The Forgotten Factor, Part II — The Property Factor

Having addressed the continuing influence of the payroll factor in approximately 23 jurisdictions, it’s time to address the continuing influence of the property factor, which for tax years commencing in 2020 is used in the apportionment formulas of 20 states. Those states are Alaska, Alabama, Arkansas, Arizona,¹ California,² Florida, Hawaii, Idaho, Kansas, Massachusetts, Maryland, Montana, North Dakota, New Hampshire, New Mexico, Oklahoma, Tennessee, Virginia, Vermont, and West Virginia. While the State of New York does not use a property factor in its apportionment formula, both New York City and the Metropolitan Commuter Transportation District use a three-factor formula that includes a property.

The History of the Property Factor Under UDITPA

The Uniform Division of Income for Tax Purposes Act was approved and recommended for adoption by the National Conference of Commissioners on Uniform State Laws in 1957. The purpose of UDITPA was to address the division of income of a multistate business among the states that had the power to tax a portion of that income.³ Most states adopted UDITPA through adoption of the Multistate Tax Compact. Inclusion of a property factor in the apportionment formula was intended to reflect the income-producing nature of invested capital in a state.

The current Multistate Tax Commission’s audit manual defines the property factor as “a fraction, the numerator of which is the average value of real and tangible personal property owned plus the capitalized rental real and tangible personal property used in the production of business income in-state and the denominator of which is the average value of all of the owned real and tangible personal property plus the capitalized rental property used in the production of business income during the tax period.”⁴ A review of this definition reveals nuances that many practitioners may not be aware of.

Valuation of Property

How should property be valued? Most states value owned property using original cost; a few, such as Mississippi, value property at book value.⁵ Others, such as Florida, Kansas, and West Virginia, permit property to be reported at net book value if the original cost of the property cannot be determined.⁶ The selection of valuation method is arbitrary.

What is the date of valuation? Most states value property using an average value during the tax year, which is generally computed by averaging beginning and ending values.⁷ Some states, however, reference value of inventory in accordance with the taxpayer’s valuation method used for federal income tax purposes.⁸ This can be a challenge for assets acquired in an asset acquisition, as it will be necessary to obtain information regarding the original cost of the assets. The MTC audit manual notes that “if significant property is added during the latter part of the year, the averaging by monthly values may be necessary to reflect the average value for the income year properly. Significant acquisitions or dispositions of property, which can cause material fluctuation, should be accounted for by weighted-averages.”⁹

Treatment of Goods in Transit

The treatment of goods in transit is an element of the property factor that is often overlooked. Alaska, Alabama, California, Florida, Idaho, Kansas, Massachusetts, Maryland, Missouri, Mississippi, Montana, North Dakota, New Mexico, Tennessee, and Utah require goods in transit between a taxpayer’s locations to be included in the taxpayer’s property factor based on the state of destination.¹⁰ In Vermont, this provision applies only to goods in transit between points in the state; goods in transit between a taxpayer’s in-state and out-of-state points is only included in the denominator of the property factor.¹¹ For goods in transit between a seller and buyer, the states of Arkansas, Idaho, Massachusetts, and Vermont require such goods to be included in the property factor numerator based on destination if such value is also included in the denominator of the factor.¹²

Treatment of Mobile Property

Mobile property — generally considered to be titled motor vehicles, rolling stock, vessels, aircraft, trailers, and other movable property — is often subjected to specific provisions, which acknowledge the highly movable nature of the property, as well as to limit tax planning opportunities.

The general rule is that mobile property is included in the numerator of the property factor based on the time spent in the state during the tax year. For large pieces of mobile property such as construction cranes, which are often at a job site for a long period of time, this is usually not difficult to track. For more mobile property, such as road construction equipment, tracking can prove to be challenging. Using bar coding and advanced means of electronic tracking, location information is now more easily captured by sophisticated technology systems and also used for purposes of inventory and loss control and logistics planning.

Some states provide additional provisions. In Arizona and Utah, if income generated by mobile property is allocated, non-allocable, or exempt, then the property will be excluded from the numerator of the property factor.¹³ In Hawaii, the numerator of the factor will be the average value of property in the state during the tax year, regardless of whether the property is owned, rented, or used.¹⁴ The states of Maryland and Mississippi do not include mobile property in the property factor.

Not all states look to the property’s percentage of time spent in the state. Louisiana and Oklahoma use the percentage of mileage that occurs in the state, rather than the time the property is present in the state,¹⁵ while Massachusetts apportions based on “in-state use” to use everywhere — a notable distinction from merely being present in a state.¹⁶

Treatment of Real Property

Real property is includible in the property factor, as would be expected, although, again, there are nuances. Most states’ statutes contain an indirect exclusion by language that excludes real property from the property factor if it does not meet the “used during the income year to produce business income” requirement of the statute. The statutes of Arizona, North Dakota, and Utah provide additional language stating that if income from such property is specifically allocated, non-allocable, or exempt, the property is excluded from the numerator.¹⁷

Some states expand on the inclusion of real property. Massachusetts includes the value of leases and improvements of real property, whether located in or out of state. New Mexico provides that property is included in the factor regardless of whether it is actually used in the state — as long as the property is available or capable of being used in the regular course of the taxpayer’s business during the year, the property will be included in the factor. This includes properly held as reserved or standby facilities.¹⁸ Additionally, leasehold improvements will be treated as if owned by the owner of the property, not the user of the leasehold improvements, regardless of the owner’s actual use of the improvements or whether the owner is entitled to the improvements upon the expiration of the lease.¹⁹

Property under construction during the year is generally excluded from the property factor until it is put into use, which is primarily considered to be the date a temporary certificate of occupancy is granted. Some states provide additional exclusions, such as for property used in qualified research and development activities.²⁰

Treatment of Tangible Personal Property

Tangible personal property owned by a taxpayer is generally included in the property factor to the extent that the property is used during the tax year to produce business income. Like their treatment of real property, Arizona, North Dakota, and Utah exclude tangible personal property from the factor if income from the property is allocated, non-allocable, or exempt.²¹ Florida’s exclusion for R&D property extends to tangible personal property as well.²²

Assets that are depleted over time, such as oil and gas reserves and mineral deposits, are usually included in the property factor at original cost, with no reduction made for depletion. The treatment of intangible drilling costs expensed for federal tax purposes varies from state to state, and expenses that have been capitalized for federal tax purposes will generally be included in the original cost basis.

Treatment of Intangible Personal Property

Many states include the value of intangible personal property in the computation of the property factor, primarily for financial institutions. An exception is provided for goodwill. Intangible personal property includes cash or currency, loans, repurchase agreements, installment obligations that were applied for in the state, credit card receivables from customers in the state, and securities used to maintain required balances for federal or state deposit requirements.

For corporate partners of a partnership, the partnership’s real and tangible personal property used during the year in the regular course of its business will flow through to the corporate partner to the extent of the corporation’s interest in the partnership.

Treatment of Rented Property

The treatment of rental property can be delineated between real property and tangible personal property. Many states follow the convention that rented property is valued at eight times the net annual rental rate.²³ Why is that? This historical formulation has been used by rating companies to assign an obligation value to operating leases (noncapital) whose costs flowed through the income statement, but for which there is no balance sheet liability, even though the obligations cannot easily be discharged.²⁴ In 2016 the Financial Accounting Standards Board issued Accounting Standards Update No. 2016-02, Leases (Topic 842).²⁵ Under generally accepted accounting principles, a lessee must determine whether a lease is an operating or a finance lease. Both types of leases require a lessee to record a right-of-use asset and a lease liability on the balance sheet.²⁶

However, the income statement presentation is different. For an operating lease, the lease cost is allocated on a straight-line basis over the lease term. For a finance lease, interest on the lease liability is recognized separately from the asset amortization. Typically, lease expense is higher in the earlier years of the lease term.²⁷ Despite this change to recognize a balance sheet entry for the financial reporting of leases that is now fully effective for both public and nonpublic entities, the valuation assigned to leases for state property factor purposes has remained stagnant and does not recognize the new valuation method adopted under GAAP or international financial reporting standards.

While the average value of property is generally determined by averaging beginning- and end-of-year values, some states grant discretionary authority to the taxing authorities to require an averaging of monthly values if it is reasonably required to properly reflect the average value of the taxpayer’s property.²⁸ And some states will exclude from rental costs advanced rent and depositions and service charges that are separately applied. Income from sub-leases are usually not deducted in determining annual rent expense.²⁹

Conclusion

As always, real life is more complicated and complex than it may appear, and the computation of the property factor is no exception. In the continued advancement of states to move to the use of a single sales factor, it is easy to forget the impact and nuances of the property factor.