Keep Data Center Taxes Cool in a Hot Market

Benjamin Blair is an Attorney with the law firm of Faegre Baker Daniels LLP.

As more of our financial and personal lives run through digital networks, skyrocketing demand for data centers has developers racing to deliver new supply. Private equity and REIT financing are fueling rapid growth amid highly publicized merger and acquisition activity. But when the public’s eye turns to the high prices in these transactions, the taxing authorities are rarely far behind.

Prudent developers and investors are keenly aware of the many business incentives available for new data centers, from hiring and training inducements to abatements and sales tax exemptions for new equipment. The ongoing expense of ad valorem property taxes is often overlooked, but neglecting opportunities to curtail excessive assessments can become a costly mistake. Aside from the cost of financing and energy, property taxes tend to be the highest recurring expense of owning a data center.

Tax assessors often lack expertise in the data center market, and the unusual nature of these properties makes valuation using common assessment processes difficult. Further, because of constant change in the sector, even well-intentioned assessors may use outdated market data, which can reflect a misleading balance of supply and demand.

As a result, assessors often fail to properly value the real estate component of the property, forcing operators to pay more than their fair share of taxes. Knowing the ways that assessors commonly overstate the value of data center real estate can arm operators and developers with the tools to reduce this burden.

Constant Evolution = Rapid Obsolescence

Most jurisdictions initially assess data centers using a replacement cost estimate, less depreciation. When assessors see construction permits with tens or hundreds of millions of dollars in estimated costs, they often believe that those figures are the appropriate value for assessment purposes. But the assumption that construction cost equals taxable market value is usually wrong.

Data centers built by owner-occupants can reflect costs and features that are valuable to that user but atypical in a speculative project, or lacking value to the market. Further, the initial cost of developing a data center often captures expenses that do not add real property value. Personal property and intangible assets may be built into the construction costs, but should not be included in the assessment.

Assessors often understate depreciation because the depreciation schedules they commonly use lack data center categories. It is a mistake to apply depreciation factors designed for warehouses, light industrial or other property types, because those may have much longer economic lifespans than data centers. Short-lived mechanical and electronic components might represent 10 percent to 20 percent of cost in a typical building, but are often 50 percent in a data center. The assessor must accelerate depreciation to reflect the proportion of the property that is short-lived.

Data centers are exposed to more obsolescence than other property types because their design and construction has evolved to provide 100 percent uptime and ever-greater reliability. The cost to retrofit legacy data centers to accommodate cutting edge technology is almost always greater than the cost to build new, and this forces older facilities to go down-market in search of tenants.

Other external factors that can affect value include fluctuations in electricity prices, which can make a facility less competitive. In many markets, the extensive incentive packages provided for new data center development can create such a preference for new construction that it diminishes the resale value of existing centers. This obsolescence must be removed from the value for property tax purposes.

Isolate Real Property

The distinction between real and personal property is critical for taxation because ad valorem property taxes apply only to real estate, not to personal property and intangible assets. Taxing the value of the entire going concern instead of just real estate will lead to the taxation of non-taxable value or, worse, the double taxation of personal property.

For that reason, it is important to recognize the difference between permanent structures and fixtures that do not qualify as real property. Assessors often add to real estate assessments items of personal property such as underground cables, fire suppression technology and cooling systems, but these may not qualify as real property components. If an item is included on a personal property tax return, its value should never appear as part of the real property.

Likewise, assessments must exclude intangible assets and business value. This value is more than just trademarks and software; any value created by the operator’s business – including power procurement strategies and agreements, environmental permitting, and even the value of assembling utility access and colocation benefits – is exempt and must be excluded from the real property assessment.

An Ounce of Prevention                                                                                                                                             

Although most jurisdictions discourage tax assessors from “chasing sales” of real estate to set assessments, increasingly large sale prices can be too tempting to resist. Sale prices are rarely pure real estate transactions, however, making reliance on such prices suspect. Further, many transactions are not at market levels and are therefore inapplicable for tax purposes.

Nevertheless, because assessors often key off recent sales prices, it is incumbent on purchasers to identify and segregate the value of the real estate. Buyers must ensure the recorded deed and transfer taxes reflect only real property value, not the entire transaction price. One option is to commission an independent study, which will be most effective if produced prior to closing and before the value is reported. Ambiguity will almost always be construed in favor of a higher assessment for tax purposes.

Data center owners should regularly evaluate their portfolios to determine whether opportunities exist to reduce property taxes. When discrepancies appear, owners who aggressively challenge the assessment will improve the profitability of their investments.

Opinions expressed in the article above do not necessarily reflect the opinions of Data Center Knowledge and Informa.

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