D.C.’s Highest Court Rules Property Improvements and Ground Lease are Separate Taxable Interests

By: Michael Colavito, SALT Director

At a glance:

• The main takeaway: A District of Columbia ruling found that an interest in a ground lease and property improvements were separate taxable interests under the state’s real estate transfer and recording taxes, meaning that the taxpayer could be liable for such taxes on amounts well in excess of the property sale price.
• Impact on your business: Many states have taxes on the transfer of real estate interests (including leases and controlling interests in entities that own real estate), and it is important to analyze the impact of these taxes on your transactions and examine potential alternative structures to minimize the potential liability.
• Next steps: Contact Aprio’s State and Local Tax (SALT) team to find out how we can assist you with your real estate transactions.

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The full story:

The District of Columbia Court of Appeals recently held in MEPT St. Matthews v. District of Columbia that a sale of property for $58.8 million encompassed two separate taxable interests for recordation and transfer tax purposes, where the transfer consisted of property improvements (in the form of an office building) and the interest in a ground lease. Although the Court of Appeals reached this decision rather easily given the plain language of the applicable statute, the issue of how much additional tax, if any, the taxpayer will be liable for was remanded back to the trial court for additional findings of fact.

Depending on the conclusions reached in the remand proceedings, the taxpayers could potentially be liable for additional recordation and transfer tax on amounts well in excess of the price for which the property was sold.

Below, we unpack the details of the case and the potential implications for taxpayers.

A closer look at the case

The District of Columbia imposes a 1.1% recordation tax and a 1.1% transfer tax on the transfer of an interest in real property. Both taxes are triggered by the filing of a deed that reflects the transfer of the property. Further, the applicable statutes regarding how to calculate the tax base for the recordation and transfer tax are virtually identical. Those rules generally provide that the 1.1% taxes are imposed on the consideration (which is generally the sales price) when a deed conveys title to real property. However, if an interest is transferred in a ground lease with a term of at least 30 years, then both taxes are based on either the annual average rent or 150% of the value of the real property covered by the ground lease. 

In MEPT St. Matthews, the taxpayer paid the recordation and transfer taxes based solely on the $58.8 million sales price for the property. The District argued that the $58.8 million consideration paid for the property only accounted for the transfer of the property improvements and not the ground lease, and that under the law the transfer of the ground lease was a separate taxable transfer. Therefore, the District proposed an additional tax based on 150% of the land value. 

Based on the plain language of the recordation and transfer tax laws, the Court of Appeals agreed with the District that despite there being only one deed, there were two separate interests that were transferred (i.e., the title to the improvements and the ground lease), the value of which is separately taxable. However, the trial court did not address whether any portion of the $58.8 million sales price was paid for the ground lease. This issue, as noted above, has been remanded back to the lower court. 

The ruling explained

Based on the language in the District’s recordation and transfer tax laws, it’s difficult to find fault in the court’s conclusion that the sale at issue involved two separately taxable property interests. Still, the conclusion on the remanded factual issue of whether part of the $58.8 million sales price was for the interest in the ground lease could have a far greater impact on how property purchase agreements need to be drafted in the future. 

It is rather clear under the recordation and transfer tax laws, which the Court of Appeals confirmed in MEPT St. Matthews, that the structure of a transaction and the mechanism of the transfer cannot alter the reality that certain property transfers include separate taxable interests that must be assessed as provided under the law. However, the issue on remand will address what substantiation is needed to show that a bundled sales price encompasses the value of multiple taxable interests. This issue seemingly will be examined based in part on the language in the applicable purchase agreement. 

In MEPT St. Matthews, the ruling notes that the taxpayer agreed to sell its “right, title, interest and obligations” in the property for $58.8 million. The purchase agreement also refers to both the improvements and the ground lease. However, an appraisal of the property of just over $59 million refers to the “subject” of the appraisal as a “10-story office building . . .”  The District points to the appraisal as support for its contention that the taxpayer overlooked the ground lease; this is despite the appraisal repeatedly mentioning the ground lease. These documents likely will be extensively reviewed in the remand proceedings.

The bottom line

It is possible that separately stating the portions of the $58.8 million total sales price that were attributable to each interest would have prevented the entire dispute in MEPT St. Matthews. For now, maybe that’s the main takeaway for taxpayers that are selling property located in the District in which similar interests are being transferred.

Many states impose real estate transfer/recording taxes similar to the one imposed by the District, and they can be imposed on a broad range of transfers involving real property — including transfers of leases and transfers of equity interests in entities that own real property. 

Aprio’s SALT team has experience advising clients on a wide range of state and local tax matters, including real estate transfer taxes. We can assist your business to ensure that it complies with all its state and local tax obligations as well as recommend alternative structures that may minimize these liabilities. 

We constantly monitor these and other important state tax topics, and we will include any significant developments in future issues of the Aprio SALT Newsletter.