HIGHLIGHTS:

  • In Summer 2017, the Supreme Court of California is scheduled to review a 2014 decision by the California Court of Appeal for the Second District, which held that a change in ownership of an entity that indirectly owns real property through another entity is considered a "change of ownership" – thereby resulting in the imposition of a documentary transfer tax pursuant to the California Revenue and Taxation Code.
  • Prior to 2009, California cities and counties were unable to access change of ownership filings. However, Senate Bill 816 and Assembly Bill 563, passed in 2009 and 2011, respectively, allowed counties and cities to access this previously unobtainable information and therefore the ability to impose documentary transfer taxes for entities that had changed ownership.
  • The Supreme Court of California's decision will determine whether local governments have the ability to impose a documentary transfer tax on a legal entity that indirectly owns real estate within the state and has the potential to result in considerable consequences concerning commercial real estate transactions in California.

The Supreme Court of California is slated to review a 2014 decision by the California Court of Appeal for the Second District, which held in 926 North Ardmore Avenue, LLC v. County of Los Angeles that a change in ownership of an entity that indirectly owns real property through another entity is considered a "change of ownership" – thereby resulting in the imposition of a documentary transfer tax pursuant to the California Revenue and Taxation Code.

In reaching its decision, the Supreme Court of California will determine whether local governments have the ability to impose a documentary transfer tax on a legal entity that indirectly owns real estate within the state. This decision has the potential to result in considerable consequences concerning commercial real estate transactions in California.

Background

Under California's Documentary Transfer Tax Act (Cal. Rev. & Tax. Code §§11901-11935), counties and cities may enact their own ordinances imposing a tax on transfers of various interests in real property. While the Act does not itself impose transfer taxes on transfers of ownership interests in entities owning real estate, transfer taxes will apply if a partnership or limited liability company is deemed "terminated" for federal income tax purposes (Cal. Rev. & Tax. Code §11925(b)), and will be based on the value of all real property held by the entity (Cal. Rev. & Tax. Code §11925(b)). A transfer of at least 50 percent of an entity's interests within a 12-month period is considered a "termination" for federal income tax purposes.

Prior to 2009, California cities and counties were unable to access change of ownership filings and were therefore unable to assess documentary transfer taxes against properties that had changed ownership. However, Senate Bill 816 and Assembly Bill 563, passed in 2009 and 2011, respectively, allowed counties and cities to access this previously unobtainable information and therefore the ability to impose documentary transfer taxes for entities that had changed ownership. Armed with this newly available information, cities and counties began to assess documentary transfer taxes against legal entities who had filed change of ownership filings. Many cities and counties, including San Francisco, have enacted ordinances extending the application of transfer taxes to any change in control of an entity that would trigger reassessment of real estate taxes (see, e.g., San Fran. Bus. & Tax Reg. Code Art. 12-C §1114).

926 North Ardmore Avenue, LLC v. County of Los Angeles

In 926 North Ardmore Avenue, LLC v. County of Los Angeles, brothers Bruce and Allen Averbrook, acting as trustees of a family trust, created a limited liability company (LLC) in order to hold an apartment building located at 926 North Ardmore Avenue. Following this transaction, the trust subsequently transferred its interest in the LLC to a limited liability partnership, which was also owned by the trust. In 2008 and 2009, the Averbrooks sold approximately 90 percent of their interest – 45 percent to be divided between two trusts – and subsequently filed a "statement of change in ownership of legal entities" pursuant to the California Revenue and Taxation Code. In 2011, upon receipt of this information, the County of Los Angeles demanded payment of a documentary transfer tax, claiming the transfer of the limited partnership interests constituted a change in ownership and therefore necessitated payment of a documentary transfer tax. The LLC paid the tax and subsequently filed suit against the County of Los Angeles demanding a refund, claiming that the transfer of the ownership of the partnership did not constitute a taxable event for two reasons: 1) the sale of a partnership that owns a single-member LLC that holds title to realty does not constitute "realty sold" under the California Revenue and Taxation Code, and 2) that the subtrusts' sale to the two separate trusts should not be categorized as a taxable transfer or sale because the partnership did not hold title to any real property but rather owned an entity that held title to the property.

The Superior Court rejected these arguments and the Appellate Court affirmed, holding that a documentary tax may be applied to transfers of interests in legal entities if the transfer results in a "change of ownership" pursuant to the California Revenue Taxation Code and the Los Angeles County Code (i.e., when at least 50 percent of an entity's interests are transferred within 12 months). The court held that, even though the LLP did not hold title to the property but rather owned another entity that owned the property, any ownership change in the entity that owns the property (directly or indirectly) constitutes "realty sold"; therefore, the transfer tax could be imposed. The court added that ruling otherwise would effectively allow property owners to evade transfer taxes by transferring real estate to a subsidiary established by the property owner, and then selling the subsidiary rather than the actual real estate. The California Supreme Court granted review of the Appellate Court's decision and is scheduled to decide the case in Summer 2017.

Practical Considerations

By reformulating the tax liability that arises under a change of ownership of an entity that does not directly own real property but rather owns another entity that holds title to the property, Ardmore significantly broadens the scope of the law governing the payment of documentary transfer taxes. The practical significance of the decision, if it is not overturned by the California Supreme Court, is the ability of cities and counties to assess a documentary transfer tax, potentially retroactively, against entities that previously avoided paying such taxes by virtue of indirectly owning real estate.

Pending a final decision on Ardmore, those involved in structuring deals and conveying real estate in California should 1) consider whether taxes on transfers that are not expressly taxable under the Documentary Transfer Tax Act or the applicable county/city ordinance but are considered "changes in ownership" for property tax purposes should be paid, and 2) consider applying for a refund of the transfer tax.