by Bernard B. Kolodner

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 pr