The Pennsylvania Department of Revenue recently revised the Pennsylvania realty transfer tax regulations, changing the taxability of certain transactions in ways that can create pitfalls for unwary parties to real estate transactions. The revisions include, among other things, four changes that may be of particular relevance to parties involved in commercial real estate transactions.
Assignments of Real Estate Contracts
In Allebach v. Commonwealth, a 1996 decision, the Pennsylvania Supreme Court held that the taxpayer, a farmer who entered into a contract of sale with a real estate developer, was not subject to realty transfer tax on the amount for which the contract was later fl ipped by the developer to a third party. The language of the Court’s opinion seemed to imply that the amount paid for the contract assignment should escape Pennsylvania realty transfer tax altogether, and that is the reading generally ascribed to the opinion by practitioners. The new regulations will, by their terms, overturn that result and subject parties to the assignment of a real estate contract to realty transfer tax liability.
Under normal principles of statutory interpretation, the Pennsylvania Department of Revenue cannot, by its promulgation of administrative regulations, overturn a Pennsylvania Supreme Court decision that interprets the existing Pennsylvania realty transfer tax statute. But it is the position of the Department of Revenue that these new regulations do not overturn the precise holding of Allebach, but rather address the taxation of the assignor, which was not directly at issue in Allebach, so that the language of the Allebach opinion to the effect that the realty transfer tax did not apply to the assignment at all must be considered only dicta insofar as it applies to any party other than the original seller.
Indeed, the new regulations might be read to go even further than simply subjecting such an assignment to realty transfer tax. There is concern among some practitioners that the transfer tax imposed by the new regulations whenever a real estate contract is assigned would be computed on the same basis as would apply in the case of a resale of the property for a price equal to the sum of the original contract price and the price paid for the assignment. In effect, this would impose duplicative transfer taxes whenever there is an assignment of a real estate contract – even where, for example, the assignment is for no consideration, as is often the case when the party entering into a realty purchase contract assigns the contract at closing to an affi liate.
There is an example in the regulations that clearly states that the transfer tax imposed on an arm’slength assignment of a real estate contract applies only to the price paid for the assignment of the real estate contract. The logic of the example should mean that an assignment for no or nominal consideration, such as an assignment to an affi liate, should not result in additional realty transfer tax – at least where the realty has not appreciated above the original contract price. But, pending clarifi cation of this point, to eliminate the risk of duplicate transfer tax altogether, it is safer to include the contemplated title-holding entity as a party to the original contract to purchase Pennsylvania real estate.
Like-Kind Exchange Transactions
The new regulations create a potential for multiple transfer taxes where a reverse like-kind exchange under Internal Revenue Code section 1031 necessitates the use of a so-called exchange accommodation titleholder (EAT) to hold title to replacement property pending the sale of the taxpayer’s relinquished property for the exchange. Transfers to and from an agent do not generally trigger the realty transfer tax, and most states treat accommodation parties to section 1031 exchanges as agents for these purposes – consistent with applicable common-law agency principles. The new regulations exclude EATs from the defi nition of a taxpayer’s “agent,” however, so that both the deed to an EAT and the subsequent deed from the EAT to the taxpayer will trigger realty transfer tax according to the regulations. (Whether a court would agree with the new regulation’s conclusion in the agency issue is open to debate.)
The new double transfer tax on reverse like-kind exchanges can, however, be readily avoided through the EAT’s use of tiered entities that are disregarded entities for federal income tax purposes, but not for transfer tax purposes. Thus, unless the Department of Revenue changes this aspect of the regulations or issues clarifying guidance to eliminate the apparent double tax, one can expect most signifi cant reverse like-kind exchanges of Pennsylvania properties to use a tiered entity structure. (The Department of Revenue has acknowledged in published rulings that transfers of the ownership interests in an upper-tier entity do not amount to a taxable transfer of an interest in a “real estate company” for realty transfer tax purposes. The new regulations do not change this result.)
The new regulations also state that a qualifi ed intermediary (QI) in a deferred like-kind exchange will not be treated as a taxpayer’s agent either, so there is concern among some practitioners that the assignment of purchase and sale contracts to the qualifi ed intermediary will result in multiple transfer tax also. (Unlike an EAT, a QI generally does not acquire title to any properties but only accepts assignments of contract rights.) Under the logic of the example in the regulations discussed above, there should not be a second transfer tax applicable to such an assignment, because the arm’s-length consideration for the assignment is zero or nominal. But clarifi cation of this point is currently being sought.
The new regulations affi rm that recording a deed solely to confi rm an entity’s existing real estate ownership following a conversion of the entity (for example, a limited partnership converting to a limited liability company) is not taxable. The Pennsylvania Supreme Court’s somewhat confusing decision in the Exton Plaza case, decided in 2000, already mandated this result. In codifying the effect of that decision in the new regulations, the Department of Revenue has added some specifi c requirements designed to ensure that the conversion is a mere change in form of the entity. The requirements are:
- the entity, as opposed to its owners, must hold title to the real estate at the time of the conversion;
- all property rights, obligations, liens and proceedings of the entity must be unaffected by the conversion;
- the entity must not be required to wind up its affairs or pay its liabilities and distribute its assets;
- there must be no change in proportionate ownership as a result of the conversion; and
- title to real estate cannot revert or be impaired because of the conversion.
Prior to the amendment, the regulations simply provided that in a sale-leaseback transaction (other than a fi nancing transaction, which is exempt from realty transfer tax altogether), the sale was subject to the realty transfer tax, but the leaseback was not. Under the new regulations, the leaseback in a non-fi nancing transaction is free of realty transfer tax only if the lease is for a term of less than 30 years.