Deciphering the Tax Status of Leased Property

The County appealed, arguing that the cattle ranching property was not agricultural under Arizona law because it did not meet all of the four criteria for classification as agricultural grazing land under Arizona Revised Statutes (A.R.S.) sections 42-12151 to 12152. Those criteria are:

1. That the grazing land has a carrying capacity of at least 40 animals and the number of animals there is economically feasible;
2. That the property is being used for agricultural purposes, and for at least three of the previous five years it has been in active production as such under generally accepted agricultural practices;
3. That the property has a reasonable expectation of operating profit from its agricultural use; and
4. That the property, if consisting of noncontiguous parcels, is managed and operated on a unitary basis, with each parcel making a functional contribution to the agricultural use of the property.

The County conceded that the property leased to Bush had a carrying capacity of more than 40 animals, so the first of these criteria was not in issue. However, it objected to the lower court's findings on the remaining elements.

Active Use for the Requisite Number Years

Arizona Revised Statutes, section 42-12152(A)(1), requires that, to qualify as agricultural land for tax purposes, a property must be in active agricultural production for three of the previous five years under generally accepted agricultural practices. The court noted at the outset that the grazing of livestock is considered "active production."

Here, the tax year in issue had a valuation date of Jan. 1, 2013, making the "previous five years" of interest 2008 to 2012. With this in mind, the appellate court found that the evidence supported the tax court's finding that the property met the requirement. Why? Because Bush ran his own cattle on the land in 2008, and his sublessee ran cattle there in 2011 and 2012. Additionally, failure to use an agricultural property as such in one of the five years is excused under Arizona law if an act of God prevents it (see, A.R.S. section 42-12152(A)(1)(a); here, drought in the years 2009 and 2010 represented such an act of God, so one year of failure to use the land for agriculture was excused.  Therefore, the property was "actively in production" as a grazing location, or was permissibly inactive because of an act of God, for four of the previous five years.

Proof of Profitability

On the question of the profitability of the landlord's parcel, the tax court had granted him partial summary judgment after he submitted his own affidavit attesting that the property was "actively producing with an expectation of profit." The tax court accepted this affidavit as positive proof because, in 2012, the State Legislature had added to its code section 42-12152 subsection (C), which provides that the reasonable-expectation-of-profit requirement "shall be satisfied if the owner files with the assessor an affidavit of agricultural use, signed by the owner attesting that all information in the affidavit is true and the property is actively producing with an expectation of profit." (Emphasis added.).

In challenging this grant of partial summary judgment, the County argued that although the 2012 legislative change directed the tax authorities to accept a landowner's affidavit as to the profitability of an alleged agricultural property as definitive proof, this was not what should happen here because other rules of statutory construction dictated a different outcome. Specifically, the County argued that the court should not accept the landowner's affidavit because of:

1. The absurdity doctrine (allowing judges to deviate from a clear statutory mandate when the outcome of its dogged application to a particular case would be absurd);
2. Arizona Rule of Evidence 602 and Arizona Rule of Civil Procedure 56(e), which set out the minimum requirements for evidence that the court is allowed to consider;
3. The need to avoid impermissibly binding the judicial branch; and
4. The unfair tax advantage this landlord gained over other landowners who did not submit an affidavit declaring their land's expected profitability.

The appellate court was not swayed by the County's arguments, explaining that they must be unavailing "in the face of clear and mandatory statutory language stating that the reasonable expectation of operating profit requirement "shall be satisfied" if the owner signs and submits the appropriate affidavit. Citing to the decision in Butler Law Firm, PLC v. Higgins, 243 Ariz. 456 (2018), the court concluded that because the landowner filed the proper affidavit, and because the statutory language was clear that this action alone would suffice to meet the requirement of showing the land's profitability as an agricultural enterprise, "we apply the plain meaning [of the statute] and our inquiry ends." In other words, there was no wiggle room in the statute for declaring an affidavit of agriculturally-generated profit untrue; the affidavit's very existence in the court record is enough to prove the profitability element of the "agricultural" designation.

The court opined that the state legislature must have intended this outcome because it could have dropped the profitability component completely from the criteria for declaring a tract agricultural grazing land, or it could have done as it did here and made the manner of proof easy (or, presumably, it could have gone further and required additional proof). The Arizona legislature chose one means of proof and that means must be respected, the court found.

The appellate court noted, however, that the County had a remedy at its disposal should it discover that the landowner's affidavit was inaccurate. It is set out in A.R.S. section 42-12157, which provides in pertinent part, that: "If an owner of property or the owner's agent intentionally provides false information on an application form, … [t]he property shall be reclassified immediately as being used for a nonagricultural use[,] … [t]he owner is liable for the additional taxes[,] … [and t]he owner shall also pay a penalty …." The court observed, therefore, that "if the County is concerned that a taxpayer has filed a fraudulent affidavit, the County can take remedial action," but "in classifying property for tax purposes, the County cannot ignore the directive of A.R.S. section 42-12152(C) that the affidavit satisfies the reasonable expectation of operating profit requirement."

Functional Contribution of the Property to the Cattle-Raising Agricultural Use

The appeals court noted that under section 42-12152(A)(3), property consisting of noncontiguous parcels must be managed and operated on a unitary basis, with each parcel making a functional contribution to the agricultural use of the property. Both parties to the appeal agreed, therefore, that because lessee Rancho Asueno is composed of noncontiguous parcels, including the property in issue here, that to obtain agricultural classification the property that had been leased to Bush must make a functional contribution to the agricultural purposes of Rancho Asueno.

So, the first question for the court was, how is a "functional contribution" defined? And, since the statute does not give a definition, the court turned to the Arizona Department of Revenue's Agricultural Property Manual (2012) (Manual). The Manual defines a "functional contribution" as a "positive economic benefit derived from the agricultural use of an individual parcel of land that is incorporated into an agricultural operation." Manual at 1.8. Further, it states that a parcel of land can make a functional contribution to the agricultural use of the property through "common management, combined production, or by simply facilitating the movement of … agricultural commodities from one parcel to another within the operation." Id. It was here that the County sought to peel away the property's agricultural-use designation.

Tenant Bush managed the leased property in tandem with his other parcels of land, so the common management requirement was met.

On the "functional contribution" question, the County argued that Rancho Asueno got no agricultural benefit from the leased land because the sublessee was using it rather than Bush and his ranch operation. In response, Bush testified that when he sublet the leased property to a sublessee he ensured that the land would remain at his disposal to graze the Rancho Asueno cattle should an event like low rainfall ever make forage on his other properties scarce. This, the landlord and tenant asserted, contributed to Rancho Asueno's overall ranching operation, satisfying the "functional contribution" factor.

The County's counter-argument that this "possible use" of the land by Rancho Asueno, at some time in the future, was merely speculative got nowhere with the appellate court, which pointed out that "the test for functional contribution is not limited to use by the property owner; it focuses on whether the agricultural use of the land provides a positive economic benefit. See, A.R.S. section 42-1215(A)(3); Manual at 1.8. And the testimony at trial was that sublessees grazed cattle on the Property and that Rancho Asueno benefitted from the subleases." In other words, it does not matter who benefits from the agricultural use of the property, it only matters that the agricultural use of the property provides a positive economic benefit to someone.

Leasing to a Party Involved in an Enterprise Subject to a Special Tax Category

From a commercial leasing law perspective, the County's argument that the sublessee's agricultural use of the property was of no use to the landlord as taxpayer was one of the most interesting of the case. The County pointed out that neither the landlord nor the lessee had used the property for the agricultural purpose of grazing since 2008. Since 2011, the land had been sublet to another party, which the County argued was a commercial transaction for the landlord and lessee, the agricultural activities of the sublessee being too far removed from them for any agricultural purpose to be attributed to the landlord's use of the property.

For this argument, the County relied on Krausz ex rel. KGC Trust 1 v. Maricopa County, 200 Ariz. 479, (App. 2001), a case in which a landlord/taxpayer leased a building to the Arizona Department of Environmental Quality, a government entity. The property was assessed for tax purposes at the commercial property rate, and the landlord objected. That assessment was upheld by the courts because Arizona Revised Statutes 42-12002(12) stated that any property put to a commercial use must be taxed as a commercial rate unless the property is specifically given another classification under the law. A property used for a government purpose was not a specific carve-out under Arizona law for tax assessment purposes, so the commercial property designation was upheld in Krausz. The County took from this case that leasing a property to another makes that property a commercial one, no matter what purpose the tenant puts it to. The appeals court disagreed, distinguishing Krausz by pointing out that "agricultural use" is a specific category carved out for special tax treatment under Arizona law. Thus, because the use of the property was agricultural, that is what controlled, not the presence of a lease or a sublease situation.

Conclusion

Each jurisdiction's laws will differ, with different tax schemes being applied to vacant, blighted, residential, agricultural and commercial properties, among others. The significance of the tax category a property falls into can be huge, and tax assessors and property owners will often disagree. The existence of a landlord/tenant situation can confuse things, as we saw here in Krausz, because the use to which the tenant puts the leased property might, or might not, affect its tax category. Care should be taken to understand the tax code in a property's jurisdiction so that a landlord whose tenant uses the property for a purpose that receives favorable tax treatment reaps the advantages of that fact when it comes to tax time.

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Janice G. Inman is Editor-in-Chief of this newsletter.