Form Over Substance Prevails in a Pennsylvania Real Estate Transfer Tax Case

Aerial view of housing estate and plant in garden.

By: Jess Johannesen, SALT Senior Manager

At a glance 

  • The main takeaway: Taxing authorities typically look to the substance of a transaction, as opposed to the form, to determine tax consequences, although there are exceptions in non-income-tax cases.
  • Why it matters to you: As a taxpayer, you must structure the form of your transactions properly to yield the intended tax consequence.
  • Next steps: Aprio’s State and Local Tax (SALT) team can help ensure that your transactions are executed in a manner to satisfy any exemption that may be applicable.

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The full story:

For income tax purposes, we often see the application of “substance over form” doctrine to reflect the underlying realities of transactions, regardless of their form or structure. For example, the substance-over-form doctrine typically arises in debt versus equity distinctions. If an investor really has equity but their business documents the contribution as debt (in order to take a deduction for interest it pays on the “loan”), courts could recharacterize the debt as equity for income tax purposes, which would prevent the business from deducting the interest.

However, when dealing with non-income taxes, it is not unusual to find that state taxing authorities and courts are more inclined to apply form over substance. This was the case in a recent Commonwealth Court of Pennsylvania opinion, which held that M6 Realty, LLC (the Petitioner) was not exempt from the state’s real estate transfer tax as a result of the sequence of events surrounding the property transfer.[1]

Let’s review how the case played out

In this case, a husband and wife owned real estate located in Bucks County, Pennsylvania, which was encumbered by a mortgage held by a bank. While the description of the facts is a bit unclear, it appears that the owners were in default on the loan. Pursuant to a “Deed in Lieu Agreement” among several parties (including the Petitioner), the Petitioner agreed to become the holder of the loan/mortgage and then accept a deed to the real property from the husband and wife as payment-in-full for the defaulted loan.

On September 3, 2015, the deed was executed, conveying the real estate from the husband and wife to the Petitioner. Subsequently, on September 8, 2015, the mortgage assignment was executed whereby the Petitioner became the holder of the mortgage. All of those documents were recorded with the Bucks County Recorder of Deeds. At the time of the recording, no real estate transfer tax was paid.  About a year later, the state issued a notice of assessment for about $14,000 (plus interest and fees), which ultimately led to the current case.

Pennsylvania’s real estate transfer tax is imposed on the value of real estate transferred by a deed, instrument or other writing, and the tax is payable, in part, either at the time the document is recorded by the county or within 30 days of the acceptance of such document.[2] Pennsylvania’s real estate transfer tax includes an exemption for transfers “by a mortgagor to the holder of a bona fide mortgage in default in lieu of a foreclosure.”[3]

Based on that exemption provision, the Petitioner argued that the transfer of the real estate was exempt from the real estate transfer tax. However, the Court said the record reflects that on the date the deed to the Petitioner was executed, the mortgage was held by a separate company and that it was not until five days thereafter that the mortgage was assigned to the Petitioner. Accordingly, the Court concluded that the Petitioner was not “the holder of a bona fide mortgage in default in lieu of a foreclosure” on the date that the property was transferred, and therefore, the real estate transfer tax assessment was affirmed.

The majority opinion focuses on the timing of the transactions to conclude that the Petitioner did not meet the statutory exemption at the time of the transfer, arguably elevating the form of the transaction over its substance. As the dissenting opinion in the case notes, “these events are all part of a single transaction that, when viewed as a whole, indicates [the] Petitioner stepped into the shoes of the [mortgager] and assumed the [mortgager’s] rights under the [husband and wife’s] promissory notes and mortgages.”

The bottom line

Sales taxes and real estate transfer taxes are examples of “transaction taxes” (i.e., they are imposed on the occurrence of a specific event or transaction). However, income taxes are more akin to a business activity tax because they are imposed on a taxpayer based on some measurement of activity (in this case, income) over a period of time. Perhaps it is this distinction that gives rise to the different application of substance over form.

Whatever the reason, it is important for businesses to understand the potential application of form over substance since they can ultimately plan around it. For example, a simple reversal of the sequence of events in the case above would have exempted the transaction. Aprio’s SALT team has experience with these issues and can assist you to ensure that your transactions are executed in a manner to satisfy any exemption that may be applicable.

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.

Contact Jess Johannesen, SALT Senior Manager, at jess.johannesen@aprio.com or  Jeff Glickman, partner-in-charge of Aprio’s SALT practice, at jeff.glickman@aprio.com for more information.

This article was featured in the September 2021 SALT newsletter.

[1] M6 Realty, LLC v. Commonwealth of Pennsylvania, Case No. 797 F.R. 2017, 08/04/2021.

[2] 72 Pa. Stat. Ann. §8102-C.

[3] 72 Pa. Stat. Ann. §8102-C.3(16).

Disclosure

Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding the matter.

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