On June 5, 2018, the voters of San Francisco passed Proposition C (Commercial Rent Tax for Childcare and Early Education), which imposes a new gross receipts tax (Childcare Tax) of 3.5% on rentals of "commercial space" in the City of San Francisco with a reduced 1% tax on rentals of "warehouse space." The tax proceeds will be used to fund early care and education for young children. The city already collects a gross receipts tax on many businesses operating in the city, which is a tax based on total gross revenues (as opposed to profits) that a business receives from operations within the City and County of San Francisco limits. Taxable revenues include rents from leasing commercial property such as office buildings, warehouses, industrial spaces and retail spaces.

The new tax is in addition to the existing tax on gross receipts, which is a progressive tax ranging from 0.285% to 0.3% (0.285% for gross receipts between $0 and $5 million and 0.3% for gross receipts above $5 million). In 2021, a new marginal rate of 0.325% will commence on gross receipts at the $25 million level. Effectively, the Childcare Tax will increase the 2019 "all-in" gross receipts tax rate for commercial rent income to 3.785% or 3.8% for most types of commercial space. The Childcare Tax will become effective on January 1, 2019.

The Childcare Tax will not apply to businesses with $1 million or less in total gross receipts. In addition, the Childcare Tax will not apply to rents from the following:

  • leases to retail spaces (except for formula retail spaces such as Rite Aid, Blue Bottle Coffee and Chipotle);

  • leases for "industrial use," which includes, for example:
    • agricultural and beverage processing;
    • automobile assembly;
    • manufacturing;
    • storage yard (storage of building materials or lumber, stones or monuments, livestock feed or contractors' equipment if stored within an area enclosed by a wall or concealing fence not less than six feet high; does not include vehicle storage or hazardous waste facility);
    • volatile materials storage (bulk storage of inflammable, highly combustible or explosive materials);

  • leases to "arts activities" spaces, which include, for example, studios, workshops, dance schools and art-related business service uses;

  • residential real estate where the primary use is for the purpose of dwelling, sleeping or lodging (other than as part of the business activity of accommodations);

  • nonprofit organizations that are leasing spaces as commercial landlords; or

  • leases to nonprofit organizations or to federal, state or local governments.

As noted above, "warehouse space" is subject to a reduced Childcare Tax rate of 1%. "Warehouse space" means commercial space that is used for commercial storage (i.e., storage in an enclosed building for contractors' equipment, building materials or goods or materials used by other businesses at other locations) or for wholesale storage (i.e., storage in an enclosed building for wholesale merchandise that is not accessory to a wholesale sales use). "Warehouse space" also includes storage yard spaces and volatile materials storage spaces, but, as noted above, those types of spaces are exempted from the Childcare Tax.

The "combined return" rule applicable to the existing gross receipts tax applies to the Childcare Tax as well. A person subject to the Childcare Tax must file a gross receipts tax return for all of that person's related entities on a combined basis. A person is a "related entity" to a taxpayer if that person and the taxpayer are permitted or required to have their income reflected on the same combined tax filing in California. The Childcare Tax returns are to be filed at the same time and in the same manner as returns filed for the existing gross receipts tax.

The Childcare Tax is likely to add a significant additional burden (estimated by the city controller to be approximately $146 million annually) on commercial property owners. Buyers in pending transactions should take note and should revisit their underwriting. Borrowers subject to existing debt service coverage ratio requirements should also be aware. Finally, landlords should review the terms of their leases and determine whether the lease terms would allow them to pass through the additional tax expenses to their tenants. Depending on the terms of the lease, the increased taxes may be passed on to tenants as an operating expense. A well-drafted "operating expense" definition may state that the tenant is responsible for all "foreseeable or unforeseeable" taxes imposed by the government on the rent under the lease. On the other hand, tenants who are negotiating new leases or given the opportunity to re-negotiate their current leases should consider negotiating for language that entirely or partially carves out the Childcare Tax from the definition of "operating expenses" that can be passed through to the tenants.