Money and Dirt: A blog on legal issues impacting California real estate investment, development, and secured lending

CA Supreme Court: Entity Ownership Change Can Trigger Documentary Transfer Tax

Many entities are formed for the sole purpose of buying and holding real estate.  In this setup, legal title is held by the entity itself (not the entity’s owners), but the entity’s owners have a “beneficial interest” that can have tax consequences.

When does a change in entity ownership trigger a documentary transfer tax?

The California Supreme Court has shed light on that issue in a recent decision — 926 North Ardmore Avenue, LLC v. County of Los Angeles.

Facts: a complicated series of entity ownership transfers, leading to documentary transfer tax

Beryl and Gloria Averbrook owned an apartment building in Los Angeles.  They established a family trust, and transferred the building into it.  Beryl died in 2007, and the family trust’s assets were transferred to an administrative trust maintained for Gloria’s benefit.

Gloria’s sons, Bruce and Allen Averbrook, were named successor trustees.  Bruce and Allen formed two entities — an LLC established to acquire and hold the building, and a partnership.  The administrative trust was the sole member of the LLC, and also held a 99 percent interest in the partnership.

The administrative trust then participated in the following transactions: (1) it conveyed the building by grant deed to the LLC; (2) it transferred its membership interest in the LLC to the partnership; and (3) it divided its 99 percent interest in the partnership and distributed it to four sub-trusts maintained for Gloria’s benefit.  None of these transactions changed Gloria’s beneficial interest in the building.

Later, a “different kind of transaction” triggered the County’s imposition of a documentary transfer tax.  In that transaction, three of the sub-trusts transferred all of their interests in the partnership to two trusts maintained solely for the benefit of Allen and Bruce.

The transfers were documented by written agreements, including six limited partner transfer and substitution agreements.  There were no grant deeds or other instruments transferring legal title to the building.  The Allen and Bruce trusts executed promissory notes to Gloria’s sub-trusts, and the amount of those notes was tied to an appraisal of the building.

After the transfers, the Allen and Bruce trusts each held an approximate 45 percent interest in the partnership, which was the sole member of the LLC.  The LLC still held legal title to the building.

After the LLC filed a statement with the State Board of Equalization describing these transfers, the Los Angeles County Assessor determined that the transfers resulted in a “change in ownership” of the building under Revenue and Taxation Code section 64(d).

The LLC paid the amount demanded and filed a claim for a refund, arguing there was no change in ownership of the building.  The County denied the refund claim, and the LLC sued.

The trial court and court of appeal decisions

The trial court also denied the claim, and the LLC appealed.

On appeal, the court of appeal affirmed the trial court’s decision.

Then the Supreme Court granted review.

The Supreme Court’s opinion

The Supreme Court agreed with the lower courts and rejected the LLC’s refund claim.

The Court explained that while generally the transfer of an interest in a legal entity does not result in a taxable change in ownership of the entity’s real property, there are exceptions to this rule.  Under one of those exceptions, there is a change in ownership of all real property owned by a legal entity when: (1) the property was previously transferred to that entity, but that transfer was deemed not to be a change in ownership under Revenue and Taxation Code section 62(a); and (2) interests representing more than 50 percent of the total interests in the entity are subsequently transferred by any of the original owners.

The Court held that is exactly what happened here.  The initial transfers — of the building from the administrative trust to the LLC; of the LLC from the administrative trust to the partnership; and of the partnership from the administrative trust to the sub-trusts — were deemed NOT a change in ownership because Gloria’s beneficial ownership of the building did not change.  But the subsequent transfer of interests in the partnership from Gloria’s sub-trusts to the Allen and Bruce trusts WAS a taxable change in ownership.

The Court confirmed that a written instrument conveying an interest in a legal entity that owns real property may be taxable even if the instrument does not directly reference real property and is not recorded.  The “critical factor,” the Court held, was “whether there was a sale that resulted in a transfer of beneficial ownership of real property.”

Lesson

Even if the legal title to real property stays with one entity, a transfer of ownership in that entity can change the beneficial ownership of the real property so as to trigger a documentary transfer tax.

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