Law& Policy: The Transfer Trap

How to avoid excess taxes on real estate sales transactions.

By Edward Mansell

Ed Mansell HeadshotThe practice of imposing transfer taxes on real property transfers has been around for a long time. And for just as long, savvy investors have been structuring real estate transactions as entity sales to minimize the tax burden on the parties involved. In recent years, increased cooperation and exchange of information between county recorders and other branches of government, along with increased budget demands on municipalities and rising property values, have motivated municipalities to find ways to capture tax revenue from entity transfers in the sale of real estate.

Municipalities are continually updating their procedures for assessing and collecting transfer taxes, occasionally to the surprise of taxpayers, and failure to evaluate properly the transfer tax burdens at the structuring phase of a transaction can leave both purchasers and sellers of real estate with substantial and unexpected transfer tax bills.

Taxable vs. Non-Taxable Sales

Real estate transfer taxes are generally assessed when there is a “transfer” (as determined by local statute) of real property, and the tax rates and the calculations thereof are unique to each assessor and governmental entity. Transfer taxes are calculated using the fair market value of the property and purchase price, and are occasionally adjusted based on factors such as the value of any debt assumed. Payment of the transfer tax is negotiated by the seller and the purchaser, and while customs have evolved over the years regarding who is responsible for the payment of transfer taxes, these should be considered at every level at the onset of negotiations. Care should be taken when completing the transfer tax forms to be submitted to the relevant taxing authorities. Don’t leave this task to the title company.

When the seller of real estate directly transfers its interest in the real estate to a purchaser, the transfer is documented by the recording of a deed or other instrument of conveyance, which puts a municipality on notice that a transfer has occurred. With certain exceptions, these transactions will generally be subject to a transfer tax assessed by the local municipality.

“Entity sales” are the less traditional ways of conveying an interest in real property. With a significant number of real estate interests being held by single-asset entities, practitioners have approached the transfer of interests in these entities as alternative deal structures, which may help mitigate transfer tax consequences.

Of course, there are other tax and liability matters that should be carefully evaluated before structuring a transaction as an entity sale, but assuming those risks are acceptable, an entity transfer has been viewed as an effective way to mitigate transfer tax burdens in some jurisdictions. However, these transactions are now under siege, as some jurisdictions have adopted new rules and procedures that could trap the unadvised.

Golden State Strategies

California’s active markets, big-budget demands and skyrocketing real estate values are driving municipalities into the hunt to bag big tax payments from entity transfers. A 2009 change to the California Revenue & Taxation Code gave county recorders in California access to records detailing when entity transfers occurred. Real estate purchasers can face substantial and unexpected transfer tax bills, with penalties that could exceed 25 percent of the unpaid tax amount as well as interest that accrues from the due date.

This change has not been well received by taxpayers. Currently, the issue of what types of transactions may be subject to a transfer tax is pending in front of the Supreme Court of California in 926 North Ardmore Avenue, LLC v. County of Los Angeles. In Ardmore, the owner of real property contested a tax bill assessed by the county of Los Angeles after a transfer of more than 50 percent of the beneficial interests in a single-purpose entity that owned and managed an apartment building.

Ardmore tackles the issue of whether or not certain types of entity transfers may be subject to tax consequences. The specific issue in Ardmore is whether or not the transfer of more than 50 percent of the beneficial interests in the entity that owns the real property constitutes “realty sold” under the California constitution. But the overarching theme is that municipalities are becoming more and more active in pursuing the tax revenue from real estate transactions, and unadvised real estate practitioners could be caught in the transfer tax snare.

Edward Mansell is an associate in the San Francisco Office of DLA Piper. He specializes in the acquisition and disposition of office, industrial, multifamily and hotel properties. He also represents owners and tenants in leasing transactions. This article originally appears in the October 2016 issue of CPE, the Energy Issue.