Death and (Real Estate) Taxes

March 2015

In California, owners of real estate do not have to pay property taxes based on the current value of their properties.  Instead, owners generally get the benefit of only having to pay property taxes based on the value of their real estate at the time of purchase (subject to 2% annual increases). This means that as prices and values of real estate shoot up by double digit percentage increases in a hot market, as often occurs in California, property taxes stay basically the same for owners who hold on to their real estate, or, in statutory terms, until there is a change of ownership. This is known as “Proposition 13 Protection,” named after the proposition implementing the rule, which was passed by California voters in 1978.

In addition to property taxes, when real estate is sold in California, there is sometimes a tax on the transaction known as a documentary transfer tax (“DTT”). DTTs are imposed by various counties throughout California on the document that is used to evidence the transfer, such as a grant deed. Cities may also impose transfer taxes—and many cities, such as Los Angeles, do.

For years, real estate and tax attorneys have helped their clients structure their transactions to avoid being subject to the property tax re-assessments that are triggered by a change of ownership, and the DTT imposed on the instrument used to transfer real estate. In 2014, the Second District of the California Court of Appeals addressed both issues in two different cases.

Statutory Scheme

The California Constitution, under Article 13A, explicitly permits a property tax reassessment when real property is purchased or when a change in ownership occurs (including gifts and inheritances). Under the California Taxation and Revenue Code (the “Code”) section 64(a), however, the purchase or transfer of ownership interests in a legal entity holding real property (such as an LLC) is generally not considered a change in ownership of the property for tax reassessment purposes. But Code sections 64(c) and (d) provide two important exceptions to section 64(a) — (1) if the majority control of the entity is transferred in one or more transactions to a single party, or (2) if cumulatively more than 50% of the interests in an entity have been transferred to other parties by any of the original co-owners of the entity (regardless of whether a single person holds a majority interest). In either of those circumstances, a change in ownership will be deemed to have occurred and a property tax reassessment will be imposed.

Pursuant to Code section 11911, counties and cities are entitled to impose a DTT on each deed, instrument, or writing by which any lands, tenements, or other realty soldwithin the county or city shall be granted, assigned, transferred or otherwise conveyed to, or vested in, the purchaser or purchasers, or any other person or persons, by his or their direction. Los Angeles County has adopted this tax.

2014 Cases

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

926 North Ardmore Avenue, LLC (“Ardmore”), a single-member entity owned an apartment building in Los Angeles. Through a series of transactions, BA Realty, LLLP (“BA Realty”) became the sole owner of Ardmore. BA Realty then sold 90% of its partnership interests, 45% to each of two trusts. Following the sale, the Office of the Assessor for Los Angeles County concluded that the sale of 90% of the interests resulted in a change in ownership of the apartment building and reappraised the property’s value. Ardmore paid the supplement tax assessment without objection. Following Ardmore’s payment, the Los Angeles County Registrar-Recorder/County Clerk sent a notice to Ardmore stating that the change in ownership of the legal entity controlling Ardmore (i.e., the sale by BA Realty to the trusts) meant that a DTT was also due. Ardmore paid the $11,000.00 transfer tax, but filed a claim with Los Angeles County seeking a refund. The claim was rejected. Ardmore filed a lawsuit challenging the imposition of the DTT.

The Court of Appeals examined whether under Code section 64(d), BA Realty’s cumulative transfer of more than 50% of the ownership interest in Ardmore to the trusts, constituted “realty sold” (an undefined term) under the Code to permit imposition of the DTT.

The traditional view in California has been that “realty sold” for property transfer tax purposes mostly only includes the customary sale or transfer of property—i.e., when a deed or other instrument is required to be recorded. The only legal entity transfer that is explicitly considered “realty sold” is the transfer of a partnership’s interests when the partnership is terminated.  However, the definition of “realty sold” has expanded over the years to include other legal entity transfers. Several counties, including Santa Clara, Monterey, and Napa, have amended their tax ordinances to explicitly provide for the transfer tax to apply when there is a change in ownership of any legal entity holding real property. Los Angeles County, which has not amended its tax ordinances in this manner, has stated on its website that it applies the same approach of imposing the transfer tax that it applies to a change in ownership of a legal entity holding real property.

The court considered the legislature’s intent in regard to the statute’s application and held that the legislature intended for the DTT to apply when property is transferred through the sale or transfer of a legal entity holding the real property. Further, the court found that Los Angeles County had given proper notice of the imposition of the transfer tax on its website. Consequently, the court held that “realty sold” had the same meaning as “change in ownership.” Therefore, the transfer of the present interest of Ardmore was sufficient to trigger the transfer tax.

Ocean Avenue LLC v. County of Los Angeles

Since 1999 to this day, Ocean Avenue LLC (“Ocean LLC”) has owned the Fairmont Miramar Hotel in Santa Monica. Hotel Equity Fund VII, LP (“HEF”) used to own Ocean LLC until 2006, when it sought to sell the hotel to MSD Capital LP (“MSD”) – an entity owned by Michael Dell. Rather than directly selling the real estate to MSD by way of a traditional grant deed, the parties instead structured the transaction as a transfer of the interests of the Ocean LLC entity as follows: (1) 49% of the LLC interest to Susan Dell (Michael Dell’s wife), (2) 42.5% of the LLC interest to an entity 99.9999% owned by Michael Dell, and (3) 8.5% of the LLC interest to another entity that was 68% owned by Michael Dell.  Mr. Dell’s actual combined interest in Ocean LLC through the various entities was 48%.

Under section 64(c)(1) of the Code, a change of ownership for purposes of property tax reassessment occurs when a single person or entity acquires more than a 50% interest of the company capital and profits. The Los Angeles County Assessor and the Assessment Appeals Board disregarded the “more than 50%” transfer to a single person or entity rule, and concluded that a change in ownership occurred nevertheless because, among other things, HEF transferred all of its interest in the hotel by transferring 100% of the Ocean LLC interests to all the buyers.  The Assessor and the Appeals Board argued, in part, that substance over form should dictate that a change in control occurred.

The Dells appealed arguing that no change in ownership occurred because none of the individuals or entities acquired more than 50% interest in Ocean LLC. The Superior Court and the Appellate Court sided with the Dells in interpreting the statutes, including a specific rule that states that the interests of a husband and wife are not attributed to one another for purposes of counting the 50 percent threshold. The courts also rejected the Assessor and Appeals Board’s substance over form arguments. As a result, the Assessor was not entitled to reassess the value of the hotel property based on the HEF transfer to the Dells.

Conclusion

Based on these cases, parties should be mindful of the various ways to structure their transactions to minimize real estate tax consequences.