Revised Philadelphia Transfer Tax Ordinance Requires Reconsideration of Commercial Real Estate Transactions
On December 8, 2016, the Philadelphia City Council approved a bill intended to close various perceived loopholes used by owners of commercial real estate to minimize or avoid the City’s realty transfer tax. Mayor Kenney is expected to sign the bill. The new rules will become effective on July 1, 2017.
Philadelphia enjoys the dubious distinction of having one of the highest (if not the single highest) realty transfer tax rates in the country. In addition to the 1% tax imposed by the Commonwealth of Pennsylvania, the City of Philadelphia imposes transfer tax at a rate of 3%, which will rise to 3.1% after December 31, 2016. This high tax rate motivates owners of office buildings and other commercial real estate to find ways to avoid or minimize the tax. Last August, the Philadelphia Inquirer reported that in 2015 and the first part of 2016 there were at least eight sales of commercial real estate located in the City with a value in excess of $100 million, but in only one of these cases was realty transfer tax paid on the full purchase price. The new loophole closing bill was introduced one month after the front page article in the Philadelphia Inquirer, presumably to address these types of transactions.
The bill shuts down or restricts three commonly used techniques for avoiding or minimizing realty transfer tax:
- Tax on Acquired Real Estate Company. When tax is imposed on the transfer of interests in a “real estate company,” the City transfer tax will now generally be imposed on the “actual consideration paid for the company” rather than on the computed value of the real estate owned by the real estate company. This shuts down a very commonly used tax savings technique, since it is common to see situations where the price being paid for commercial real estate is substantially higher than its computed value. Computed value is the assessed value of the real estate times the common level ratio factor (which is currently 1.02 in Philadelphia). Although Philadelphia’s Office of Property Assessment attempts to assess all real estate based on current fair market values, it is still common to see cases where the assessed value is far below the agreed sales price, particularly when the real estate prices have been rising rapidly.
- Expanded Definition of Acquired Real Estate Company. Under current law, transfer tax is imposed if there is a 90% or more change in ownership of a real estate company within a three-year period of time. This has led to various types of “89/11” transactions that were intended to sell as large an interest in the company as possible without triggering tax. Under the bill, a change of ownership interests in a real estate company will trigger tax if there is a 75% or more change in ownership within a six-year period of time. It remains to be seen if this will give rise to “74/26” transactions or whether this change will make such transactions too difficult to pursue.
- Additional Restriction on Use of Computed Value. Another way, under current rules, to take advantage of a low computed value for the real estate being sold is to provide that at least some portion of the consideration will be paid in a form other than cash. Under current rules, this would cause the sale to be taxed based on the computed value of the real estate, rather than the amount being paid. Under the bill, the tax base will never be less than the amount of cash and the “readily ascertainable fair market value” of non-cash consideration given in exchange for the property.
As noted, the foregoing changes will become effective on July 1, 2017. These changes only affect Philadelphia’s 3% (soon to be 3.1%) realty transfer tax; they do not affect the 1% realty transfer tax imposed by the Commonwealth of Pennsylvania. These new rules will require a reconsideration of the optimal way to hold commercial real estate in the City of Philadelphia.
If you would like to discuss how you are affected by the transfer tax bill, please contact the authors or the attorney at the firm with whom you are regularly in contact.