Transfer Tax Liabilities Can Creep Up on You

Real estate transfer taxes can result in unexpected tax liabilities to real estate owners and investors, even where a transaction may have been “tax free” for federal and state income tax purposes. Many states make computing the liability for transfer tax a simple exercise; if you record a deed, you pay a tax. However, a sizable number of states and municipalities now have a controlling interest concept. What this typically means is that if you own or acquire a fifty percent (in some jurisdictions, more than fifty percent) interest in an entity that owns real property, a transfer tax may apply.

Many, but not all states have formulated some variation of the controlling interest transfer concept. Generally, where 50% (or more than 50%) of an entity that owns real property is transferred within a specified amount of time, the transaction will be viewed as if the property itself has been sold (at the applicable percentage) and the tax will apply.

In determining what constitutes a controlling interest, some jurisdictions look on a transaction-by-transaction basis to determine if the fifty percent threshold has been met, while others will look over a certain time frame, often referred to as the aggregation period.

Things get even a little worse as some jurisdictions have a per se rule (any transfers within a particular time frame will be aggregated), some have a presumption (any transfers within a time frame will be aggregated unless you can prove otherwise) and others incorporate the presumption approach in which the jurisdiction can rebut the presumption (transfers outside the time frame can be shown to be part of a plan, no matter how long the time period). Many jurisdictions hold both the transferor and transferee liable for the transfer tax. A transferor could end up being liable for a tax on a minority interest that was sold many years prior.

I refer to this as “creeping aggregation” and a tax liability for a controlling interest transfer could arise completely unexpectedly.

Different jurisdictions have different rules. For example, Connecticut and New Jersey presume transactions within a 6-month period should be aggregated, while New York State and City provide a three-year presumption, and Vermont provides no time frame but looks to those acting in concert.

What does this mean for your real estate transaction? Say you were to sell your minority interest in an LLC that owns real property in New York City. Two and one half years later a letter arrives by certified mail from the New York City Department of Finance. They have information that you were involved in a real estate transfer and would like you to remit the transfer tax immediately. The City transfer tax rate is 2.625% of the selling price of the real property.

While you did not sell a controlling interest in real property and believe you shouldn’t be subject to the transfer tax, the aggregation rules likely have come into play. Although the rules are much more complicated, for simplicity’s sake, let’s say that any transaction that takes place within a three-year period is presumed to be part of a plan and will be aggregated with other transactions, to determine whether a controlling interest in real property has been transferred, and the transfer tax is triggered. The reason you received the letter is someone else (even the party you sold to) just bought an interest in the same real estate partnership from someone else.

What could you have done to avoid this problem? Well as far as the taxing jurisdiction is concerned, not much. Both the transferor and transferee are primarily liable for the tax, and they will seek to collect from whomever they get the tax from first. You can, of course, put a provision in the sales agreement that the buyer of your interest will be responsible for paying the tax if either he or even someone else triggers the tax at a later date. Granted, the taxing authorities can still look to you for the tax, but at least you may still have an avenue of recourse.

For more information, please contact Wayne Berkowitz or visit our State and Local Tax Practice page.