When property professionals refer to a ground lease, they usually suggest a long term (normally 30-99 years, consisting of options to extend) lease pursuant to which a residential or commercial property owner rents land (but not improvements) to a renter, and the renter is allowed to build a structure on the land throughout the lease term. During the ground lease term, the occupant will normally own and diminish the enhancements. At the end of the term, ownership of the improvements generally transfers to the residential or commercial property owner, or the ground lease may need the ground occupant to remove them. Ground lease property owners and occupants can each gain take advantage of the arrangement; however, versatility is not typical of ground leases.

They Can Tax That?

A couple of states, counties and municipalities around the country tax the transfer or task of an occupant's interest in a ground lease. Now, however, thanks to some current judgments by the City of Chicago Department of Finance, in Chicago, you'll be paying early and often for the opportunity of not simply transferring a ground lease, but getting in into one.

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

The State of Illinois, like lots of states, enforces a tax on the "benefit of moving ... a beneficial interest in real residential or commercial property situated in Illinois, at the rate of 50 cents for each $500 of worth or portion 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 associated improvements )that attends to a regard to thirty years or more years when all choices to renew or extend are included whether any part of the term has expired. "(35 Ill. Comp. Stat. 200/31 -5. )The Illinois Department of Revenue holds that the transfer tax uses to the project of the ground lease by a renter, 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 Larger Piece of the Pie (or Dirt)

Chicago likewise taxes the "the advantage of transferring title to, or useful interest in, genuine residential or commercial property located in the city, whether or not the agreement or contract attending to the transfer is entered into the city", and, like the State, Chicago specifies an advantageous interest in genuine residential or commercial property as "the lessee interest in a ground lease (consisting of any interest of the lessee in the related enhancements) that attends to a term of 30 years or more years when all alternatives to restore or extend are consisted of, whether or not any portion of the term has ended" (Chicago Municipal Code § 3-33-020(A)( 2 )). However, as the City of Chicago's monetary circumstance has deteriorated, Chicago has taken a significantly broad view of both what makes up a ground lease and when the tax on a ground lease is due. On December 16, 2014, the City of Chicago Department of Finance released Real Residential or commercial property Tax Ruling # 5, which provides that by the simple act of granting a renter the right to use real residential or commercial property under a long-term ground lease, a property manager is moving a taxable "beneficial interest in real residential or commercial property" within the significance of the Chicago Municipal Code. In brief, you have to pay a transfer tax for the development of a ground lease, and not simply the task of an occupant's interest in a ground lease. Moreover, on January 19, 2020, the City of Chicago Department of Finance released Real Residential or commercial property Tax Ruling # 6 which offers that, in the eyes of the City, the reality that the lease includes not only the land but also a building does not prevent the lease from being thought about a ground lease (interested to see what the City does not think about to be a ground lease ...).

So What's the Damage?

So now that we understand that, a minimum of in Chicago, both the creation of a ground lease and the transfer of a renter's interest in a kind of lease that most real estate experts would not consider a conventional ground lease are taxed, how do we understand when the tax is due and just how much it is? Chicago's City Code informs us that the taxable transfer cost is "the factor to consider provided for the transfer of title to, or advantageous interest in, genuine residential or commercial property, valued in cash, whether paid in cash or otherwise, consisting of cash, credits and residential or commercial property, identified with no reduction for mortgages, liens or encumbrances ...". According to Ruling # 6, if the consideration furnished includes quantities that are not for the lessee's interest in real residential or commercial property then those amounts might be deducted for purposes of computing the taxable transfer cost. But what does this mean with regard to a lease? Ruling # 6 offers assistance.

For an existing taxable ground lease, the transfer rate is the consideration paid to the initial lessee, by the brand-new lessee, for the transfer of the rest of the lease.

On the other hand, when a brand-new taxable ground lease is being developed, the transfer rate is the swelling amount that represents the present economic equivalent of the lease payments to be made throughout the term (leaving out any option durations that have not yet been exercised). A discount rate of 110% of the Long-term Applicable Federal Rate (AFR), based on month-to-month compounding for purposes of Section 1274(d) of the Internal Revenue Code that is in effect for the calendar month in which the transfer happens, is utilized to accomplish this.

Because calculating the present worth of future lease payments can often include uncertainty - for circumstances, if the quantities of those payments will depend on future occasions, such as gross revenues or other variable efficiency steps-- Chicago allows taxpayers the option of postponing payment of the tax till the corresponding lease payments are made. Alternatively, a taxpayer can pay tax based on a transfer cost equal to the estimated fair market value of the real residential or commercial property to be rented (as most just recently certified by the Cook County Board of Review).

If the lease requires the lessor to include improvements after the time of the transfer, it gets even more complex. The City allows the taxpayer to: (a) pay tax at the time of the transfer based on the approximated FMV of the land plus the lessor's approximated cost of supplying the extra enhancements (note, though that this quote undergoes audit, and if the actual expense differs 10% or more from the quote, then the taxpayer and the City reconcile), or (b) pay tax based upon the estimated FMV of the land as unaltered and then, after the improvements are added, file an extra statement and pay any additional quantity due.

Financing a Ground Lease Interest - You Can Mortgage That?

Financing an occupant's ground lease interest raises a variety of intricate questions, the main of which is whether the lease allows for a leasehold mortgage and whether the ground proprietor should subordinate its interest in the ground lease to a tenant's leasehold mortgage. When markets retract, the ground property owner may want to enable the subordination of its interest for the residential or commercial property's redevelopment. If the lending market needs a mortgage on the landlord's cost interest in the land, perhaps the occupant can approve the proprietor a participating interest in the job? Or, the ground proprietor could concur to the encumbrance of the land with a mortgage if the ground renter can offer equity or the lender restricts the optimum lien exposure to the land. With a motivated ground renter and ground property owner, 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 building and construction is total, the provisions most likely considered the construction of the task's present structure-and limited the ground occupant's capability to develop anything various. For occupants, the hope is that the ground lease contains a mechanism by which a ground occupant can start 'from the ground up' and redevelop the residential or commercial property with the proprietor's sensible permission as a matter of right under the ground lease.

But even if financing and the ground occupant's ability to restore the enhancements on the residential or commercial property are not at issue, some ground leases consist of use constraints that could prevent the ground occupant's plans to redevelop. The ground property manager might own nearby land and desire to keep some or all of the use restrictions stated in the ground lease in place. If the greatest and finest use of the residential or commercial property contravenes the use constraints stated in the ground lease, or more notably, the ground proprietor's interests in running its surrounding residential or commercial property, the ground occupant could be stuck in the mud. It is in the ground property owner's interest to effectuate a reuse of the residential or commercial property, though, as any enhancements to the project are likely to go back to the ground proprietor at the end of the ground lease.

If concerns with usage limitations can be overcome, adequate term on the ground lease stays and funding is readily available, either through a leasehold mortgage or pseudo joint venture with the ground property manager, a tenant's ground lease can be redeveloped. However, if a ground renter tries to designate 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' monetary straits grow progressively dire, it will be fascinating to see whether the State follows the lead of its largest city and broadens its scope of which leases it taxes to include the development of a ground lease. and at what points in the life of those leases it taxes them. Let us hope not.