Real Estate Reporter, August 2005

THE “NEW” RULES OF EMINENT DOMAIN – HOW TO SURVIVE AND PROSPER

By Barry MacNaughton and David B. Coher

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

The recent ruling of the U.S. Supreme Court in Kelo v. City of New London, adds to this complicated state of affairs. Despite all of the commentary decrying the ruling, Kelo creates little to justify any greater cause for alarm among California property owners than the state of affairs prior to the ruling. What Kelo did, in short, was to give the high Court’s seal of approval to the present reality for California property owners. That reality includes the possibility of the use of eminent domain to condemn property for resale to public-private redevelopment partnerships or to private developers.

Property owners should prepare for the battle over eminent domain by arming themselves with knowledge of the process and the appropriate team of attorneys and appraisers to ensure they receive fair compensation – not just for the property itself, but also for business losses, including goodwill, severance damages, if applicable, and improvements. Without such preparation, property owners often receive less than 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 almost inevitably assures you of getting substantially less than the actual value of the property.)

What Is Eminent Domain?

Eminent domain, better known as condemnation, is the power of a government agency to force the sale of real property by a private owner for a “public use,” with or without the property owner’s consent. When government does this it must pay “just compensation” for the property, calculated as described below. The problem is that governmental agencies often severely undervalue property and offer far less than the true value of a property as “just compensation.”

The definition of a “public use” justifying condemnation is very broad. Traditionally, public uses included schools, parks, highways and fire and police stations. More recently, however, there has been a significant increase in governments exercising the power of eminent domain for redevelopment projects, even where the property will be transferred to a private developer and never again freely open 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.

In its recent decision of Kelo v. City of New London, the U.S. Supreme Court affirmed that eminent domain is proper where the government can meet a relatively minimal burden of showing that such a transfer is for a “public purpose,” such as a redevelopment program. While eschewing any “rigid formula,” the Court ruled that such a “public purpose” need not require the “condemned property be put into use for the general public.” Accordingly, a condemnation in furtherance of a “carefully formulated program of economic rejuvenation is entitled to [a court’s] deference.”

In Kelo, the City of New London, reeling from the closure of the Naval Undersea Warfare Center in its Fort Trumbull neighborhood, established the public-private New London Development Corporation (NLDC) to redevelop the former Navy base and surrounding neighborhood. The massive redevelopment plan called for the construction of a waterfront conference hotel, 80 new residences and a new U.S. Coast Guard Museum, all organized into a 90-acre “urban neighborhood.” The plan required the purchase or condemnation of 115 privately owned properties. Nine property owners, who collectively owned 15 of the parcels, objected to the redevelopment plan on the grounds that the public private NLDC’s use of the land would not amount to a public use. The Supreme Court found that the redevelopment plan, while not a traditional use of eminent domain, was perfectly acceptable, as the NLDC’s “program of economic rejuvenation” was “carefully formulated” and, therefore, sufficient to constitute a public use. In short, the redevelopment would advance a public purpose and, accordingly, it
was a permissible use of government power to seize private property, regardless of the eventual private use of the land, as New London would benefit from expected economic growth.

Similar stories play out regularly across California and, indeed, the nation. The Kelo decision merely confirms as legitimate what has been occurring in California for years – the condemnation of private property for alternative private use with an expectation of higher economic utilization. The battle over these decisions is only formally confirmed by the Kelo decision to be a political battle at the local and state government level over whether to redevelop and what land will be taken.

Especially in light of the Kelo decision, it is difficult to challenge the government’s use of the power of eminent domain in the courtroom. Successful court challenges typically center on defects in the governmental agency’s procedure. However, those defects are almost always curable, resulting in more delay, not retention of the property.

The battle to avoid eminent domain entirely now must be taken to city hall, not to the courthouse. However, the battles to ensure that property owners receive fair market value for their properties will still be staged in the courtroom. Therefore, 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. It is unusual that the intrinsic value of the property is enough to justify the expense of fighting the condemnation of the property. It is often a wiser
and more cost-effective business decision to concentrate efforts on obtaining the highest level of “just compensation” rather than the expensive and time-consuming process of challenging the seizure itself.

How Is “Just Compensation” Determined?

Both the United States and California Constitutions 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 (including the value of future development plans for the property); and,
(4) Impairment of business goodwill.

These forms of compensation are available, where appropriate, to any property owner whose interest is acquired by a government agency. For example, a business tenant on a property is entitled to compensation for the value of his or her 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” that 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 appraisers. 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. Especially in an active real estate market, the selection of the right appraiser becomes critical. The appraiser needs to be more than just a skilled real estate appraiser; he or she must be able to value improvements and business goodwill, and have sufficient testimonial experience to appear credible in front of the judge or jury making the ultimate determination.

Such preparation is 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 a 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 often entitled to interest and, in certain situations, the recovery of litigation expenses and attorney fees. However, such recovery may be significantly limited.

The Tax Implications of Condemnation – The §1031/1033 Exchange?

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 eminent domain proceedings. While Internal Revenue Code §1031 places significant time constraints on an exchange of investment property when freely chosen by the owner, §1033 extends the time for such an ‘exchange’ to three years from the date of judgment. That extended period is particularly critical in real estate markets like the present one, in which replacement property may be overpriced and often 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 presented by 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.

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