Based upon a new California tax case decision, scheduled federal tax law sunset provisions, and a new City of Los Angeles transfer tax enacted in the just concluded November 2022 election, new changes are coming to the taxation of real estate. Below is a discussion of several of these new real estate tax law changes.
1. New December 2022 California Tax Case Denies Section 1031 Tax Treatment to Partners Where Real Property is Distributed to the Partners Immediately Prior to that Property’s Sale, Followed by the Partners’ Attempted Section 1031 Exchange
The California Franchise Tax Board continues to be more aggressive than the Internal Revenue Service in auditing and challenging Section 1031 tax-deferred exchanges by partnerships. Clients who distribute real property from a partnership to its partners immediately prior to that property’s sale, followed by some partners attempting to do a Section 1031 exchange into other real property while other partners receive cash upon that property’s sale (the so called “drop and swap” exchange), must observe certain formalities in order to achieve favorable Section 1031 tax treatment.
The California Office of Tax Appeals (known as the “OTA”) on December 5, 2022 released a new tax decision (dated as issued on November 2, 2021) in the case of F.A.R. Investments, Inc. (OTA Case Nos. 19125618 and 19125619, Pending being classified as a Precedential decision). F.A.R. Investments, Inc. held that where a real property is liquidated from the partnership and distributed to the partners immediately prior to closing that property’s sale to a third party, but the partners individually fail to exercise incidents of ownership over that real property, then Section 1031 tax exchange treatment will be denied to those partners. F.A.R. Investments, Inc. teaches California taxpayers that the partnership’s liquidation should be done well before a real property listing agreement is signed or any type of marketing for the property’s sale is attempted. Thus, the partnership’s liquidation should not be done after a letter of intent, or a real estate purchase agreement is signed. Instead, the real property should be liquidated from the partnership to the partners well in advance of the property’s sale and the partners as tenants-in-common (and not the partnership) should for a period of time collect rents, have any property loan in the partners’ names, and pay any property operational expenses. To limit liability exposure, individual former partners (who become instead tenants-in-common on the partnership’s liquidation) can utilize single member limited liability companies to own their respective tenancy-in-common interests in the relinquished property.
The longer in advance of the proposed property sale that the partnership’s liquidation is completed, the more likely a successful Section 1031 tax result is achieved. As can be seen in F.A.R. Investments, Inc. the California Franchise Tax Board continues to aggressively audit Section 1031 exchanges, including attempted “drop and swap” liquidations of partnerships immediately prior to closing a real estate sale transaction.
When a partnership wishes to sell properties and do a Section 1031 exchange, with some partners receiving cash from the property’s sale while other partners receive replacement real estate or where partners want to each receive different replacement properties, there are alternative tax planning strategies available. For example, a tax-free partnership division could first be effectuated under Section 708 of the Internal Revenue Code, so that one of the divided partnerships receives cash in the sale transaction, while another divided partnership does a Section 1031 exchange. Alternatively, the partnership could sell its real property and exchange into multiple replacement real properties and designate certain replacement real properties for certain partners. Another planning strategy (as discussed above) is to liquidate the partnership and distribute the real estate to the partners as tenants-in-common (and the former partners operate that real property for a period of time as tenants-in-common) in advance of the sale of that relinquished real property. Finally, there are tax planning techniques where promissory notes are utilized for those partners that wish to cash out on the property’s sale. Each of these tax planning strategies has certain risks and benefits, both tax and otherwise, and each strategy needs to be evaluated on a case-by-case basis.
2. Increase of the City of Los Angeles Transfer Tax for the Sale and Transfer of Commercial and Residential Real Estate
Measure ULA (sometimes referred to as the “mansion tax”) has passed in the just concluded November 8, 2022 election. Basically, Measure ULA increases the transfer tax for the transfer of real estate in excess of $5 million which is located within the City of Los Angeles. The new tax revenues from this increased tax are to be used for affordable housing and to assist residential tenants. This new tax applies to the sale of both residential homes and commercial real estate located within the City of Los Angeles.
Currently, the City of Los Angeles and the County of Los Angeles impose a documentary transfer tax on instruments being recorded to transfer real estate. The City of Los Angeles’ current real estate documentary transfer tax is imposed at the rate of $4.50 per $1,000 of consideration paid for real estate transfers, and the County of Los Angeles current real estate documentary transfer tax is imposed at the rate of $1.10 per $1,000 of consideration paid for real estate transfers. Thus, there currently is (before this new Measure ULA tax) a total tax of $5.60 per $1,000 of consideration paid for real property sold within the City of Los Angeles (or a current tax of 0.56%).
The new Measure ULA tax is in addition to the current existing combined County and City of Los Angeles documentary transfer tax of 0.56%. Measure ULA imposes a new additional transfer tax of 4% on City of Los Angeles real property (residential and commercial) sold which is valued in excess of $5 million but less than $10 million, and if the real property is valued at $10 million or more, then the new additional Measure ULA tax increases to 5.5% of the real property’s value. Importantly, the amount of any loan encumbering the property is not deductible for calculating this new Measure ULA transfer tax. Additionally, this new tax applies to the entire property’s sale amount and not just the amount in excess of the $5 million and $10 million thresholds. This new tax applies even if the real property is sold at a loss. Note that there are provisions in Measure ULA to adjust the thresholds of this new tax based upon future inflation.
There are certain narrow exceptions from the new Measure ULA tax, such as for certain affordable housing developments. The goal of this new real estate transfer tax is to provide revenue for affordable housing programs and for homeless prevention programs.
Although not entirely clear, it is expected that the City of Los Angeles will try to apply this new tax to transfers of interests in legal entities (such as transfers of partnership or limited liability company interests) which results in a change of ownership for property tax purposes.
This new real estate transfer tax imposes a new significant tax for transactions on or after April 1, 2023 of both residential homes and commercial properties located within the City of Los Angeles. As an example, upon a $30 million sale of an industrial real estate building located within the City of Los Angeles, this new Measure ULA tax imposes a new additional $1.65 million of tax on the sale regardless of the size of the loan encumbering the building. Note that there is an ambiguity in the language of Measure ULA and it is possible that the City of Los Angeles could allow only a 4% tax on the amount in excess of $5M and up to $10M of the sales price of the property which is sold for greater than $10M (but the City’s position on this interpretation is unclear at the current time). This new Measure ULA tax is in addition to the City and County documentary transfer taxes on such property’s transfer and any state or federal income taxes.
3. The Inflation Reduction Act of 2022 Changes Affecting Real Estate
The Inflation Reduction Act of 2022 (known as the “IRA”) includes tax incentives affecting real estate. One of the goals of the IRA is to encourage clean energy and to reduce carbon emissions into the atmosphere. The IRA contains provisions providing investment tax credits and/or production tax credits. The goal of the investment tax credits is to encourage investment in renewable energy projects, such as from solar and wind energy sources. The tax credit starts out at 6% of the taxpayer’s cost basis for eligible property and can increase to 30% if specified wage and apprenticeship requirements are also met. There are recapture provisions for the investment tax credit if the property is sold or ceases to qualify within a period of five years from its placement in service. The investment tax credit vests at an amount of 20% per each year (thereby reducing the recapture of those credits). Owners of real estate projects can choose between the investment tax credit or the production tax credit. The IRA also contains tax incentives for certain wages for employees who work on construction projects, provided they are paid at “prevailing wages” (which is defined by statute).
The amount of the investment tax credit and production tax credit can increase if the real estate project is located in certain specified areas known as an “energy community”. Energy communities are certain specified brownfield sites and areas that have minimum employment levels or certain other areas having revenues from coal, oil, or natural gas.
4. The Section 199A 20% Pass-Through Deduction is Scheduled to Expire
The Section 199A 20% pass-through deduction for qualified business income is scheduled to expire on December 31, 2025. Rental real estate enterprises may in certain circumstances be treated as a trade or business to qualify for this Section 199A pass-through deduction. Section 199A was a Republican sponsored tax provision in the 2017 Tax Cuts and Jobs Act and has been unpopular among Democrats. Since the Republicans no longer control both houses of Congress to pass an extension tax bill, this Section 199A 20% pass-through deduction may expire as scheduled on December 31, 2025. The original idea of Section 199A was to provide similar tax treatment to partnerships and S corporations that C corporations receive due to the reduction of the C corporate tax rate from 35% to 21% in 2017. The current corporate income tax rate of 21% will remain permanent after December 31, 2025 under existing tax laws, even though the Section 199A deduction is scheduled to expire.
Due to incoming Congress’s political party split it will be difficult for any significant federal tax legislation affecting real estate to be enacted prior to the 2024 Congressional and Presidential elections. However, the taxation of real estate transactions remains a focus of federal, state, and local governments, due in part to the large increase in real property values over the past several years and federal, state, and local governments’ search for additional tax revenues.
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