Beginning next year, the Washington real estate excise tax (REET) will convert to a tiered rate structure from the current flat-rate structure, resulting in a big increase in the rate for more valuable properties.
Currently, the law imposes a uniform state tax rate of 1.28% of the value of real property triggered by either (1) the sale of real property or (2) the transfer of a controlling interest (50% or more) in an entity that owns Washington real property.
Beginning January 1, 2020, the state rate will be imposed at different tiers, as follows:
- 1.1% of the selling price up to $500,000;
- 1.28% of the selling price above $500,000 and up to $1,500,000;
- 2.75% of the selling price above $1,500,000 and up to $3,000,000; and
After January 1, 2020, the combined rate for many properties could be as high as 3.5% for the portion of the value over $ 3,000,000 after local rates—typically 0.25% or 0.5%—are added.2
To guard against taxpayers’ manipulating transactions to take advantage of the graduated-rate schedule, the Department of Revenue is authorized to “disregard the form” of “related transactions” and potentially to treat a series of sales as a single sale. The legislation does not address the time period within which sales might be aggregated.
Since the governor signed the legislation on May 21, there has been increased focus and awareness of potential unexpected liabilities associated with changes in the controlling-interest provisions.
Issues arising from the new law are somewhat hidden, including taxes that may be due on an unreported transfer of control even after the property itself has been sold to a new owner. To help peel the onion, we review below the basic background of the tax, provide some examples under the new law, and identify challenges now facing property owners, buyers, investors, investment managers, and all of their advisors.
REET on Controlling Interest Transfers
The theory of the tax is that the sale or acquisition of 50% or more of the ownership interests in a legal entity that owns Washington real property is tantamount to selling or buying the real estate it owns. Though the threshold for imposing REET is the transfer of 50% or more of these interests, the tax applies to 100% of the value of the entity’s Washington real property.3
“Control” is measured by different factors, depending on the type of entity:
- Corporations (under current law), or for for-profit corporations (beginning January 1, 2020): a controlling interest is represented by 50% or more of the combined voting power of all classes of voting stock
- Partnerships, LLCs, and trusts (under both the current and revised law), and nonprofit corporations (under the new law only): a controlling interest is represented by 50% or more of the capital, profits, or beneficial interest in the entity
Law Extends REET Aggregation Period
As a result of the legislation, the aggregation period on property transfers or acquisitions of a controlling interest will lengthen to 36 months from the current 12-month period. Given the complexity of the law’s definition of “controlling interest,” it may be very difficult to ascertain the information required to determine whether or not the tax has become due.
Furthermore, sales and purchases are aggregated differently across the applicable period. Important distinctions include:
- Sales of partial interests by a single seller, or purchases of partial interests by a single buyer, that add up to 50% or more trigger the tax.
- Sales by diverse owners are not aggregated even if selling in a coordinated fashion if the buyers are different and not “acting in concert.”
Purchases of partial ownership interests may be aggregated among multiple buyers who are “acting in concert” to reach the 50% threshold.
Hidden Statutory Liens May be Incurred Under Changes to REET
REET applies not just when ownership-interest transfers in an entity that owns Washington real property reach the 50% level; the tax can also apply when a change of control occurs in an entity that controls the Washington property owner – e.g., potentially far up a multi-tiered ownership chain of wholly owned subsidiaries.
REET is generally the obligation of the seller of the entity interest (other than interests in a publicly traded company). Purchasers and the entity itself are also liable for the tax, and there is a statutory lien imposed on the property when tax has not been paid, although the lien is not of record until the Department of Revenue takes some sort of enforcement action.
As a result, buyers of real property face the risk of acquiring property subject to a “hidden” statutory lien for REET that should have been paid on a prior direct or indirect change in control of the seller.
Three Examples of Tax Liability Under the New Law
First: The simplest example would be an entity that holds real property in Washington and is owned itself by four equal partners, shareholders, or LLC members, F, G, H, and I. In July of Year 1, F sells her 25% share to her brother, Z. In December of Year 3, Z agrees to buy out H. Z has acquired 50% of the entity ownership in less than 36 months and has triggered the tax. F and H are primarily liable for the tax (at 50% of tax on the property’s value for each), though Z and the entity are also liable.
Second: Suppose two married couples, the As and the Bs, each own 50% of an LLC that owns a nice vacation property. Mr. B dies and bequeaths his quarter interest in the LLC to his children, but only one daughter can afford to keep the property, and she buys out her siblings’ right to share in inheriting the entity. Ms. B dies less than three years after Mr. B and the same thing happens. The daughter has acquired a controlling interest in the LLC. REET is due on the full value of the property, unless the daughter can find a REET exemption.
The surprise for Mr. and Ms. A in this situation is that the LLC would also be liable for the tax – not just the parties directly involved in the transactions (the transferors (the two estates) and the transferee (the Bs’ daughter)). The As would hope that the LLC agreement allocates all the liability for REET to the B side, but they may be disappointed.
Third: Suppose Washington real property is owned by a single-purpose entity that is an investment vehicle for a multi-tiered investment group. Suppose further that, on July 1 of Year 1, the highest-level holding company sells a 40% stake in itself to New Investor X and makes a partial redemption of existing owners’ interests with the proceeds. No REET is due because only 40% of the interests has transferred.
Suppose further that, on March 1 of Year 4, the holding company makes another partial redemption of the initial owners’ interests. This redemption is equal to one-third of their collective remaining 60% ownership interests, or 20% of the holding company’s entire ownership, and suppose that this transaction does not qualify for any REET exemptions. Arithmetically, the redemption reduces the initial owners’ stake to the same percentage as that of New Investor X, 50%.
The result of the second redemption is that the aggregate ownership interest acquired by New Investor X in the holding company is 50%, or a controlling interest. Because the company that owns the Washington real property is wholly owned, this same acquisition level is attributed to it. REET is due and is imposed on the full value of the property, but nothing has changed with respect to the direct ownership entity. Particularly if the holding company, the original owners, and New Investor X are in a distant state, they may not realize that these types of transactions trigger the tax.
Challenges Under the New Law
Is there a lien on the property from a prior, unreported transfer of a controlling interest?
While a latent-lien issue exists under current law every time real property changes hands, the short, 12-month aggregation period gave comfort that most parties would flag the issue and deal with the potential consequences of transactions within such a period.
In fact, audit assessments of REET on unreported controlling interest transfers are virtually if not completely unknown. With the extended 36-month aggregation period, memories will be challenged and consciousness of potential REET consequences will attenuate as time passes.
Some challenges and scenarios posed by the enhanced risk of a tax lien include:
- Buyers, understanding there may be a latent lien for prior, unknown transfers of a controlling interest, may be compelled to ask for representations regarding the absence of such a taxable event or lien.
- Sellers may be led to conduct internal reviews to confirm the absence of a prior taxable transfer.
- Title insurance companies and buyers will face questions regarding whether this risk is covered by either a standard or an extended coverage owner’s policy, and they may start requiring more information from the seller/owner of the real property as to prior transfers of direct and indirect ownership interests.
What are the audit mechanisms under the new law?
Currently, an entity renewing its “corporate” license with the Washington Secretary of State is asked in writing whether it owns real property and whether it incurred a transfer of controlling interest in the prior year. The new law will require the Secretary of State to change the form to ask if there has been a transfer in the prior year of any interest equal to “at least one-third of a controlling interest in the entity.”
In other words, the transfer of one-sixth of total ownership interests should be reported on the new form. This will not necessarily be an easy question to answer, and it merits careful attention each year in light of the statutory tests and requirements.
Legal advisors and providers of corporate maintenance services should alert clients to this issue each year. The Department of Revenue receives copies of these forms from the Secretary of State and compares the data to reported transfers.
Potentially compounding the confusion, the one-sixth test for annual disclosure does not track with the test for taxation, since any small transfer that contributes to the 50% threshold is relevant. Entities that do not disclose transfers on the form could be subjected to an evasion penalty of 50% if a taxable transaction is uncovered later on.
Allocating tax among multiple sales as a legal matter
Under current law, the regulations provide that the taxable selling price varies by value at the time of each of the part-ownership transactions that contribute to the taxable transfer. Over a 12-month aggregation period, this principle was not often in play.
However, the value of the Washington property will definitely change over three years. Unless the rules change, the tax will be prorated among transactions (and their participants) by:
- Allocating a portion of liability to each contributing transaction ratable to its share of the total amount of interests transferred, and then
- Applying tax to that share of the value of the property at the time of the partial transfer.
For example, if three separate 20% LLC owners sell over time to a single buyer, each seller will be treated as having sold one-third of the interest transferred. As a result, each seller will be charged with tax equal to 33.33% of the value of the property as of the date of that seller’s transaction times the applicable rate.
How to allocate liability among co-owners by contract
Co-owners of an entity that owns Washington real property, directly or indirectly, may want to determine in advance whether any REET liability potentially owing in the future is collectible from co-owners who sell their interests “early” in the 36-month rolling period. It is an exercise similar to the issue raised by the new federal income tax partnership audit rules – if the IRS assesses additional income tax against a partnership for prior years, will departed partners be asked to contribute to the liability for years in which they were partners?
Eventually, provisions for requiring or disclaiming potential REET contributions could become a feature of buy-sell terms and transfer restrictions in shareholder, partnership, and LLC agreements.
For ease of reading, this alert does not address all the complexities that will arise in administering the new tax, nor any of the exemptions from tax, which are important.