Under California law, there are two separate tax implications affecting California real estate transfers that result in a “change in ownership” of the real property - a property tax reassessment and a real property transfer excise tax.
Section 60 of the Cal. Rev. and Tax Code provides that 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.” Pursuant to article XIIIA of the California Constitution, a change in ownership triggers reappraisal and reassessment for property tax purposes.
Generally, the transfer of an interest in a legal entity (like a corporation, partnership or limited liability company) does not result in a change in ownership of the entity’s real property. However, pursuant to Section 64 of the Cal. Rev. and Tax Code, there is a change in ownership of all real property owned by a legal entity where shares or interests representing more than 50 percent of the total interests are transferred by the original owners in one or more transactions.
California has a separate Documentary Transfer Tax (sometimes referred to as a real property transfer tax) adopted in 1967 by the Documentary Transfer Tax Act (“DTTA”), and found in section 1191 of the Cal. Rev. and Tax Code, which permits any county or city to levy 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 purchasers” if the consideration exceeds $100. The DTTA was patterned after the now repealed Federal Stamp Act (Excise Tax Reduction Act of 1965, Pub. L. No. 89-44, effective January 1, 1968). The DTTA (like the Federal Stamp Act) is generally silent on the application of the documentary transfer tax to changes in entity control (with no deed transfer), except that a taxable transfer is specifically deemed to occur when a partnership terminates under section 708 of the Internal Revenue Code (e.g., as a result of a sale or exchange of 50 percent or more of the total interest in partnership capital and profits during a 12-month period).
In 926 North Ardmore Avenue, LLC v. County of Los Angeles, 229 Cal. App. 4th 1335, Case No. S222329 (Cal. Sup. Ct. June 29, 2017), the California Supreme Court affirmed the California Court of Appeals’ decision allowing California counties and cities to impose a documentary transfer tax on real property whenever there is a transfer of an interest in a legal entity that owns real property located in California that constitutes a “change in ownership” under Section 64 of Cal. Rev. and Tax Code. There was a strongly worded dissent pointing out that DTTA “says nothing about the taxation of entity interest transfers”.
Under the facts of the case, the owners of a partnership which owned 926 North Ardmore Avenue, LLC, a single member LLC, which had been established to hold and manage an apartment building, sold approximately 90 percent of their interests to two trusts. The sale was reported to the California Board of Equalization (“BOE”) for property tax purposes through a “statement of change of ownership” and the BOE deemed the sale to be a change in ownership for property tax purposes. Los Angeles County then sent the taxpayers a bill for the documentary transfer tax which the taxpayers paid under protest.
The taxpayers argued that the documentary transfer tax cannot be imposed on a written instrument that transfers an interest in a legal entity, even if the legal entity owns real property, unless the instrument refers to or shows the location of the property. According to the taxpayers, the plain language of section 1191 of the California tax code restricts its scope to instruments that directly reference real property. In addition, the taxpayers argued that the tax cannot be imposed on unrecorded documents because the DTTA provides no mechanism for tax collection when a written instrument is not recorded. The documentary transfer tax is due and payable at the time of transfer.
In rejecting the taxpayers’ arguments, the California Supreme Court determined that section 1191 of the Cal. Rev. and Tax Code must be interpreted as authorizing a tax on any instrument by which an interest in real property is sold, whether directly by deed, or indirectly, as part of a transaction involving the transfer of a legal entity. Relying upon federal law (the since repealed Federal Stamp Transfer Act upon which the DTTA is based), the court noted that whether the substance of a transaction warranted imposition of the federal stamp tax, federal courts often focused on whether there was a change in beneficial ownership of the real property.
Relying on Carpenter v. White, 80 F. 2d 145 (1st Cir. 1935), which held that if a transaction resulted in the transfer of beneficial ownership of real property for consideration it was subject to the federal stamp tax, the California Supreme Court similarly found that the transfer of beneficial ownership through the transfer of ownership in a legal entity owning, directly, or indirectly, real property, is subject to the documentary transfer tax. The court concluded by holding that section 11911 “permits the imposition of a documentary transfer tax whenever a transfer of an interest in a legal entity results in a change in [a more than 50%] change in ownership of real property … so long as there is a written instrument reflecting a sale of the property for consideration”.
Based on 926 North Ardmore Avenue LLC the documentary transfer tax may be imposed by a county or city when (i) the legal entity interest transfer is in writing, (ii) the transfer is made for consideration, and (iii) the transfer constitutes a more than 50 percent change in ownership. It is no longer relevant whether the written instrument is recorded or references the real estate.
The take away from this decision, is that when there is a transfer of a legal entity that holds California real estate and the transfer constitutes a “change in control” requiring a filing with the BOE for property tax reassessment purposes, a documentary transfer tax may also be imposed whether or not the transaction requires the issuance of a new deed. Query whether the 926 North Ardmore Avenue LLC decision will be applicable to a county or city ordinance that currently simply states that it only applies to “recorded” documents. Any transfer of interests in a legal entity resulting in a change in control will require additional or expanded due diligence as to whether the legal entity owns or leases (pursuant to certain long term lease agreements), directly or indirectly, any California real estate.