August 2003

As if construction issues, financing, tenancy and maintenance aren’t enough, property owners in California are increasingly facing yet another challenge: state and local governments exercising their power of eminent domain to condemn and purchase property. Many cash-strapped governmental agencies facing mandates to build public works or redevelop “blighted” neighborhoods lack the money to buy the property at its true market value. These agencies often turn to eminent domain as a way to acquire property at less than full market value.

This article will acquaint property and business owners with the basics of eminent domain, its procedures and the determination of the necessary “just compensation” for the government to condemn your property. Armed with this knowledge and the appropriate team of attorneys and appraisers, property owners can insure they receive fair compensation, not only for the property itself, but also for any compensable business losses, lost goodwill, severance damages and improvements.

Property owners or tenants faced with an eminent domain action must arm themselves with the necessary tools to get the fair market value of their property or leasehold interest. [One thing is certain – simply accepting the government’s opening bid for your property interest assures you of getting substantially less than its actual value.]

Eminent domain is the power of government agencies to acquire property from a private landowner for a “public use,” with or without the property owner’s consent. When government exercises the power of eminent domain, it must pay “just compensation” for the property, calculated as described below. In short, the power of eminent domain or condemnation is the power to force the sale of private property to a governmental agency as long as that agency is willing to pay just compensation for the property. The problem is that governmental agencies often offer far less than the value of a property as just compensation.

The definition of “public use” justifying condemnation is very broad. Typical public uses include schools, roads, parks, highways, and fire and police stations. More recently, there has been a significant increase in governments exercising the power of eminent domain for neighborhood redevelopment, even where the property will be transferred to a private developer and may never be open again to the general public. For example, eminent domain has been used to condemn property that is sold to a private developer who builds a mall or a movie theater. Courts have consistently held that eminent domain is proper where the government can meet a relatively minimal burden of showing that such a transfer is in the public interest to redevelop blighted or distressed property as part of a redevelopment program.

It is difficult to challenge the government’s use of its power of eminent domain. Successful challenges typically center on defects in the governmental agency’s procedure under relevant California law. Those defects are almost always curable, which means that the successful challenge results more in delay than in retaining the property. It is a highly unusual case where a private party can resist a government’s exercise of its power of eminent domain for all time.

A property owner must make an initial business decision when receiving notice that his or her property is subject to an action for eminent domain. Given the difficulty of a successful challenge to the government’s condemnation power, it is unusual that the intrinsic value of the property is enough to justify the expense of the fight. The property owner can recover the value of any future development plans for the property through the just compensation process. It is often more cost-effective and remunerative to concentrate efforts on obtaining the highest level of just compensation rather than the expensive and timeconsuming process of challenging the eminent domain proceeding itself.

The procedures for an eminent domain proceeding are prescribed by statute. The governmental agency must comply strictly with these procedures, hence the rare successful procedural challenge to an eminent domain proceeding. The purpose of these procedures is to give a property owner adequate notice of the fact of eminent domain, the reasons for the taking, and the just compensation that owner can expect if he or she accepts that initial, usually low, government offer.

The first thing a property owner will receive is a written expression of interest by a government agency and an attempt to schedule a date to appraise the property. The agency then appraises the property, including any improvements, and transmits an offer to purchase the property along with a summary of the appraisal. The property owner is generally entitled only to a summary of that appraisal.

The next step is for the government agency to hold a public hearing to adopt the necessary “resolution of necessity” to acquire the property by eminent domain. All concerned citizens are entitled to appear at the hearing to voice any objections to the proposal. It is important for property and business owners to appear at the hearing either in person or through counsel because certain defenses to eminent domain and/or compensable property rights can only be raised in later court proceedings if raised at the hearing on the resolution of public necessity.

The next step is an eminent domain complaint filed in the Superior Court by the agency seeking to acquire the property. That complaint will name as defendants the property’s owner, all tenants, and the holders of any encumbrances on the land such as financial institutions or previous sellers if seller financing was used. The complaint then must be served on all those defendants, meaning all of those defendants will have notice that the property will be taken by eminent domain.

The property owner is now at a critical crossroads. He or she can accept the government’s offer, which is almost always less than the full value of the property and does not include any lost business income or goodwill. Alternatively, the property owner can retain counsel and an appraiser to determine the highest and best compensation for the property or, in rare cases, to fight the eminent domain proceeding itself.

The choice of counsel and an appraiser is critical. Property owners should seek counsel with experience in handling eminent domain matters and who are backed by partners with real estate and tax experience, to adequately quantify the highest and best value for the property and minimize adverse tax consequences.

Counsel also will be critical in choosing an appropriate appraiser for the defense of the action. The value of property and business losses in eminent domain actions is determined by statutes and precedent. It is not the same as a simple present value appraisal. It is important to retain an appraiser with an adequate background in eminent domain proceedings to establish not just the value of the property “as is,” but also its value at its highest and best contemplated use, the value of any business losses through relocation, and the value of any lost goodwill. Experienced eminent domain counsel can usually guide the property owner to the appropriate appraiser.

After the case is filed, the condemning agency must deposit the probable amount of just compensation into the court. This is usually the same as the initial offer to purchase the property. The agency can also request early possession of the property from the court. Early possession is usually granted by the courts unless the property owner can show significant hardship. Again, it is important to have counsel present to argue that hardship, if it exists. Where early possession is granted, the property owner and any tenants will have at least 90 days to vacate the property.

The matter will go forward to a trial by jury of the amount of reasonable compensation. This is preceded by an exchange of expert reports between the condemning agency and property owner and mandatory settlement discussions on the property. The key issue of the case is thus joined, the amount of “just compensation” the condemning agency must pay for the property.

Both the United States Constitution and the California Constitution provide that private property may not be taken for a public use without payment of “just compensation.” In practical terms, a property or business owner should seek compensation for the value of (1) the real property itself; (2) improvements pertaining to the real property; (3) business losses; and (4) business goodwill. This compensation is available to the property owner and to any other party whose property interest is acquired by the government agency. For example, a business tenant on the property is entitled to compensation for the value of his lease, the value of fixtures and equipment, and the loss of business goodwill suffered as a result of the acquisition.

These rights raise a cautionary and planning issue. Most properly drafted leases contain a “condemnation clause” which sets forth the entitlement to compensation as between the owner and tenant in an eminent domain proceeding. These clauses generally specify whether the tenant is entitled to any “leasehold bonus value,” i.e., the value of the tenant’s leasehold interest. Courts have uniformly held that condemnation clauses are enforceable. Even under these provisions, the tenant is often entitled to his or her own fixtures, equipment and business goodwill. Where there is no condemnation clause, the property is generally valued as a whole and that value is divided up among the owner and the tenants according to their respective interests in the property. Many property owners do not realize that if the property is rented at less than then prevailing market rates and the business tenant has amassed significant goodwill, it is often the business tenant who will receive the lion’s share of the just compensation, not the underlying property owner.

The determination of the appropriate market value is made by dueling expert appraisal testimony. Real estate appraisal is far from an exact science, and the difference between the government appraisal and the property owner’s appraisal is usually tens of thousands of dollars and can be hundreds of thousands or even millions of dollars. The selection of the appropriate appraiser becomes critical. The appraiser needs to be more than just a skilled real estate appraiser; he or she must be able to value business goodwill, the value of improvements, and have sufficient testimonial experience to appear credible in front of the judge or jury making the ultimate determination.

These proceedings are important even where only a portion of the property is taken. Often, the government needs only a portion of a particular property, such as a strip of land, to widen a street. In those cases, just compensation is determined using the value of the part taken and also the damage to the remaining property, often called “severance damages.” Severance damage is the amount of damage to the remaining portion of the parcel that is caused by the severance of the remainder from the part taken, or by the construction and operation of the project for which the property is taken. Severance damages can be minimal or they can be quite high, such as when the project will bring significant traffic or pollution near residential property.

Owners are entitled to compensation for their improvements as well as the property itself. These improvements must be valued “in place,” which means the value of the improvements as part of a going concern, not the salvage or resale value of those improvements.

California’s eminent domain law also provides that a business owner may be entitled to compensation for any loss of business goodwill caused by a taking of the property on which the business is located. This business goodwill concept has not been adopted by most other states. Goodwill is generally valued based on the sustainable income flow, as used by an expert appraiser.

Finally, a property owner is entitled to interest and, in certain situations, the recovery of litigation expenses and attorneys’ fees. The government generally must pay interest from the date it takes early possession or from the date of judgment. A litigant can usually recover court costs, filing fees and deposition fees. A property owner can recover all or a portion of his attorneys’ fees if the owner has made a reasonable settlement proposal to the government at least 30 days before trial, and the government has made an unreasonable offer. The reasonableness of these offers is determined by the court.

The final issue most property owners must confront in an eminent domain proceeding is the tax consequences of the government taking. The taking of property by eminent domain is a sale which may trigger a taxable capital gain, unless that gain is “rolled over” into a replacement property to defer taxation.

The Internal Revenue Code provides relief for property owners who lose property in an eminent domain proceeding. Internal Revenue Code §1033 lengthens the time for an owner to locate replacement property to three years from the date of judgment. That extended period is particularly critical in real estate markets like the current one in which replacement property may be overpriced and oftentimes simply unavailable. That window also provides a possible opportunity to purchase replacement property in a down market occurring within three years of the date of judgment in an eminent domain action. It is critical to have experienced tax counsel available to guide property owners through the tax issues in an eminent domain action.

Armed with the right assistance, a property owner can navigate the waters of eminent domain to receive full and fair compensation and resolve tax issues. That assistance is best provided by a team including litigation counsel experienced in eminent domain matters, an experienced real estate and business appraiser and experienced tax counsel. A quality team of professionals will provide value in the form of increased compensation that far exceeds the costs of those services – a real “win win” for all concerned

If you have any questions regarding this bulletin, please contact Barry MacNaughton, Esq., at 310.281.6342 or bmacnaughton@ecjlaw.com. If you would like to be a part of the mailing list for the Real Estate Reporter or if you would like to receive copies electronically, please contact Cynthia S. Kaiser at 310.281.6328 or ckaiser@ecjlaw.com.

Real Estate Reporter

How To Survive And Prosper In An Eminent Domain Action