When is “Realty Sold?” Documentary Transfer Tax May be Due When Control of A Legal Entity Changes

It is common for owners of commercial real property to hold title through a separate legal entity.  By doing so, owners can generally maintain their Proposition 13 tax basis and avoid an increase in property tax – notwithstanding changes in the ownership of the entity – until a transfer of ownership occurs.  A transfer may occur by a sale of the asset or by a change in the controlling interest of the legal entity.  Payment of documentary transfer tax – on the other hand – could be avoided in some jurisdictions until the sale of the asset to a third party, notwithstanding internal transfers of ownership of the legal entity.

The California Supreme Court recently determined that local jurisdictions may use the “change-in-control” framework established under Proposition 13 to impose documentary transfer tax when there is a change in the beneficial ownership of an entity that holds title to real property.  The decision disregards the textual distinctions between the statutory language of Proposition 13 and the Documentary Transfer Tax Act (“Act”).  It does, however, validate the aggressive documentary transfer tax interpretations made by some jurisdictions, including the City and County of San Francisco, which has adopted a standard that interprets “realty sold” as including “any acquisition or transfer of ownership interest in a legal entity that would be a change of ownership of real property. . . .”  See San Francisco Bus. & Tax Regulations Code § 1114.  The documentary transfer tax imposed on commercial real property sales can significantly increase transaction costs.

The Relevant Statutory Framework

Proposition 13 provides considerable property tax benefits to the owners of real property, insofar as the tax basis for commercial real property is not increased to fair market value unless and until ownership of the property is transferred.  One relevant exception is that property may be reassessed when there is a “change of ownership” in the entity that owns the real property.  Generally speaking, if more than 50% of the ownership of a legal entity that owns real property changes, all property owned by that entity is subject to reassessment.

The “change of ownership” framework that applies under Proposition 13 is not used under the Act.  Instead, documentary transfer tax may be imposed by a city or county whenever real estate is “sold” within its jurisdiction.  Cal. Rev. and Tax Code § 11911 [emphasis added].  The Act contemplates that the documentary transfer tax will be imposed on “each deed, instrument, or writing” pursuant to which a conveyance of real property is made.  Id.

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

In late June of 2017, the California Supreme Court issued its much-anticipated decision in 926 North Ardmore Avenue, LLC v. County of Los Angeles.  Rehearing was denied.  In North Ardmore, the Court considered whether documentary transfer tax may be assessed when beneficial ownership of real property is conveyed, i.e., when there is a change of ownership of a legal entity that indirectly owns the property, through another entity.  The Court determined that documentary transfer tax may be imposed when the beneficial ownership of real property is conveyed in exchange for the payment of money or other consideration, i.e., circumstances which the Court determined “reflects a sale.”

The facts of North Ardmore illuminate the complexities of some estate plans and the potential consequences of those complexities.  There, the original owners of the commercial property – Husband and Wife – held title in the name of a family trust.  Approximately 35 years later, the Husband passed away, and the trust assets passed into an administrative trust (“Trust”) for the benefit of the Wife (“Spouse”).  The adult children of Husband and Wife were named as successor trustees (“Trustees”).

After Trustees received control over the Trust and the Property, they then formed other legal entities and completed a variety of transactions pursuant to which the indirect ownership of the property was conveyed to other legal entities that were under their sole control.  The entity that held title to the asset did not change.  In exchange for the various transfers, however, several promissory notes were conveyed to the Wife, by means of other trusts created for her benefit.

The Trustees reported the various transfers in the ownership of the entities by filing a Change in Ownership Statement with the Board of Equalization, as required by California Revenue and Taxation Code section 480.2(a).  Based on that filing, the Los Angeles County Assessor determined that a change of ownership occurred and issued a supplemental property tax assessment.  The County also levied documentary transfer tax, which was challenged.

The Supreme Court’s Analysis

The California Supreme Court identified the issue in North Ardmore as whether the County had authority to tax the written instruments that transferred the beneficial ownership of the property from the Trust to the legal entities they controlled.  It characterized the task as one of statutory interpretation.  The Court then noted that the statutory language provides that “when realty is sold . . . the document effecting that sale is subject to taxation.”  The taxpayer argued that the mere conveyance of an interest in a legal entity – even an entity that owns real estate – does not result in the sale of realty.  It also argued that documentary transfer tax was not properly assessed because no document conveying the property was recorded.

The relevant section of the Act – California Revenue and Taxation Code section 11911 – was found to be ambiguous because it makes no distinction between a written instrument that conveys a direct interest in real property and an instrument that conveys an interest in a legal entity that owns real property, i.e., an indirect interest.  The Court resolved the ambiguity with reference to California Revenue and Taxation Code section 11925, which contains an exemption that relates to partnerships, and provides that the documentary transfer tax will not be imposed if the entity is a “continuing partnership” that continues to hold title to the realty.  The Court also referenced a similar exemption in the Federal Stamp Act, on which the Act is based.

The Court reasoned that the Act’s inclusion of an exemption that relates to partnerships, but not to other legal entities, meant that the legislature intended that the Act could be triggered by the transfer of interests in a legal entity, and the indirect transfer of real property.  It disposed of the taxpayer’s argument that the Act only applied to documents that were recorded by commenting – in a footnote – that the documentary transfer tax is an excise tax, imposed “on the privilege of conveying real property by means of a written instrument.”  Ultimately, the Court concluded that a written instrument – recorded or not – that conveyed an indirect interest in real property may be taxed under the Act.

After reaching its conclusions on the legal framework, the Court evaluated the facts presented by North Ardmore.  It was determined that a taxable transfer occurred when beneficial ownership of the property was transferred from Wife to the Trustees.  The Court reached its decision with reference to the “change in ownership” rules that are established under Proposition 13, and trigger a reappraisal of property for tax purposes.  Specific reference was made to statutory language that provides that the transfer of a “present interest” in real property occurs when there is a change in the beneficial ownership, which has a value substantially equal to the value of the fee interest.  Critical to the outcome: when the indirect ownership in the real property was transferred, Wife received promissory notes as payment.

The Likely Consequences of the Decision

Following the decision in North Ardmore, it is likely that many jurisdictions in California that impose documentary transfer tax will adopt a reading of the Act that implements the “change-in-control” framework that previously applied only to Proposition 13 reassessment.  We also expect that jurisdictions will become more aggressive with their collection efforts.

Authored by Reuben, Junius & Rose, LLP Attorney Corie A. Edwards

The issues discussed in this update are not intended to be legal advice and no attorney-client relationship is established with the recipient.  Readers should consult with legal counsel before relying on any of the information contained herein.  Reuben, Junius & Rose, LLP is a full service real estate law firm.  We specialize in land use, development and entitlement law. We also provide a wide range of transactional services, including leasing, acquisitions and sales, formation of limited liability companies and other entities, lending/workout assistance, subdivision and condominium work.