A California Court of Appeal held that the sale of real property to a lessee having an original lease term of more than 35 years did not result in a change in ownership triggering reassessment for property tax purposes. Proposition 13 established a 2% per-year ceiling on increases in the assessed value of real property. One of the notable exceptions to this limitation is the occurrence of a change in ownership, after which assessors are authorized to reassess real property at its current market value. A change in ownership has three elements: (1) a transfer of a present interest in real property (“present interest”); (2) including the beneficial use of the real property (“beneficial ownership”); and (3) the value of which real property is substantially equal to the value of the fee interest (“value equivalence”). The person who has a present interest, beneficial ownership, and value equivalence is regarded as the primary owner of the property.  

A change in ownership can occur by the creation of a leasehold interest in real property for a term of 35 years or more because the lessee is regarded as the primary owner of the property—the lessee obtains a present interest in and the beneficial use of the property, and the value of the property is substantially equal to the value of the fee interest. The expiration of a leasehold interest in real property with an original term of 35 years or more results in a change in ownership too. In contrast, the creation and termination of a leasehold interest with an original term less than 35 years will not result in a change in ownership because, although the lessee obtains a present interest in and beneficial ownership of the real property, the value of the property is not substantially equal to the value of the fee interest. In other words, the lessor is regarded as the primary owner in a short-term lease of real property.  

In 1977, the owner of the subject property entered into a 60-year lease with a general partnership that subsequently constructed and operated a shopping center on the property. In 2006, with approximately 30 years left on the lease, the owner and lessee amended the lease and extended the term another 15 years. The owner sold the property several weeks later to a consortium comprising, among others, a partner in the general partnership that was leasing the property and an outside investor. The question before the Court of Appeal was whether the transactions resulted in a change in ownership.  

Drawing on guidance issued by the California Board of Equalization, the court referred to the first transaction as an “over/under/over” scenario—when there is less than 35 years remaining on a lease with an original term of 35 years or more, the parties extend the lease so that the term is, once again, 35 years or more. The court agreed with the Board’s conclusion that the extension of a lease in an over/under/over scenario does not result in a change in ownership. A change in ownership occurred when the leasehold interest for a term of 35 years or more was initially created. The value equivalence shifts to the lessor when, through the passage of time, the remaining term drops below 35 years; however, the extension of the lease causes the value equivalence to shift back to the lessee. No change in ownership occurs because the lessee at all times retained a present interest in and beneficial ownership of the subject property.  

The court found that the second transaction—the sale of property encumbered by a lease with an original term of 35 years or longer to the lessee—did not result in a change in ownership. Under California law, a change in ownership does not occur upon the transfer of a lessor’s interest in real property encumbered by a lease with a remaining term of 35 years or more. A rule adopted by the Board follows this statutory exclusion but also provides that a change in ownership does not occur even when the subject property is transferred to the lessee. The court agreed with the rule’s conclusion, noting that all three elements for a change in ownership are present upon the creation of the lease agreement. The transfer of the underlying fee interest, whether to the lessee or a third party, does not create a change in ownership because the lessee retains primary ownership under both circumstances.  

A second Board rule says that a change in ownership occurs when the lessor transfers its interest in real property encumbered by a lease with a remaining term of less than 35 years. The court disagreed with this second rule and held that the mere passage of time cannot transfer primary ownership of the property to the lessor. The lessee became the primary owner of the property upon the initial creation of the long-term lease and remained the primary owner upon the transfer of the underlying fee interest.  

The court next turned to the issue of whether the lease extension and sale of the underlying fee interest, together, constituted a sham intended to avoid a change in ownership and reassessment of the subject property. The county assessor, wary of the fact that the general partnership was effectively acting as both lessee and buyer, applied the step transaction doctrine and concluded that a change in ownership had occurred. The court held that the step transaction did not apply. The court found no evidence that the outside investor participated in or encouraged the lease extension, which necessarily meant that the parties could not have shared the same goal of avoiding reassessment from the outset. The court also determined that the 15-year lease extension had economic substance independent of the subsequent sale of property. Dyanlyn Two v. Cnty. of Orange (2015) 23 Cal.App.4th 800.