefully review the leases and the owner's expense and escrow reports. This will determine how the owner has been applying the escrows and whether the owner has been properly applying them in accordance with the terms of the leases. In reviewing this information, the purchaser will likely encounter one of the following:

  • The lease states that the escrows will be applied on a cash basis and the owner has been doing so properly. In this instance, the purchaser knows what to expect, but will likely want a reduction in the purchase price because the purchaser may be out-of-pocket for taxes that it did not anticipate at the time of negotiating the purchase price. For example, if all of the leases have 5 years remaining and the tenants do not renew or the purchaser cannot find replacement tenants, then the purchaser will be solely responsible for the payment of the taxes that accrue during the last lease year. Most purchasers assume that the tenants will be responsible for taxes that accrue during their occupancy;

  • The lease states that the escrows will be applied on an accrual basis and the owner has been doing so properly. In this instance, the purchaser knows what to expect and is assured of the owner possessing escrows for the period it owned the property;

  • The lease states that the escrows will be applied on an accrual basis and the seller has been applying them improperly on a cash basis. (This is a likely scenario). In this instance, the purchaser would be out a full year of escrows if not properly addressed in the purchase and sale agreement. As a practical matter, a tenant most likely would not care about the improper application since taxes generally increase each year and the tenant is relieved of paying taxes that accrue during the last and, most likely, expensive year; or

  • The lease is ambiguous as to how the escrows will be applied or provides the owner with various options. (This is the most likely scenario.) In this instance, the purchaser will need to confirm how the owner has been applying the escrows (uniformly or not), interview the tenants to confirm how they have been accounting for their deposits, and address the issues that arise in the negotiation of the sale and purchase agreement.

Here is an example of a worst-case scenario for a purchaser: The owner constructed the property and has been applying escrows on a cash basis, whether or not the leases permit such application. All of the leases run for 10-year terms and the sale is taking place in the third year. If the purchaser does not properly address the tax prorations in the purchase and sale agreement to account for the taxes that will accrue during the 10th year of the leases (and be payable the following year), the purchaser will be solely responsible for the taxes that accrue during that last year without having any escrows allocated to such amounts.

Once the parties have determined how the escrows have been applied and if such application has been done in proper accordance with the leases, the parties can then address how they desire to equitably prorate and, possibly, reprorate the taxes. In instances where the owner wants a final proration at closing, the parties might simply agree to an equitable adjustment in the purchase price. In any event, this area is where the creativity of the parties' respective lawyers is required. There is a myriad of methods that can be used to accomplish the parties' goals with respect to the proration and reproration of taxes.

In sum, in counties that bill taxes in arrears, it is important for an owner to understand the ramifications of applying escrows on a cash or accrual basis and to be assured that the lease language correctly reflects the method the owner will be using. The owner's application of the escrows generally will not become an issue until the property is marketed for sale. Ultimately, the purchaser bears the burden of uncovering how the owner has been applying the escrows and whether such application has been done properly. It will be during this investigation period that the parties most likely will be revisiting and re-negotiating the proration and reproration provisions of the sale and purchase agreement. Be aware, turning a blind eye toward boilerplate provisions could end up costing you in the end.

This article contains material of general interest and should not be construed as legal advice or a legal opinion on any specific facts or circumstances. Under applicable rules of professional conduct, this content may be regarded as attorney advertising.