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Nightmare in Creation

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By Lowell L. Kalapa
(Released on 3/8/09)

Legislators are probably an excellent example of the Pavlovian theory in that they have a knee-jerk reaction to complaints made by their constituents. And why not, after all, an elected official’s number one priority is to make sure he or she will be reelected.

Many times lawmakers come up with responses that seemingly were arrived at in a vacuum or at least there is no acknowledgment that there are side effects to their proposed solutions. Such is the case with a bill that will tax the lessor of real property on the value of the improvements on the land when the lease term expires and the lease is not renewed.

No doubt the bill is in response to some lessee who has lost his or her lease and must vacate the improvements on the property which might or might not have been built and paid for by the lessee. The proposal sitting in the legislative hopper would levy a tax on the owner of leasehold property equal to ____% of the value of the improvements on the leasehold property at the termination of the lease under the conditions delineated in the bill. The bill goes on to provide that the revenues generated from this surcharge are to be used for public education and affordable housing in the state.

Obviously, there is some lessee who is not happy that such improvements have to be surrendered upon the termination of the lease without any compensation. On the other hand, it should be noted that the lessee knew full well that someday the lease would come to an end and that there was no promise of compensation for improvements. Further, it should be acknowledged that leasing, as opposed to an outright purchase of the land in fee, gives the lessee an economic and financial gain in not having to sink as much capital into acquiring the site, capital that can then be used for equipment, improvements, and payroll. Thus, the lessee had a choice

between leasing the real property or attempting to find a site which was available in fee.

It is also questionable whether or not the state can change the terms and conditions of an existing contract by imposing a tax where one was never a consideration in the lease of the property.

Apparently the sponsors never consider the unintended consequences of imposing such a tax on leasehold improvements. One of the most onerous prospects that this proposal may create is that it would throw a pall over all future offerings to lease property in the state. Why would a landowner put himself or herself in a position to be exposed to a substantial tax liability should the lease terminate?

Thus, this proposal may bring the practice of leasing property to a screeching halt or with a substantial hike in lease rents to insure there is enough cash to cover any potential tax liability from this proposal. Thus, the cost of living or doing business in Hawaii would go even higher.

It will become even more expensive to establish a new business or build multi-family housing in Hawaii, as there is the prospect that the fee owner will have to pay this tax. As noted above, the lessee knew and understood the terms of the lease when it was entered into including the prospect that the improvements may have to be forsaken at the end of the lease with no compensation.

If, in fact, this proposal is adopted and thereby causes lessors to reconsider terminating the lease, what will happen to the improvements on the property? In many cases the uses of the property say forty or fifty years ago are probably no longer appropriate or good uses of that property today. So the improvements may be allowed to deteriorate or the lessor may prohibit the lessee from making improvements because that would only increase the value of the improvements creating a very expensive tax liability should the lessor decide in the future to terminate the lease.

So instead of continual upgrades of improvements on leasehold property, conditions will deteriorate and urban blight will take over the neighborhood. The bottom line is that this proposal takes away the rights of the lessor by punishing the landlord for wanting to do something else with the property.

One has to remember that a lease of property is a contract. When that contract is entered into all parties know the consequences when the lease term expires. Well intended as this proposal may be, it utilizes the tax system to achieve a political goal to appease some constituents and creates an economic nightmare.

Lowell L. Kalapa is the president of the Tax Foundation of Hawaii. Mr. Kalapa’s commentary is printed each week in the Maui News, West Hawaii Today, Garden Isle News, and the HawaiiReporter.com.

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