Measure ULA – The City of Los Angeles “Mansion Tax” Part 2
As discussed in Part 1 of this blog, Measure ULA imposes an additional tax on transfers of real property within the City of Los Angeles of 4% of the consideration or value if the same exceeds $5,150,000 but is less than $10.3 million, or 5.5% if the consideration or value is $10.3 million or greater.[1] We also discussed the exemptions to Measure ULA including transfer of a partnership interest and transfers not changing the beneficial ownership interests in the transferred property. In Part 2, we will discuss deal structures to avoid or minimize the Mansion Tax.
Step Transaction Doctrine
Any avoidance strategy that involves more than one step must pass muster under the step transaction doctrine, which determines whether “the transaction should be treated as a whole or whether each step of the transaction may stand alone.”[2] Three tests have been developed for application of the step transaction doctrine: (1) the end result which combines all steps when it appears that all such steps were intended at the outset to reach the ultimate result, (2) the interdependence test which combines all steps when it appears that no individual step would have been taken without any of the others and (3) the binding commitment test which combines all steps when there is binding commitment to take later steps once the first step is taken.[3] If any of the three tests is satisfied, then the steps will be combined into a single transaction.[4] The greater the amount of time separating each step, the less likely that the steps will be combined.[5] In addition, the existence of a valid business purpose other than tax avoidance is also a factor militating against application of the doctrine.[6]
Structures to Reduce Transfer Tax
1. Transformation of Tenancy-in-Common Interests into Partnership Interests.
Suppose two siblings (X and Y) inherit a rental property in the City of Los Angeles valued at $11 million. They hold title as tenants in common. The siblings wish to sell the property but, in the meantime, wish to insulate themselves from liability (both in the operation of the property and its eventual sale) by contributing the property to an entity. They plan the following steps:
1. They each contribute their interest in the property to XY LLC, a newly formed limited liability company in return for a 50% interest in the LLC. The LLC is taxed as a partnership. This step is exempt from transfer tax because only the form of ownership changed, not the siblings’ beneficial percentage interests in the property.
2. X transfers his interest in XY LLC to X LLC, a single member LLC owned solely by X, and B transfers his interest in XY LLC to Y LLC, a single member LLC owned solely by Y. As a result, XY LLC is then owned by X LLC (whose sole member is X) and Y LLC (whose sole member is Y). This step is also exempt from transfer tax because again only the form of ownership changed, not the siblings’ beneficial percentage interests in the property.
3. One year later, X LLC and Y LLC market the property and collectively sell a total of 99% of the interests in XY LLC to Z, an unrelated third party, after which XY LLC continues to own the property. This step is exempt from transfer tax since it constitutes a sale of a partnership interest after which the partnership continues to own the property.
Since this structure includes multiple steps, it must be evaluated under the step transaction doctrine. If the doctrine applies, all steps are collapsed into a single transaction under which the siblings sell 99% of their original interests to Z, which would be subject to transfer tax. Under the end result test, we determine whether all steps were intended to reach the ultimate result: the sale of 99% of the beneficial interests in the property to Z. In this case, sale of 99% of the siblings’ interest in the property was only one of their goals; they also wished to insulate themselves from liability both in the operation of the property and its ultimate sale. Since the property was owned by an LLC and not by the siblings individually during the one-year period before the sale, they were insulated from claims arising from ownership of the property (unless they were personally at fault for the claim) and since the partnership interests were sold by their LLCs and not by them individually, they were again insulated from certain liabilities in connection with such sale. Thus, it appears that this test should not apply.
Under the interdependence test, we ask whether each step would have been taken without any of the others. Again, due to their desire to protect themselves from future liabilities, the siblings would have completed the first two steps whether or not they were able to sell the property. As a result, this test does not appear to apply. Finally, the binding commitment test clearly is inapplicable since the first two steps are completed one year before the property is placed on the market. Thus, it appears that in this case, the step transaction doctrine would not require the collapse of the individual steps into a single transaction. Accordingly, the applicable exemptions may be applied to each individual step thereby precluding liability for transfer tax.
2. Lease with a Term of Less than 35 Years
Rather than sell real property, the owner of property in the City of Los Angeles could instead enter into a long-term lease with another party, which lease includes a fair market value tenant purchase option that may be exercised at the end of the lease. As long as the lease term is for under 35 years, including renewal options, the lease transaction generally does not constitute a change in ownership.[7] However, this bright line seems to apply only to “ordinary leases of real property for a definite term of years”, and courts still look to the substance of a transaction rather than its form in analyzing whether a change of ownership has occurred.[8] In federal income tax matters, the IRS has provided taxpayers with numerous factors that are considered in determining whether a lease should be substantively characterized as a sale, including but not limited to whether there is an option to purchase, whether the option is likely to be exercised, and the intention of the parties.[9] Thus including a tenant purchase option in the lease could lead a court treat the transaction as a sale. A lease containing a bargain, fixed-price tenant purchase option, for example, is highly likely to be considered substantively equivalent to a transfer of ownership, whereas a lease with a fair market value tenant purchase option (or no tenant purchase option) would less likely be characterized as a sale.[10] While courts traditionally stick to the 35-year bright line for most leases, leases with terms that appear more like sales should be analyzed on an individualized basis. Since this transaction includes only a single step, the step transaction doctrine does not apply.
3. Allocating a Portion of the Purchase Price to Personal Property
A couple owns a home in the City of Los Angeles containing valuable art work. They sell the home for $6 million, but allocate $1 million of the purchase price to the art work. Since transfer tax applies only to “realty sold”, it does not apply to personal property, such as art work. As a result, only $5 million of the purchase price is subject to transfer tax. Since the current threshold for application of the Mansion Tax is $5,150,000, the Mansion Tax should not apply to this sale. And since this transaction includes only a single step, the step transaction doctrine does not apply.
[1] L.A.M.C. § 21.9.2(b).
[2] Shuwa Investments Corp. v. County o Los Angeles, 1 Cal. App. 4th 1635, 1648 (1991)
[3] Id.
[4] McMillin-BCED/Miramar Ranch North v. County of San Diego, 31 Cal. App. 4th 545, 556 (1995).
[5] Id. at p. 558-59.
[6] It is unclear whether the existence of a valid business purpose other than tax avoidance precludes application of the step transaction doctrine, but it is at the very least a factor that contributes to its non-application. See Smith v. Commissioner of Internal Revenue, 78 T.C. 350, 389 (1982) (stating that “[t]he step transaction doctrine generally applies in cases where…[t]he whole purpose of the unnecessary stops is to achieve tax consequences differing from those which a direct path…would have produced”) (emphasis added); but see also Associated Wholesale Grocers, Inc. v. U.S., 927 F.2d 1517, 1526-27 (10th Cir. 1991) (holding that a valid business purpose is a “factor in determining whether form and substance coincide”, but such a purpose does not itself preclude application of the step transaction doctrine).
[7] Cal. Revenue and Taxation Code § 61(c); see also 731 Market Street Owner, LLC v. City and County of San Francisco, 50 Cal. App. 5th 937, 946 (2020) (applying the principles of Cal. Revenue and Taxation Code § 61(c) to documentary transfer tax because “realty sold” for purposes of Cal. Revenue and Taxation Code § 11911 is highly similar to change in ownership in Cal. Revenue and Taxation Code § 61(c)).
[8] Thrifty Corp. v County of Los Angeles, 210 Cal. App. 3d 881, 884-85 (1989).
[9] Hardy, K. & Forbes, S. Lease Options: When Does the IRS Consider it a Sale? https://www.jmco.com/articles/real-estate/lease-options-sale/; see also IRC Rev. Proc. 2001-28.
[10] See Wells Fargo v. U.S., 91 Fed. Cl. 35, 38 (2010) (affirmed 641 F.3d 1319 (2011)).