California Court Holds that Transfers of Interests in Entities Owning Real Property Can Result in Transfer Taxes
July 27, 2017
In California, counties and cities may apply a transfer tax on a deed, instrument or writing by which a real property interest is transferred for consideration – including the transfer of an ownership interest in a legal entity that owns real property.
Real estate transfer taxes (RETT) are regularly applied by states and their subdivisions upon the transfer of property from one person or entity to another. Often, taxpayers will only encounter them when making a purchase of real estate, although they can also apply to transfers of leasehold interest. In addition, these taxes may arise during an internal restructuring or a business acquisition when the underlying assets include real estate interests. Since RETT are not as common as income and sales/use taxes, they have a tendency to be overlooked during a transaction, resulting in tax liability that may have been avoidable with proper planning. It is rare to see a court case addressing RETT, but on June 29, 2017, the California Supreme Court issued a decision holding that the state’s RETT may be imposed by California local jurisdictions on transfers of interests in a legal entity that owns real estate. 
As background, RETT are typically imposed by states upon either a transfer of a real estate interest or upon the recording of documents that evidence a transfer of a real estate interest (some states may refer to these as recording taxes). Regardless of the form, the tax is typically enforced at the time the document is presented to the county clerk for recording, although self-assessment of RETT may be required when there is no document that is required to be recorded. In addition, some jurisdictions have broadened their RETT rules to apply to the transfer of a controlling interest in legal entities that own real estate (these are commonly referred to as controlling interest transfer taxes).
Under California’s tax statutes, counties and cities may apply a documentary transfer tax on a deed, instrument or writing by which an interest in real property is transferred for consideration.  The plaintiff in this case did not make an actual transfer of real estate, but instead performed a transfer of a majority of the interest in a LLC that held California real property. When this transfer was reported for property tax purposes, Los Angeles County issued a documentary transfer tax assessment for the fair value of the underlying real property. The plaintiff contended that the tax could not be assessed on a document that transfers an interest in a legal entity since the actual ownership of the real estate is unchanged (i.e., at the time, the LLC continued to be the record owner of the real property).
The state disagreed with this argument by making reference to a separate code section in the California tax statutes that clarifies an exemption from this tax for partnerships that do not have a transfer of more than 50 percent of their capital or profits within a 12-month period.  In its opinion, the court reasoned that, had the legislature not contemplated the RETT applying to transfers of interest in legal entities, it would have had no need to clarify the circumstances under which such transfers would not result in a taxable event. Further, the court noted that under the plaintiff’s interpretation of the statute, any person could avoid the documentary transfer tax by simply transferring the subject property into a limited liability company and then transferring the interest of that LLC, an approach that would elevate form over substance and conflict with the purpose of the documentary transfer tax act.
Therefore, the court concluded that (i) the state’s RETT could be applied to a transfer of an interest in a legal entity that results in a “change in ownership” of the real property, and (ii) a “change in ownership” is determined under the state’s property tax statutes for revaluation under sections 64(c) and 64(d). Under those rules, a “change in ownership” generally occurs when a person or entity obtains direct or indirect control (i.e., more than 50 percent) of an entity that owns California real property. This can even occur in situations where more than 50 percent of an entity that owns California real property is transferred in the aggregate to more than one transferee in separate transactions. 
As a result of this ruling, transactions that involve a change in the beneficial ownership of California real property should be reviewed carefully (including mergers, acquisitions and restructurings) for the potential for documentary transfer tax obligations. Although some California counties and cities still only impose the transfer tax on recorded documents that transfer real property, such as deeds, many have ordinances that specifically include transfers of interests in legal entities holding real property. Others may amend their ordinances or otherwise take positions consistent with this California Supreme Court ruling.
Aprio’s SALT group has experience advising on the complexities and impact of your multistate business’s transactions and can help with planning for the tax consequences. We continually monitor these and other important state tax issues, and we will include any significant developments in future issues of the Aprio SALT Newsletter.
This article was featured in the July 2017 SALT Newsletter. You can view the full newsletter here.
 926 North Ardmore Avenue LLC v. County of Los Angeles, S222329 (Cal. Sup. Ct. 6/29/2017).
 Cal. Rev. & Tax Code §11911.
 California Rev. & Tax Code §11925. A partnership is considered a continuing partnership and is not subject to the documentary transfer tax when a transfer of interests does not result in a technical termination of that partnership (under the principles of IRC §708).
 See Cal. Rev. & Tax Code § 64 and Cal. Code Reg. 462.180.
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