United States: Tennessee Property Tax Update

Last Updated: April 24 2012
Article by Brett R. Carter

Taxation of Medical Instruments, Commercial Property Valuation Methodologies, the Charitable Exemption, and Property Tax Appeal Procedures

There have been several noteworthy property tax rulings that have been issued in March and April involving medical instruments, the valuation of commercial property, Tennessee's charitable exemption, and the payment of undisputed property taxes for purposes of appeal. These rulings provide a great perspective on the issues that commercial property taxpayers are facing in the current economic climate and what factors should be considered when appealing property values.

Exempt Inventory or Tools? Application of Personal Property Tax to Medical Devices

A recurring theme in personal property tax cases in Tennessee involves the issue of whether tangible personal property is being leased or is being used to provide services. The Shelby County Assessor has been the most aggressive tax administrator on this issue, pursuing back assessments against cable providers, satellite providers, and security monitoring companies in the past. In 2009, the Davidson County Assessor got involved and made an assessment against a provider of stage equipment, taking the position that the taxpayer was the provider of services rather than a lessor of the stage and lighting equipment. In re: Premier Global Production, Inc. (Davidson County, Tax Year 2008, Initial Decision and Order, Aug. 26, 2009). The taxpayer prevailed in that case when the administrative judge concluded that the taxpayer was leasing the equipment and any services provided by the taxpayer were only incidental to the lease of equipment.

In the most recent dispute on this issue, the Shelby County Assessor issued a back assessment in 2009 against Medtronics. In re: Medtronic Sofamor Danek USA, Inc. (Shelby County, Initial Decision and Order, Mar. 29, 2012). In Medtronics, the global provider of sophisticated medical spinal implants and surgical devices was assessed on medical instruments used to implement screws during spinal surgery. The issue before the administrative judge was whether the instruments or tools are supplies subject to assessment as personal property or exempt as inventory held by the taxpayer for sale or exchange.

The taxpayer contended that the tools were sold or leased to physicians and hospitals, submitting copies of customer agreements and testimony explaining the three-tier pricing structure used for the products depending on the size of the medical provider. Although the documents were not specifically referred to as "leases," the administrative judge concluded that the language "leaves little doubt that such an arrangement exists" as the taxpayer maintained ownership of the instruments and was required to replace damaged or lost inventory.

The assessor argued that Medtronic was the user of the tools because it had an employee in the operating room to assist the physician. The administrative judge rejected this position, concluding that there was little doubt that the end user of the tools was the doctor and the hospital and not the Medtronic employee. The assessor also argued that there was no price associated with the leases and that the taxpayer had not proven that any sales or business tax had been paid on the proceeds of the leases. The taxpayer challenged this assertion and presented the results of a 2004 Tennessee Department of Revenue audit, which concluded that the price for the tools was independently verifiable and distinguishable and that the appropriate amount of sales and business tax had been paid. Accordingly, the administrative judge ruled in favor of the taxpayer.

A 2009 amendment passed by the Tennessee legislature adopted a specific exemption for the tools and instruments at issue, leaving only the pre-amendment transactions in dispute. The parties were directed to submit an order stipulating the value or scheduling a hearing to determine the value of the property. Following a final order on the valuation, the assessor will have statutory appeal rights to the Tennessee Assessment Appeals Commission.

Important Points to Remember When Applying the Income Approach to Valuing Property

Several recent decisions in Tennessee have focused on critical components of the income approach to valuing property. These rulings highlight the importance of presenting a thoughtful and comprehensive analysis when using the income approach to value income-producing commercial property. Otherwise, taxpayers may be left with less than desirable results.

One particular case involved the valuation of a call center in Knoxville Tennessee. In re Lexington Knoxville, LLC a/k/a CVS/Caremark Call Center (Knox County, Initial Decision and Order, Apr. 9, 2012). The taxpayer's valuation expert used the income approach to valuing the subject property, noting that "triple net leases were not indicative of the [current] market." Inexplicably, three of the six rent comparables used by the taxpayer's expert were triple net leases, undermining the taxpayer's position. Moreover, the lease data used by the taxpayer was not information from leases in the local market, and the taxpayer did not even address the actual lease in effect for the call center. The administrative judge, relying on these shortcomings in the taxpayer's proof, sustained the assessor's valuation of the subject property. These deficiencies highlight the importance of using comparable data when producing a valuation report, specifically using information from similar property and/or leases that are in the local market.

The income approach was also used by the parties in a case involving the valuation of a community retail center. In re NP of Tennessee a/k/a Centro NP Residual Pool 1, (Knox County, Initial Decision and Order, Apr. 5, 2012). The parties' expert reports had similar estimates for gross income, vacancy/collection losses, expenses, reserves, and tax rates in the income analysis, but the capitalization rates were significantly different. The administrative judge adopted the assessor's capitalization rate because the taxpayer's appraisers were not present to testify or undergo cross-examination and also because the taxpayer's appraisers valued the lease fee estate rather than the fee simple estate which is the interest that must be valued for ad valorem tax purposes.

The capitalization rate is often the most critical component of the income analysis. In a case involving income approach valuation of a hotel in Gatlinburg, Tennessee, the administrative law judge rejected the capitalization rate used by the assessor because it was based on property that was different from the subject property. In re: RB Hotel Park Vista, LLC (Sevier County, Initial Decision and Order, Mar. 26, 2012). Specifically, the assessor capitalization rate was taken from an RERC survey for first-tier investment properties, but the administrative judge concluded that the subject property was "not a first-tier investment property as it was 34 years old, lacked a flag, and needed extensive renovations." Accordingly, the administrative judge adopted the capitalization rate of the taxpayer's appraiser.

Cost Approach to Valuing Property Also the Subject of Recent Decisions

The cost approach has also been the subject of recent property tax decisions in Tennessee involving undeveloped residential property. In re Elmington Capital Group, GP (Knox County, Initial Decision and Order, Apr. 5, 2012). The taxpayer purchased ten residential lots in a foreclosure sale for $13,000 per lot. In addition to relying on the sales price of the purchase, the taxpayer also introduced evidence of listings for property for sale on the same street that remained unsold. The assessor presented evidence of three vacant lots for sale from subdivisions within one mile of the subject property that, as adjusted, supported a value of $45,000 per lot for the subject lots.

The administrative judge adopted the assessor's valuation. In doing so, the judge rejected the evidence of the taxpayer because the evidence was from events occurring after the assessment date which are normally irrelevant for determining value for an earlier tax period. The judge also concluded that the taxpayer's purchase of the subject lots was not probative because the lots were purchased in bulk and because the purchase was through a foreclosure sale. The judge noted that the Tennessee Board of Equalization historically has a position of disregarding foreclosure sales because those transactions invariably involve duress. Thus, despite the recent economic downturn, it appears that the State has not changed its policy on the probative value of foreclosure sales for property tax purposes.

Appraisal or No Appraisal, That Is the Question

The difficulty with property tax cases is that often the tax savings that can be achieved do not always justify the expense of a full appraisal. Thus, in many instances, taxpayers either proceed without representation or without a professional appraisal report, instead presenting testimony of real estate brokers or managers and proof about the condition of the property. In most instances, the lack of an appraisal will put taxpayers at a significant disadvantage if the case is not settled before a hearing with an administrative judge. An example of that is In re: First Fin-OR-LLC (Anderson County, Initial Decision and Order, Apr. 3, 2012). In First Fin-OR-LLC, the taxpayer had appealed the valuation of commercial property in 2008 presenting the type of testimony mentioned above but no appraisal. The taxpayer's valuation was rejected in 2008, and the attempt at a second appeal for the 2011 tax period was also rejected—again principally because the taxpayer failed to present an appraisal report.

Despite this holding, the fact remains that administrative judges have held that fee appraisals or bona fide appraisal experts are not necessary in all appeals. In re: A&A Real Estate Investments LLC, (Shelby County, Initial Decision and Order, Mar. 7, 2012) (citing Nashwood Park Limited Partnership (Davidson County, Tax Year 2007)). In A&A Real Estate, the subject property was a commercial lot with a building once used for an Outback Steakhouse. The building had been vacant for seven years and had been stripped of all its copper, mechanical units, plumbing, and electrical components. The taxpayer presented testimony of the property manager who was also a commercial real estate broker. The property manager testified regarding the condition of the building and his inability to lease the property.

The assessor presented an appraisal expert that had conducted a cost approach appraisal, utilizing a depreciation rate of 67.9%. The administrative judge started with the assessor's appraisal, but made adjustments based on the testimony of the taxpayer's property manager, increasing the depreciation rate to 90% as well as making other adjustments. While the administrative judge did not adopt the taxpayer's proposed valuation, the testimony of the property manager resulted in material reductions in the assessor's valuation of the property, exhibiting an instance in which the absence of an appraisal did not render the taxpayer defenseless to the assessor's appraiser.

Application of Charitable Exemption to Church Property

There are numerous Tennessee property tax cases that have addressed the issue of whether property owned by a charity but held for future development is exempt. In those cases, the courts have routinely held that the Tennessee property tax statutes require, not only ownership, but also occupation and use. That use must also be "directly incidental to or an integral part of" an exempt purpose of the institution. Methodist Hospitals of Memphis v. Assessment Appeals Commission, 669 S.W.2d 305, 307 (Tenn. 1984).

The First Baptist Church Broad Street in Memphis recently challenged a revocation of the exemption on property that it owned and put to certain use. In re: First Baptist Church Broad Street, (Shelby County, Initial Decision and Order, Apr. 12, 2012). One parcel of property subject to the appeal was used to provide below rent space to certain businesses in the community and also for the church's "Clothes Closet." The administrative judge concluded that the use by the businesses, while helpful to the community in some way, was not directly incidental to the exempt purpose of the church. With respect to the Clothes Closet, the judge held that this use qualified for the charitable exemption as a reasonable part of the mission and outreach of the church.

The church also owned two other parcels of property for future development, but also used them, in part, for overflow parking and storage. The judge concluded that the limited use of the property did not qualify as "use" for purposes of exemption, but noted that the church could reapply for the exemption when the undeveloped and unused property is put to use for an exempt purpose.

Impact of Not Paying Undisputed Tax on Appeal

A recent ruling, serves as a reminder for property tax professionals that Tenn. Code Ann. § 67-5-1512(b) mandates that the State Board of Equalization dismiss an appeal for a "taxpayer who fails to pay delinquent taxes that have accrued on property that is the subject of the appeal, or who fails to pay at least the undisputed tax related to a properly appealed assessment." In Re: SN Hotel, LLC (Warren County, Initial Decision and Order, Apr. 16, 2012). Taxes that are the subject of a properly appealed assessment are not deemed delinquent if the taxpayer has paid at least the undisputed portion of the tax while the appeal is pending. Tenn. Code Ann. § 67-5-1515(b). In SN Hotel, it was undisputed that the taxpayer's taxes were delinquent for 2011 because the taxpayer had not paid the undisputed portion of the tax. Thus, the administrative judge was required by law to grant the assessor's motion to dismiss the appeal.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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