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In a landmark decision that will impact CA real estate investors and catch many people by surprise, on June 29, 2017, the CA Supreme Court affirmed a lower court decision in 926 N. Ardmore Avenue, LLC v. County of Los Angeles, 229 Cal App.4th 1335, which held that the County of Los Angeles is entitled to collect documentary transfer taxes from legal entities that own real property if upon the sale of the ownership interests in the legal entity there was a change in the beneficial ownership of the real property within the meaning of CA Rev & Tax. Code section 64 subd. (c) or (d), even if no document is recorded in the official records of the County referencing the transfer. This holding will significantly impact how investors structure the purchase and sale of real property in California.
All counties in the State of California, and some charter cities, impose a tax on each deed, instrument, or writing by which any lands, tenements, or other realty sold within the county shall be granted, assigned, transferred, or otherwise conveyed to, or vested in, the purchaser or purchasers. The amount of the tax, and the exemptions available vary depending upon where the property is located. The tax is applicable to virtually every interest in real property which can be created and transferred, including undivided fractional interests, non-temporary easements and “long term” leasehold interests. The tax is due and owing on transfer irrespective of whether the transfer instrument is recorded in the country real estate records.
Assuming transfer tax is payable with regard to a particular transfer, determination of the amount owed to the county can be challenging. The Seller must take into account the rules set forth in the county ordinance where the property is located and the City's municipal code, if it also imposes a tax. Some jurisdictions, like San Francisco, expressly impose the tax on the transfer of membership interests in limited liability companies that own real estate and others, like Los Angeles County, do not. The amount of the tax can vary dramatically.
Consider for example, a substantially identical $10,000,000 sale of property subject to $9,000.000 in continuing liens secured by deeds of trust that are located in the cities of San Diego, Santa Monica and Oakland. In San Diego County, the applicable tax rate is $1.10 per thousand, with a deduction for continuing liens. On the transfer date, the Seller would owe the County $1,100.00. For the property located in Santa Monica, the applicable County tax rate is $1.10 per thousand, and the City tax rate is $3.00 per thousand, with a deduction for continuing liens. On the transfer date, the Seller would owe the County $1,100.00, and would also owe the City of Santa Monica $ 3,000.00. With respect to the property located in the City of Oakland, the tax rate is $ 1.10 per thousand for Alameda County, with a deduction for continuing liens, and one and one half percent of the value of the consideration paid for the property, without a deduction for continuing liens, resulting in a total transfer tax of $151,000.00.
Additionally, the City of Oakland, unlike the other jurisdictions listed above, expressly imposes the tax on transfers of interests in legal entities. The City also holds the Buyer and the Seller jointly and severally liable for the tax, tolls all statute of limitations until the City has actual knowledge of the transfer and imposes a lien on the property for the amount thereof, plus penalties and interest, until the transfer tax is paid or discharged in full.
In order to avoid paying transfer taxes in jurisdictions that do not expressly include transfers of legal entities that own real property, and in certain circumstances avoid property tax reassessment,1 Sellers and Buyers have structured the transfers as a sale of interests in the entity rather than as a sale of the real estate. Single purpose limited liability companies are created to hold title to the property; upon receipt of the consideration being paid for the property, the membership interests are transferred to the Buyer.
For example, A and B each own equal interests, as tenants in common, in an apartment building. A and B transfer the apartment building to New, LLC and in exchange A and B each receive 50% of the membership interests of New, LLC. Buyer wishes to buy the apartment building. Instead of executing a grant deed to Buyer that describes the apartment building, A and B transfer their membership interests in New, LLC to Buyer. No instrument describing the transaction is recorded with the County Recorder where the property is located. The County and City will only become aware of the transfer if New, LLC files the required form, BOE-100-B, with the CA State Board of Equalization.
The facts in the Ardmore case are not unusual. Los Angeles County pursuant to Los Angeles County Code, § 4.60.020, imposes a tax on “each deed, instrument, or writing by which any lands, tenements, or other realty sold within the county shall be granted, assigned, transferred, or otherwise conveyed to, or vested in, the purchaser or purchasers.” The County Code contains additional sections that reflect each of the exemptions to the transfer tax described in the Documentary Transfer Tax Act, Rev. & Tax. Code, § 11901 et seq., including partnership exemptions contained in Rev. & Tax. Code, § 11925. Unlike the City of Oakland and other jurisdictions, the County ordinance does not expressly state that the tax may be imposed on transfers of interests in legal entities that own real estate in the county.
Rev & Tax Code sections 480.1, subd. (e) & 480.2, subd. (e) require the filing of a statement of change in ownership whenever there has been a change in ownership of a legal entity within the meaning of Rev & Tax Code section 64, subd. (c) or (d). The form must be filed within 90 days from the earlier of (i) the date of the change in control of the corporation, partnership, limited liability company or other legal entity, or (ii) from the date of a written request to file the form by the State Board of Equalization. This requirement is often missed by owners of property that reside out of state. Failure to submit the form can result in significant penalties.
The Los Angeles County Registrar-Recorder/County Clerk began enforcing collection of documentary transfer tax on unreported legal entity transfers when Rev & Tax Code section 408 was amendedin 2009 (S.B.816) to allow the Board of Equalization to inform the counties of legal entity changes in ownership.
In Ardmore, the owners of the apartment building transferred the property in 2008 from administrative trusts to an LLC. The property was not reassessed because although it resulted in a change in ownership, it was only a change in the method of holding title and not a change in the beneficial ownership of the property.(Ca Rev & Tax Code section 64, subd. (a).) Subsequently, in January of 2009, the membership interests in the LLC were transferred to two trusts. The transfers caused a reassessment of the subject property because they qualified as a change in ownership under Rev & Tax Code section 64, subd. (d).
In 2011, after discovery of the transfer to the trusts, the County Registrar-Recorder/County Clerk sent a bill to the LLC demanding payment of the County's documentary transfer tax. The LLC paid the tax and immediately filed for a refund. The LLC argued, amongst other things, that documentary transfer tax is a levy on written instruments that transfer ownership of real property, not on written instruments that transfer legal entity interests. The County denied the refund claim.
The LLC immediately filed an action which was denied by the trial court. The LLC appealed the decision to the Court of Appeals, Second Appellate District, which affirmed the trial court decision, holding that a county may impose its documentary transfer tax whenever a transfer of a legal entity interest results in a change in ownership under section 64, subd. (d).The LLC appealed the decision to the CA Supreme Court.
Various special interest groups, including but not limited to, the California Taxpayers Association, the California Alliance of Taxpayer Advocates and the Institute for Professionals in Taxation filed briefs in support of the taxpayers, objecting to the imposition of the transfer tax. The primary arguments against imposition of the tax were (i) the 2009 decision to collect taxes on entity transfers was an unlawful expansion of taxes without a vote of the people in violation of Proposition 26; (ii) the tax is an excise tax on recordation of documents and not a tax on transfer of real property; (iii) it was improper to use the definition of “change in ownership” contained in California's reassessment provisions (CA Rev & Tax Code section 60 et seq.)
The CA Supreme Court, in addition to reviewing the model documentary transfer tax act found at CA Rev & Tax Code section 11901 et seq., looked at the definition of “change in ownership” contained in the property tax reassessment provisions of the code (Ca Rev & Tax Code sections 60 et seq.) Under section 60, a “change in ownership” occurs when there “is a transfer of a present interest in real property, including the beneficial use thereof, the value of which is substantially equal to the value of the fee interest.” Although under the reassessment provisions, a transfer of an interest in a legal entity in general does not trigger property reassessment, a reassessment will occur if:
Which is precisely what happened in Ardmore.A proportional interest transfer with no resulting reassessment occurred when the property was transferred from the Administrative Trusts to the LLC. Subsequently, 100% of the membership interests were then transferred to the children's trusts.
In addressing the taxpayers' arguments on the nature of the tax- it is a tax on recordation, not a tax on transferring interests in real property- the Supreme Court disapproved of the comment in City of Cathedral City v. County of Riverside (1985) 163 Cal. App. 3d 960, that “documentary transfer tax is the fee paid in connection with recordation of deeds or other documents evidencing transfers of ownership of real property.” (Id., at p.962.) The court affirmed the holding in Fielder v. City of Los Angeles (1993) 14 Cal. App. 4th 137, 145, which states that transfer tax is an excise tax on the privilege of conveying real property by means of a written instrument.
With respect to the argument by the taxpayer that imposition of the tax on legal entity transfers after 2009 resulted in an expansion of the tax without voter approval, the Supreme Court disagreed. In footnote 14 of the opinion, the court pointed to testimony at trial by an employee of the Recorder's office who testified that taxpayers voluntarily remitted the taxes prior to 2009. All that occurred in 2009, was the release of reporting forms (previously deemed confidential) to the Recorder for the purposes of enforcing its transfer tax act.
Lastly, with respect to the incorporation of the definition of “change of ownership” from the reassessment provisions in the tax code to the transfer tax act, the court took note of the fact that the transfer tax act does not define “change of ownership”. However, it stated that adopting the taxpayer's argument would “elevate form over substance, and conflict with the purposes of the Transfer Tax Act.”
In essence, the court held that the critical factor in determining whether transfer tax is owed is whether there is a sale that results in a transfer of the beneficial ownership of the property. A transfer of the “beneficial interest” in a property occurs when the right to enjoy the benefits of a property is transferred, including the right to occupy a property and the right to receive income produced by the property. Ca Rev & Tax Rulings 462.001, 462.200 and 462.240. Thus, subject to applicable exemptions, if the beneficial interest in the real property is transferred as a result of the legal entity transfer, a transfer tax is due and owing.
As a result of the sharing of information between the BOE, assessors, cities and county recorders, along with strengthened reporting requirements to the BOE, investors should expect to see an increase in investigations by cities and counties on legal entity transfers. Furthermore, if you are in a jurisdiction that imposes the tax jointly and severally against both the Seller and the Buyer (for instance, the City of Oakland) or imposes a lien on the property to secure the payment of the tax, do not be surprised if you receive a tax bill for an entity transfer that occurred long before you acquired an interest in the property. Statutes of Limitation on tax bills, in general, don't begin to run until the taxing authority has actual knowledge of the transfer.
For more information on transfer tax and property tax reassessment, please see the article written by Dena M. Cruz, Partner, Berding & Weil and Scott Rogers, formerly with Rutan & Tucker, entitled “A Practical Guide to Transfer Taxes in California (Spring 2005) 23 Cal. Real Property Journal 13,14 and the article by Dena M. Cruz, entitled “ 2015 Update:Transfer Taxes in California (2015) 33 Cal Real Property Journal 5, 9, cited in the opinion at page 13. Copies may also be obtained by contacting the author at dmcruz@berdingweil.com.
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