The California real estate transfer tax landscape experienced a seismic shift when the Supreme Court of California upheld the imposition of Los Angeles County’s Documentary Transfer Tax (“L.A. Transfer Tax”) on the transfer of a controlling interest in a partnership that indirectly owned Los Angeles real estate through an LLC. 926 North Ardmore Avenue, LLC v. County of Los Angeles, 219 Cal. Rptr. 3d 695 (Cal. June 29, 2017). Specifically, the Court held “that the tax may be imposed if the document reflects a sale: that is, an actual transfer of legal beneficial ownership made for consideration.”
The Court’s succinct holding belies its questionable analysis that changes in ownership as determined for ad valorem property tax purposes are “precisely the types of indirect real property transfers that the Transfer Tax Act is designed to tax.” To put this analysis in context, it should be noted that, under Proposition 13, changes in ownership trigger real property reassessments to current fair market value for ad valorem property tax purposes. The Court’s analysis and holding creates the risk that California local real estate transfer tax could now be imposed whenever there is a change in ownership for California ad valorem property tax purposes – a risk that previously did not exist outside of the relatively few California local governments that had specifically modified their transfer tax rules to adopt the change in ownership rules. See, e.g., San Francisco Bus. & Tax Reg. Cd. art. 12-C, § 1114(b).
926 North Ardmore Avenue LLC (“Taxpayer”) was a single-member limited liability company that owned an apartment building in Los Angeles (the “Building”). Taxpayer was owned by a partnership, BA Realty LLLP (“BA Realty”), which, in turn, was substantially owned by a family trust (“Family Trust”). Through a series of transactions in 2009, approximately 90% of the beneficial interest/equity ownership in BA Realty was transferred by the Family Trust to two irrevocable trusts.
Such transfers did not involve the execution of a deed or other instrument transferring title to the Building, nor was the Building or its location mentioned in any of the transfer agreements; however, such transfers constituted a change in ownership for ad valorem property tax purposes. Accordingly, the Los Angeles County Assessor made a supplemental property tax assessment to reflect the fair market value of the Building at the time of the change in ownership (“Reassessed Value”), and the Taxpayer paid the property tax assessment without contest.
Then, in 2011, the Los Angeles County registrar-recorder issued a notice to Taxpayer demanding payment of L.A. Transfer Tax because the Building had undergone a change in ownership for ad valorem property tax purposes. The tax assessment was based on the Reassessed Value of the Building. Taxpayer paid the tax, and filed a claim for refund, arguing that the sale of BA Realty did not trigger the imposition of the L.A. Transfer Tax. The Superior Court denied Taxpayer’s refund claim, and the Court of Appeal affirmed its decision.
The L.A. Transfer Tax applied to the transfers of interests in BA Realty, even though title to the Building did not change.
The California Supreme Court found that the L.A. Transfer Tax applied to the 2009 transfers of BA Realty. The Court analyzed Cal. Rev. & Tax Cd. Section 11911, a part of the Documentary Transfer Tax Act, which permits California counties 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 purchaser or purchasers,” if “the consideration or value of the interest or property conveyed (exclusive of the value of any lien or encumbrance remaining thereon at the time of sale)” exceeds $100. As noted by the Court, Section 11911 is substantially similar to a provision of the former federal documentary stamp act from which it was derived.
In finding that the Documentary Transfer Tax Act encompasses transfers of controlling interests in entities that indirectly own real estate, the Court relied in part on Section 11925, which exempts from tax any transfer of an interest in certain “continuing partnerships,” that hold, and continue to hold, real property. If the Documentary Transfer Tax Act did not apply to controlling interest transfers, the Court reasoned that such an exemption would be unnecessary, and that the enactment of Section 11925 “demonstrates that the transfer of an interest in a legal entity that owns real property can potentially trigger imposition of the tax.” Accordingly, the Court concluded that “a written instrument conveying an interest in a legal entity that owns real property may be taxable, even if the instrument does not directly reference the real property and is not recorded.”
In evaluating the L.A. Transfer Tax assessment and its reliance on ad valorem property tax determinations for changes in ownership, the Court, after examining several federal documentary stamp tax cases for analogous insight, concluded that the “critical factor in determining whether the documentary transfer tax may be imposed is whether there was a sale that resulted in a transfer of beneficial ownership of real property” and that the ad valorem property tax rules for changes in ownership, which “identify a subset of beneficial interest transfers that are significant enough to approximate new ownership,” are “designed to identify precisely the types of indirect real property transfers that the Transfer Tax Act is designed to tax.” Accordingly, the Court upheld the Court of Appeal and found that the transfer of approximately 90% of BA Realty was a taxable sale of a beneficial interest in the Building.
Caveats for California Deals
The Court’s conclusion that the change in ownership rules precisely identify when transfers of beneficial ownership occur for transfer tax purposes is questionable. This conclusion does not appear to consider that the change of ownership rules for entities that directly or indirectly own California real estate can be triggered in situations when less than 50% of an entity’s equity is transferred, if the end result is that an owner ends up with more than a 50% ownership interest (e.g., if a 49% shareholder in a corporation that directly or indirectly holds California real estate acquired an additional 2% interest in the corporation). Cal. Rev. & Tax. Cd. § 64(c)(1). Further, as noted in the dissent, grafting the ad valorem property tax change in ownership rules onto the transfer tax regime is inappropriate, because “[t]hese statutory schemes…relate to distinct types of taxes: Whereas the documentary transfer tax is an excise tax on the privilege of selling real property interests – and is imposed only when that right is exercised – real property taxes are imposed on the property itself, and on a recurring basis.” Regardless, the Court’s decision now creates the risk that California local real estate transfer tax could now be imposed whenever there is a change in ownership for California ad valorem property tax purposes.
Moreover, as also noted in the dissent, the decision raises difficult valuation questions, as the L.A. Transfer Tax was imposed on the full reassessed value of the Building, even though only 90% of BA Realty was transferred. As noted above, the ad valorem property tax rules provide that a change in ownership can occur when less than 50% of an entity’s equity is transferred. Under 926 North Ardmore, not only is there risk that a transfer tax will be imposed when a change in ownership occurs, but there is risk that the tax base might be the entire reassessed value of the real estate, even if only a fraction of its owner’s equity is transferred. This inequitable result very well could be the subject of future litigation, if a sufficiently egregious fact pattern arises.
The effects of this decision will reverberate throughout the Golden State. Dealmakers in California should consider adding California local real estate transfer taxes as a red flag to their due diligence reviews.