Revise the Property-Tax Exemption

Most states grant property-tax exemptions for charities, wisely or not. The list is long: Many of us are born in tax-exempt hospitals and are buried in tax-exempt cemeteries. At a time when cities and states are struggling to balance their budgets, however, lawmakers should take a hard look at these exemptions, which largely benefit charities located in cities. When tax rates were low and cities were thriving, broad, generous, wide-reaching exemptions were acceptable. They are not today.

The property tax–exemption system around the country is a crude and inequitable approach to a difficult problem, one that needs innovative ideas that fairly balance the needs of nonprofit groups and municipal governments.

If I were a legislator, I would grant an exemption only if the activity or service were one that the government would have to perform if a private entity did not, and even then, only if the exemption were required to provide the service to all needy people. Of course, opinions will differ about where on a continuum particular activities fall. Strong candidates for tax exemption under my criteria, for example, would be the Red Cross, the Salvation Army, hospitals that treat the indigent, and libraries. Strong candidates for denial might include property owned by medical, dental, or bar associations. An apartment building owned by a hospital and rented to interns and residents would not present a very strong case for exemption, though such buildings are currently exempt in some states.

Assuming that some subsidy, in the form of an exemption from taxes, is in order, which level of government should provide it? Many of the laws that govern property-tax exemptions had their origins in the 1800s, a time when a nonprofit group was probably located in the city whose residents it served. But the growth of the suburbs and individuals’ increased mobility have produced a situation in which many of the benefits and services generated by tax-exempt organizations in urban areas are provided to residents of other jurisdictions. Where is the justice in state laws that force a city to subsidize those who live in the suburbs?

That injustice is recognized in many cases for property owned by the state. The state provides municipalities with payments intended to offset the revenue lost because of state-owned property. Although those payments may represent only a small percentage of the lost property-tax revenue, the state at least recognizes the unfairness of forcing certain municipalities to subsidize state government. Why not recognize the unfairness of forcing certain municipalities to subsidize another state objective: the encouragement of nonprofit activities?

If a subsidy is to be provided to certain organizations, what form should it take? The present treatment, an exemption from property taxes, is probably one of the least rational methods. Consider the case of two organizations: One is struggling financially and can afford only to rent office space; the other is well established and known for its generous salaries and opulent headquarters on prime downtown real estate. Has the state consciously chosen to ignore the struggling organization, but to grant a tax subsidy to the less-needy organization? Has the state consciously chosen to increase its subsidy in proportion to the land and buildings an organization owns?

Many more irrationalities exist, so it would probably be better to replace property-tax exemptions with an explicit cash subsidy. If a system of cash grants were adopted, I have no doubt that states would narrow the existing law to channel money only to the neediest organizations. But if they would not be willing to grant a cash subsidy in the same amount and to the same organizations that are now benefiting from property-tax exemptions, why should the existing system be continued? Is it because the local jurisdictions are footing the bill?

While wholesale changes in the law are probably not likely, understanding the defects in the existing system helps identify areas in which a better balance can be reached among the interests of tax-exempt groups, cities, and states. Here are some options, some of which would make a big difference in the status quo, and others less so:

* Require the permission of the local jurisdiction before any taxable property can be bought by a tax-exempt organization. That would give decision-making power to the level of government that bears the cost of the exemption and is the approach often used with exemptions granted to industrial and commercial property.

A municipality would be free to evaluate whether the presence of a particular institution was worth granting an exemption. The analogy with commercial property is useful in highlighting another similarity. States pay the cost of attracting businesses by shouldering the loss of tax money; they don’t expect local jurisdictions to do so. Why should a similar approach not be used for hospitals, colleges, and other organizations that serve the public?

Another benefit of the approach is that it allows jurisdictions to exercise rational land-use planning. For example, a city could refuse to allow a tax-exempt organization to buy property in the heart of the financial or shopping district, but welcome expansion into an area undergoing urban renewal. Furthermore, permission to expand could be based on the condition that a nonprofit group promise to create new jobs, expand affirmative-action programs, or undertake other efforts that are priorities of the city. Proper safeguards could provide that the benefits of the tax exemption would be paid back to the city if these conditions were not satisfied.

* Phase in the tax exemption when taxable property is bought by a tax-exempt organization. Doing so would cushion a jurisdiction against an abrupt decline in revenue in the year of purchase. This approach would be feasible for established organizations, but it would be improper to phase in the exemption for property bought by a newly created organization. During the start-up period, an organization is likely to be short of funds and thus most in financial need.

* Phase out the exemption. A time limit would enable new organizations to get started without the burden of the property tax, and would also recognize the jurisdiction’s interest in not being burdened with a perpetual exemption. A specific phaseout date would allow an organization to plan adequately for the eventual imposition of the property tax.

* Limit the number of acres qualifying for the exemption. This approach attempts to balance the interest of the tax-exempt organizations against the revenue loss incurred by the jurisdiction. An acreage limit recognizes that once some reasonable level of property ownership has been exempted, further expansion should not be at the expense of the local government.

* Set a dollar limit on the amount of property that can be exempt. Owning property in excess of the ceiling indicates that the organization has sufficient ability to pay that does not justify any further exemption.

* Impose a user charge. Such a charge recognizes that tax-exempt organizations consume local services and should, therefore, contribute to the costs of local government. Taking this approach would end the discrimination that currently exists between tax-exempt groups in jurisdictions that have user charges and those in jurisdictions that finance similar services through the property tax. More important, a service charge removes the incentive for a tax-exempt group to hold on to vacant or idle land that it no longer needs, a tendency that a land-starved city can ill afford. A user charge will also curtail the incentive for tax-exempt organizations to overinvest in real estate. This approach should therefore result in a more efficient allocation of resources.

* Require states to make payments to jurisdictions containing tax-exempt property. It is unfair for a city or town to bear the entire loss in property taxes caused by tax-exempt property. To channel state funds where they are needed most, payments might be made to localities that have more than the statewide average of tax-exempt property. Alternatively, jurisdictions might be reimbursed not for all their tax-exempt property, but only for the amount in excess of the statewide average.

Those options are not mutually exclusive, nor is there any reason to apply the same approach to all categories of property. What is most important is that we jettison approaches that don’t work, especially those that eviscerate the city governments that so many Americans depend on for both essential services and a high quality of life.

Richard D. Pomp is the Alva P. Loiselle Professor of Law at the University of Connecticut. This article is adapted from his essay in

Property-Tax Exemption for Charities: Mapping the Battlefield, published last month by Urban Institute Press.