Whether it is called a documentary stamp tax or a transfer tax, most states and some local jurisdictions tax conveyances of real property. In connection with transfers of interests in low-income housing, transfer taxes often create opportunities for tax savings or, for the unwary, looming traps.
Here are the two most common issues, along with taxpayer strategies to approach the tax as an opportunity rather than a pitfall.
The first scenario relates to special exemptions that may be available but that may require special care in planning the transaction. The second relates to how the parties report the transfer price to tax authorities and the potential to adjust the nominal price to account for the value of below-market financing that is part of some low-income housing programs. State tax laws vary considerably, but the following strategies will work in many jurisdictions.
Take advantage of exemptions
Investigating potential exemptions before structuring a real estate transaction can create a large tax savings. Some jurisdictions tax not only real estate transfers but also the transfer of an interest in an entity that owns real estate. A controlling interest transfer may be sufficient to trigger a real estate transfer tax.
Parties to a potentially taxable transaction should explore exemptions from transfer taxes from the outset because the availability of an exemption may influence negotiations and terms. An exemption may depend on how the transaction is structured, and altering the structure after the parties execute the agreement is often impossible.
Washington state, for instance, exempts from tax a transfer that under federal income tax rules does not involve the recognition of gain or loss for purposes of entity formation, liquidation, dissolution, or reorganization.
Consider an investor who plans to divest its controlling interest in a partnership, the sole asset of which is a Sec. 42 tax credit project. In this hypothetical example, the remaining partners want to avoid bringing in a new partner.
Correctly structuring the transaction as the liquidation of one partner’s interest for federal income tax purposes would avoid some or all of Washington’s real estate transfer tax. But if the departing partner simply sells its interest to the remaining partners, the real estate transfer tax applies. All the federal tax reporting must be consistent with the position for state tax purposes to qualify for this exemption. Though many states do not have this particular exemption, careful investigation of exemptions may reveal significant potential tax savings in any state.
Adjust the reported price
The second common opportunity or trap revolves around proper reporting of the value of the real estate transferred, which can reduce transfer tax incurred. Of more lasting importance to the buyer of a low-income housing project, proper price reporting can also help prevent over-assessments later, as assessors often rely on recorded transfer prices to set values for property taxes.
Many states base the transfer tax on the property’s market value, which is not always the same as the sales price. One way market value can differ from the sales price is when the buyer pays a higher nominal price by using below-market financing. Embedded in the concept of market value as defined by the American Institute of Real Estate Appraisers is the concept of cash equivalence, that is, the most probable price in cash or in terms equivalent to cash.
Several state courts have agreed with that definition. New Jersey’s Tax Court in 1984 held in Presidential Towers vs. City of Passaic that market value requires adjustments to account for favorable financing. The following year, Michigan’s highest court reached the same conclusion in Washtenaw County vs. State Tax Commission, requiring “a method of valuation that separates the cost of ... artificially low financing from the sales price to achieve the ‘true cash value of such property.’”
Wisconsin’s highest court, in its 1990 decision in Flood vs. Lomira Board of Review, similarly concluded that “cash equivalency adjustment is applicable whether the analysis is of the market value of comparable property or the market value of the taxpayer's property.” For states that base transfer taxes on market value, adjustments for cash equivalency should apply.
Cash equivalent adjustments should apply to low-income housing programs that receive mortgage subsidies. One such program is the U.S. Department of Agriculture’s Rural Development program, which provides long-term loans at an effective 1 percent interest rate to what are called Sec. 515 projects. Under certain circumstances, owners of Sec. 515 properties can transfer the project to a new owner who assumes the subsidized loan and preserves the low-income housing restrictions.
Transactions involving below-market financing, such as Sec. 515 preservation transfers, reflect not only the value of the real estate but also the very valuable subsidized financing. Before a Sec. 515 transfer, the federal program usually requires an appraisal to ensure that the property’s value will provide adequate security for the assumed loan. Rural Development appraisals separate asset value from the value of the financing to reach the cash-equivalent value of the property.
Reliance on such an appraisal should help in reporting the market value of the transferred property, but reporting an adjusted value can be complicated. Tax authorities may be unfamiliar with cash equivalency adjustments or simply resist accepting anything but the nominal purchase price. Competent state tax counsel should be able to present the information appropriately to the tax authorities.
Exemptions and proper price reporting can minimize the tax impact for both sellers and buyers. Engaging legal counsel familiar with locally applicable tax laws and practices early in the planning of a transaction may significantly reduce the parties’ immediate costs and the buyer’s future property taxes.
Norman J. Bruns and Michelle DeLappe are attorneys in the Seattle office of Garvey Schubert Barer, the Idaho, Oregon, and Washington member of American Property Tax Counsel, the national affiliation of property tax attorneys. Bruns can be reached at [email protected].DeLappe can be reached at[email protected]