The New Year brings significant changes to real estate transfer taxes on properties in the City of Philadelphia. They will change standard practices for how major real estate transactions in Philadelphia are structured, and they are also likely to affect how sophisticated real estate investors hold their properties long before any sale is in the works.
TAX RATE: Philadelphia has long been recognized as a national leader in the imposition of transfer tax, and it just enhanced its status for 2017.
Real estate transfers of properties within Philadelphia had been subject to a transfer tax of 4%. Of that, 1% went to the Commonwealth of Pennsylvania and 3% was for Philadelphia. Philadelphia has raised its transfer tax from 3% to 3.1%, for a current total effective combined rate of 4.1% as of January 1, 2017.
89-11 TRANSACTIONS: As a reaction to the substantial tax on the transfer of real estate, Philadelphia real estate attorneys have always searched for creative ways to avoid paying the tax. Long ago, selling interests in a company that owned real estate, rather than the real estate itself, was enough to avoid the tax, but the state legislature and City Council closed that loophole. What emerged from this process over a number of years was the “89-11” transaction, a legislated safe harbor for transactions in which no transfer tax was due so long as less than 90% of the ownership interests of a real estate company were transferred within a three year period. Entering into an 89-11 transaction meant that the prior ownership had to stay involved in the real estate company to the extent of at least 11% for three years While the prior ownership retained interest was a complication, 11% and three years was small and short enough so that where sufficient transfer tax dollars were involved, the 89-11 paradigm was frequently discussed between buyers and sellers and, somewhat less frequently, implemented.
The 89-11 safe harbor will be modified substantially for the Philadelphia portion of the tax. Effective July 1, not January 1, 2017, the new test will be 74-26 (“less than 75%”) for six years. This will substantially exacerbate difficulties of leaving a prior owner involved in the real estate company, because with a 26% stake in the ongoing operations for six years, the interests of the former owner are harder to work around. In some cases, 74% of the value of a property may not be enough both to pay off the seller’s lender and to cover the seller’s taxes from the transaction. The effect, and the intent, of these legislative changes is to restrict severely the use of the former 89-11 device.
COMPUTED VALUES: Even when buyers and sellers did not avoid transfer tax completely by using the 89-11 safe harbor, they often chose to buy/sell interests in a real estate company rather than the underlying real estate for another reason. When real estate, as opposed to an interest in a real estate company, is sold between unrelated parties, the transfer tax is based on the actual consideration paid. But when interests in a real estate company were sold, the transfer tax was determined with a formula (the “computed value”) based on the assessed value of the property for real property tax purposes. The computed value formula also applied if the consideration for a real estate transfer included non-cash property. Effectively, this was a win-win game for taxpayers. If the computed value formula produced a value lower than the actual market price, as was usually the case, especially during hot markets, the parties would prefer to transfer entity interests or use some non-cash consideration, unless other considerations were important, and the parties would pay transfer tax on that lower value. If it happened that the actual market price was lower than the computed value, the parties would transfer the real estate for all cash. The same computed value is also used for a host of other non-arm’s-length transactions that do not produce a clear measure of market value, including gifts, internal reorganizations of corporate groups, and foreclosures.
Effective July 1, 2017, that too will change for the Philadelphia portion of the tax. The actual consideration paid for the transferred interest in the real estate company, including the monetary value of consideration other than cash, will be the starting point to compute the transfer tax. Taxpayers will have the burden of proving any position they take that the actual value of the real estate is less than the price being paid for entity interests. In a non-arm’s length transaction, the computed value cannot be less than the monetary value of any actual consideration exchanged.
Together, the change from 89-11 to 74-26, and the change from computed values to actual consideration, will represent a larger tax increase for than the 0.1% rate increase. The computed value changes have the potential to affect estate planning and other family transactions as well.
These changes apply only to the Philadelphia portion of any transfer tax. The Commonwealth’s 1% tax remains subject to the old rules. In fact, the Pennsylvania legislature only recently changed the state 89-11 safe harbor to eliminate some differences from the City’s existing version.
If you have questions about whether you can be positioned to accomplish a transfer while still avoiding or reducing transfer tax, feel free to contact Bernie Kolodner at 215.496.7226 or via email [email protected], Julie Berson at 267.443.4122 or via email [email protected], or John Schapiro at 215-496-7234 or via email at [email protected].