Intangible Assets in Property Tax Appeals

By Barry J. Cunningham and H. James Stedronsky

Barry J. Cunningham, PhD, ASA, MAI, AI-GRS, is a principal in Property Tax Research, LLC, in New Hampshire, a national research and consulting firm. H. James Stedronsky practices law in Connecticut, focusing on property tax disputes.

Intangible assets are an increasingly important consideration in property tax appeal cases, where the goal is establishing a property’s taxable interest, which is often required to be the “fee simple” interest. What constitutes a fee simple interest for purposes of appraising real estate is not the same as the older Black’s Law definition of the term. Real estate appraisers created a new definition for fee simple interest in the 1980s to little fanfare. The older definition referred to the alienability of the interest and any restrictions on its transferability. The new definition of fee simple was concerned with whether the interest in real estate was “unencumbered by any other interest or estate.” This definition was meant to address whether the real estate should be valued based upon any existing lease

or whether it should be valued based on market rates and terms. Appraisers also created another term to reflect an interest in real estate conveyed subject to a lease: the leased fee estate. This definition was established as a defined term in The Appraisal of Real Estate’s 1987 edition. “Leased Fee” is not a legal term but was created to tell those reading an appraisal that a property is being valued based on an existing lease as opposed to income based on market rates and terms.

In the years between 1987 and roughly 2009, comparatively few court cases were fought about property rights. Then, in about 2009, dark store theory exploded onto the scene. A dark store appraisal undervalues a well-located and thriving retail property by comparing it to the sales of poorly located retail property that those same retailers vacated. Dark store appraisers do this by claiming that it’s a property rights debate and that the only sales one can rely on are “unencumbered” or vacated properties. In the process, they ignore the glaring fact that the empty retail property was vacated precisely because it was poorly located. The heyday of dark store theory was 2009–2019. After some early successes against ill-prepared parties, dark store theory is now losing most cases. The next frontier, one that is legitimate, is the matter of intangible assets—that is, assets that exceed the value of a real property’s fee simple interest.

This article seeks to address four topics. First, it will define what is meant by the term “intangible” assets as they relate to sales of going concerns where real estate has the most significant value. Second, it will explore the history of methods and directives from governmental, accounting, business appraisal, and real estate appraiser circles that have been applied to this issue. Third, it will show how intangible assets affect real estate values. Finally, this article will discuss how courts may address this issue, particularly when state statutory law is unclear as to the standard of valuation for purposes of taxation. Tax appeal cases are often framed by real estate appraisers who lack any education in intangible asset valuation. The goal here is to help the reader understand that intangible assets are more prevalent than one may believe and, once understood, not that difficult to identify.

Defining Intangible Assets

Real estate appraisers use the term “going concern” to label business properties that transfer as a “bundle” of property interests containing real property as well as tangible and intangible personal property. Appraisal Inst., The Appraisal of Real Estate at 663 (2020). Hotels and senior housing are good examples. Business appraisers, on the other hand, refer to these property types as “real estate centered entities,” or RECEs. Shannon P. Pratt, Valuing a Business at 729–30 (2022). The Dictionary of Real Estate Appraisal, published by the Appraisal Institute, adopted the definition of intangible assets—nonmonetary assets without substance—from the American Society of Appraisers (ASA), the International Valuation Standards (IVS), and accounting standards. Appraisal Inst., The Dictionary of Real Estate Appraisal at 97 (7th ed. 2022). In Understanding Business Valuation, Trugman defines intangible assets as a “bundle of rights” having at least one of these elements: (1) they can be reasonably described; (2) they can be purchased or developed internally; (3) you can point to when they were created; and (4) they are transferable, as in they can be bought, sold, licensed, or rented. Gary R. Trugman, Understanding Business Valuation at 745–46 (2022). For example, consider a common and generally accepted hotel operating expense that contributes to business value, the management fee. Eric E. Belfrage, Business Value Allocation in Lodging Valuation, 69 Appraisal J. 277 (2001). It can be described as the cost for organizing operations and is generally developed internally and is created when the hotel begins operations. Such management value is clearly not a part of the real estate. This is highlighted by the fact that, in some instances, an owner of the real estate might lease the hotel to a thirdparty manager. In business valuation, a determination would be made as to how a portion of the value of the RECE should be attributed to intangible property or business interest as opposed to an interest in real estate. This is an important part of the education of a business appraiser but is not addressed in the training of real estate appraisers.

The federal tax code, 26 U.S.C. § 1060, requires that the purchase price of a going concern be allocated among various property types. It defines asset classes. Real estate and tangible personal property are categorized as asset Class V. Class VI property consists of licenses, leases, trademarks, and contracts. Class VII is goodwill. The latest accounting standards under FASB 805, entitled Working Draft of AICPA Accounting and Valuation Guide: Business Combinations, pose a three-part test for what constitutes a business: Is it a substantive process? Is there an integrated set of assets generating income? Is there a workforce that results in income? AICPA, Working Draft of AICPA Accounting and Valuation Guide: Business Combinations at 25, 29 (Sept. 15, 2022). For example, they identify leasing and management personnel as an “organizing workforce . . . performing a substantive process” (id. at 38) and management and leasing as “critical to producing rental income” (id. at 39). Absent a workforce, there is no substantive process, and no income is generated.

For tax appeals regarding going concerns or RECEs, intangible assets can take one or both of two forms: businesses and contracts. At its core, a business consists of three elements: (1) people and (2) the processes they employ to (3) generate income. Consider a hotel. The real estate, as it is commonly defined by appraisers and in most state statutes, is the land and the “sticks and bricks.” When a hotel owner signs a franchise agreement with a national franchisor, the owner is now effectively encumbering the real estate. Contracts, leases, and licenses are the second form of intangible asset affecting the value of the underlying real estate. Contracts are intangible assets and are personal property. Whether they add value over and above the value of the underlying real estate can be debated, but they are technically personal property. Intangible assets often take the form of both businesses and contracts, whether leases, franchise agreements, or employment agreements.

It needs to be emphasized that these various definitions are definitions used by appraisers; they do not necessarily reflect the legal definitions in state courts. Often courts will adopt the definitions used by appraisers, as they have largely done with the term “fee simple.” Nonetheless, the appraiser must consult with the attorney as to how the courts in the subject state define these terms. If there is no law on point, then the attorney and appraiser can argue that the court should adopt their working definition. Courts very often give great deference to definitions as used in professionally authoritative texts. Importantly, there are also unspoken premises used by appraisers. Does fee simple mean starting the analysis as if vacant or does it mean stabilized? Because appraisers never say, one has to look to the data they use to understand their underlying premise.

Intangible Assets’ Effect on Value

Hotels are good examples of where an intangible property interest may directly affect the real estate value. But first we need to separate real estate from the business that functions inside it. As mentioned, the fee simple interest of the real estate alone is defined in The Dictionary of Real Estate Appraisal as “absolute ownership unencumbered by any other interest or estate, subject only to the limitations imposed by governmental powers of taxation, eminent domain, police power, and escheat.” Supra at 73 (emphasis added). Under the plain meaning of this definition, a property that is unencumbered by any estate is a property that has no tenants or occupants of any kind. It is an empty or vacant building. Under this definitional premise, to properly value the fee simple interest, the appraiser must deduct from the stabilized net operating income the cost of reaching stabilization. A stabilized property benefits from people and the systems and processes they employ to procure, in this case, tenants. It is rare that an appraiser does this, though this is not a substantial intangible—maybe 5 percent to 10 percent.

Note the importance of an underlying assumption. If one assumes the property is vacant, isn’t that dark store theory? It is not. If the hotel property is well-located, it will quickly be encumbered by a franchise and stabilized occupancy will be reached shortly, if not immediately. The cost of stabilizing will have little effect on its valuation. This is different from comparing a well-located hotel to the sale of poorly located hotels, now vacant. Notice the distinction: It is not whether a property is vacant—it is whether the property is well-located. Dark store theory is about ignoring location differences and is only disguised as a property rights debate. For a solid review of this issue, the reader is referred to Stephen F. Fanning, Larry T. Wright & Rick J. Muenks, Highest and Best Use and Property Rights—Does It Make a Difference?, 86 Appraisal J. 171 (2018).

The hotel’s “business” is the workforce that functions inside the real estate, employing systems and processes to generate income. With most hotels, the success of that business operation—producing income via overnight stays using people and processes—is governed by a franchise contract. In an apartment complex, big box retail, or office property, the business of producing income is governed largely by leases and management contracts. For a convenience store in the business of selling products and gas, the business is usually governed by a franchise or management contract. In all these instances, if you take away the people and their processes, no income or lease providing income is generated.

Intangible assets can create intangible value over and above the value of the underlying real estate solely as the result of an above-market contract. Consider national pharmacies. They would buy land and build a pharmacy for $3 million. The total development cost includes all costs for land and building and even a return for making the effort. From standard appraisal theory, cost equals value in a stable to modestly rising market. In this example, the property’s fee simple value would be $3 million. But the pharmacy would then commit to an above-market rent and sell the leased fee estate for, say, $4.5 million. Ask real estate appraisers what they would call that difference in value between that $3 million and $4.5 million. Some will say “the $4.5 million is the leased fee estate; the $3 million is the fee simple estate.” I’ll say, “that’s true, but what is the actual name for the difference, the $1.5 million?” Real estate appraisers simply were not educated to the fact that the difference is intangible value attributed to the lease. Unencumbered by that lease, appraisers would agree that the property would sell for $3 million. In essence, the pharmacy business that functions inside the real estate steals money from the business in the form of higher rent to procure a higher sale price. And the higher proceeds went to financing a more rapid expansion.

Practical Valuation Methods

Building on the pharmacy example above, one can see, first and foremost, that the cost approach is very helpful. A cost approach is dispassionate as it is directed purely toward real estate value and does not involve the messy context of the sales or income approaches to value. The potential weakness of the cost approach is quantifying accrued depreciation: the reduction in value from wear and tear over time. But this should not stop one from using this approach. For the attorney who has lived through a court case arguing the finer distinctions of this sale or that sale or this rental property or that one, the cost approach is a much easier argument for the court. And, until accrued depreciation exceeds 25–40 percent, courts understand it and many prefer it.

A second point is the determination of market rent. To the extent the appraiser can provide a reliable and valid rent forecast for the underlying real estate, the cost approach can bolster an income approach. The overwhelming challenge to an income approach is that truly comparable rental data are difficult to find. What often happens when good comparable rents are not available is that the appraiser will use rentals that are less comparable physically or, especially, as to location. Then, the comparative analysis misses the true importance of location differences.

The challenge to the sales comparison approach is that most sales are of the leased fee estate—a property encumbered by some lease or franchise agreement and the sales price reflects the contract rent or franchised income. Hotels generally sell as a going concern (RECE) encumbered or governed by a franchise agreement. Surprisingly, it is rare that the parties make an allocation to real estate for the purpose of determining the conveyance tax. The real estate records do not reflect how much of the price reflects the value of the intangible and tangible personal property. Unless one has the income statements leading up to the sale, it can be difficult to reliably quantify an adjustment for intangible assets. For the prepared lawyer, the cross examination can sink the other side’s case.

When it comes to separating intangible value in a hotel, there is a long history of debates among appraisers. Those debates center on which lineitem expenses are related to business income versus real estate income. Courts have gotten bogged down on these debates unnecessarily. The key is to develop a reasonable income model for the entire going concern (RECE) and then parse the net income as it relates to real estate, tangible personal property, and intangible assets. By starting at the net income level, it avoids all these debates about income and expenses. In fact, it no longer matters which line-item expense went to what. It is assumed that when an owner “invests” in a franchise agreement that the owner will receive a return greater than the expense of the franchise. This return on the franchise “investment” generally comes from a higher average daily rate, a higher occupancy, or, at least, a more predictable income stream posing lower risk.

By beginning your analysis with net income, the valuation of the real estate interest is a less complex proposition. A court will understand that some (probably, most) of that net income supports real estate, but some income supports the value of the in-place personal property. It is then a simple step to capitalize that income related to real estate. The capitalized value of remainder income, what business appraisers might call the excess or residual earnings, is attributed to intangible assets, the business. Robert F. Reilly & Robert P. Schweihs, Guide to Intangible Asset Valuation (2016). A deeper discussion of this is covered in Barry J. Cunningham, Property Rights and the Real Estate Appraiser, 42 Bus. Valuation Rev. 11 (2023).

Jurisdiction and Premise

This discussion raises two important points worth revisiting: jurisdiction and valuation premise. When one relies on the plain meaning of the fee simple definition, that the estate is “unencumbered,” it leads to debates about what is meant by “unencumbered.” Is the property vacant and available, or does it mean that the property is stabilized? These differing positions pose the contradiction between “unencumbered” and leases or an engaged workforce. Some argue that there is no distinction between the inanimate real estate and the business and leases that encumber it. They argue that they are so inextricably linked that they are one and the same. But these are mainly arguments stemming from an audience who misunderstands the intangible nature of a business or contracts. To its credit, The Appraisal of Real Estate states, “a lease never increases the market value of real property rights to the fee simple. Any potential value increment in excess of a fee simple estate is attributable to the particular lease contract, and even though the rights may legally ‘run with the land,’ they constitute contract rather than property rights.” Supra at 415. It is no different for the contracted workforce.

Intangible value from a business or from a contract can be associated with real estate, but they are not in the nature of real estate. Everyone instinctively knows that if all the workers in a hotel decide to not show up for work, the hotel is worth less. Likewise, if that hotel is Joe’s Hotel rather than a national franchise, it is worth less, and the lower value has nothing to do with the actual sticks and bricks. All we are doing here is clarifying the nature of the components, in this case, of a hotel.

The best solution for all sides of this issue is to establish statutes regarding exactly what is taxed and what is not. Without clarifying statutes, should the assessor assume fee simple is subject to being fully stabilized? Should the assessor assume the plain meaning of “unencumbered”? Most state statutes do not answer these questions, but many states do have wording that ties fee simple estate to their standard of taxation. Even when the statutes don’t, this point may be clarified in court cases, where most, if not all, appraisers and attorneys convince the court to adopt their definition of fee simple estate, unencumbered. Whether explicitly or by default, fee simple unencumbered underlies most value disputes.

In the absence of statutory clarity, case law can inform parties. For example, the Florida Supreme Court’s Disney decision in 2020 established the notion that intangible assets reside in amusement parks. This makes sense. Joe’s Amusement Park would have less cachet and be forced to charge less than Disney Resorts. By contrast, the Ohio Supreme Court ruled that unencumbered did not mean vacant, but that appraised values for tax purposes should be based on market income stabilized. Rancho Cincinnati Rivers, LLC v. Warren Cnty. Bd. of Revision, 165 Ohio St. 3d 227 (2021). It essentially held a stabilized premise if, in fact, the property was fully occupied. New Hampshire has several court decisions admonishing the parties to use the cost approach in big box retail cases. In most court cases, though, the experts were real estate appraisers, not business appraisers, and so the debates and framing of the issues were commensurately limiting. In any event, jurisdictions can iron out these disputes by simply clarifying in law what interests are to be taxed and whether actual rents or market rents are to be considered in the income and expense analysis of value.

Summary

This article has examined the history of property rights as an unknowing proxy for intangible assets. The varying definitions of intangible assets and summaries as they relate to real estate and associated businesses or contracts were discussed. A business is simply people using systems and processes to procure income. Contracts can be leases, employment agreements, franchise agreements, or licenses. The authors have seen examples of how intangible assets reside in RECEs and how to identify them. In the end, if the reader’s jurisdiction has addressed these issues, state law will already determine how one frames a case. If not, the appraiser and attorney will, it is hoped, with proper analysis and advocacy, shape the law. Finally, the experts one hires should have a working knowledge of business valuation for these types of cases.