Unless there is an exception, sales of real estate in Pennsylvania are subject to a realty transfer tax. The tax is payable to three jurisdictions – the Commonwealth of Pennsylvania, the municipality, and the school district. The total tax due is usually 2 percent, of which 1 percent is collected by the state, while the municipality and school district each collect 0.5 percent. However, the rate of the tax due to Philadelphia and certain municipalities and school districts in Allegheny County can be higher than 0.5 percent, with the combined rate applicable to sales in Philadelphia and the City of Pittsburgh being 4 percent.
Many of the more valuable parcels of real estate in Pennsylvania are in either Philadelphia or Pittsburgh, so the 4 percent transfer tax rate applicable in those cities has provided real estate professionals with an incentive to structure transactions that are exempt from the tax. Until 1986, sales of valuable real estate owned by single-asset entities were often structured as transfers of interests in the owning entity instead of the real estate itself. Realty transfer taxes were not due because it was not a sale of real estate, but rather the intangible sale of stock. This opportunity ended when the law was changed to extend the realty transfer tax to any transfer of 90 percent or more of the interests in a “real estate company” within a three-year period. A “real estate company” is defined as any entity primarily engaged in the business of holding, selling or leasing real estate, 90 percent of which is held by 35 or fewer persons, which either (i) received “60 percent or more of its annual gross receipts from the ownership or disposition of real estate;” or (ii) owned realestate, the value of which comprises “90 percent or more of the value of its tangible assets exclusive of tangible assets which are freely transferable and actively traded on an established market.” In Philadelphia, the definition is modified and you only need the entity to have 50 percent of its value in real estate, and it includes an entity that owns 90 percent or more of the interests in a real estate company.
It was not long after the tax was extended to real estate companies that the so-called 89-11 transaction was devised. In such a transaction, a seller immediately conveys 89 percent of its interests in a real estate company, with the remaining 11 percent subject to an option that can be exercised by the buyer one day after the three-year period ends. The option price is set so that it is very unlikely that it will not be exercised. After the Pennsylvania Department of Revenue determined that such a transaction was not subject to realty transfer tax under the existing statute and regulations, the department proposed new regulations that would have clearly made 89-11 transactions to transfer tax. The proposed regulations were never adopted.
House Bill 761 of 2012, which was adopted on June 30, 2012 as part of the budget package, made numerous changes to Pennsylvania taxes, including a change affecting the taxability of 89-11 transactions. Section 12 of the bill provides that to determine if more than 90 percent has been transferred within the statutory three-year period, any transfers of interests in a real estate company will be deemed to have occurred within that period, even if the transfer is made after the period, provided all of the following conditions are met:
- the transferring party provides a legally binding commitment, enforceable at a future date, to execute the transfer
- the terms of the transfer are fixed and not subject to negotiation, and
- the transferring party receives full consideration, in any form, in exchange for the transfer.
This change will apply to transactions that occur after January 1, 2013.
It is unlikely that a buyer and seller would agree to structure a sale where condition (ii) was not met. Conditions (i) and (iii) however, both raise issues. With respect to condition (i), reasonable minds may disagree as to whether the seller has provided a legally binding commitment if the seller has provided an option. With respect to condition (iii), if the tax that otherwise needed to be paid were high enough, a seller might decide it was worthwhile to wait to receive “full consideration” until after the end of the three-year period. Indeed, currently many transactions are structured so that the consideration paid for the 11 percent interest is not received until after the end of the three-year period. The 89-11 transaction may not be dead.
House Bill No. 761 also passed a new Historic Preservation Incentive Tax Credit (the “Historic Tax Credit”). Beginning on July 1, 2013, a taxpayer may apply to the Department of Community and Economic Development (DCED) for a Historic Tax Credit Certificate, which shall be equal to 25 percent of the “qualified expenditures” determined by the Pennsylvania Historical and Museum Commission (Commission) to have been incurred by a taxpayer that owns a “qualified historic structure.” The DCED, the Department of Revenue (DOR) and the Commission are charged with developing written guidelines for the implementation of the Historic Tax Credit. In defining the terms “qualified expenditures” and “qualified historic structures,” and the other provisions, the DCED, DOR and Commission may liberally rely on definitions contained in the Internal Revenue Code of 1986, as amended, Code Section 47, in particular 47(c) (2) and (c)(3). The DCED shall not grant more than $3 million in Historic Tax Credits in any fiscal year and shall not grant more than $500,000 in Historic Tax Credits to a single qualified taxpayer in any fiscal year. The Historic Tax Credit may be carried forward for seven years but may not be carried back or create a refund. The taxpayer may sell the Historic Tax Credit with the approval of the DCED, but such assignee must use the credit in the year of the sale. It appears that the Historic Tax Credit will expire within seven years following the fiscal year of the effective date of the Act.