On December 8, 2016, the Philadelphia City Counsel signed an ordinance amending Philadelphia's realty transfer tax. The most important new provision is designed to shut down the perceived loophole for "89/11" transactions. Other provisions expand the definition of "real estate company" for purposes of the City's transfer tax and further restrict the use of computed value. These new provisions are effective for transactions taking place on or after July 1, 2017.
The Old 89/11 Loophole
Buyers and sellers of Philadelphia real estate had to contend with a 4% realty transfer tax. This tax consisted of a 3% Philadelphia tax and a 1% State tax. The realty transfer tax applied not only to direct transfers of real estate, but also to transfers of 90% or more of the interests in a "real estate company" within a three year period. A typical partnership formed to hold commercial real estate generally would be considered a real estate company for this purpose.
The expansion of the realty transfer tax to transfers of interests in real estate companies, combined with the excessive level of tax imposed by the City of Philadelphia, inevitably spurred the popularity of so-called "89/11" transactions in cases where real estate was held in partnership form. In a typical 89/11 transaction, the partners of a real estate partnership would sell 89% of the interests in the partnership and agree to sell the remaining 11% interest after three years had passed. In its most aggressive form, the selling partners would sell 99% (or more) of partnership profits and 89% of partnership capital at the initial closing and, therefore, would receive nearly all of the consideration up front.
Closing the Loophole
Philadelphia's new ordinance seeks to close the loophole for 89/11 transactions. It has changed the ownership interest that will trigger the transfer tax from 90% to 75% with a six year waiting period. [Philadelphia Code 19-1405.] Under the new provision, a 75% change in ownership will be deemed to have occurred if, within six years of one or more prior transfers, the owners of the real estate company enter into a "legally binding commitment" to transfer the remaining interests in the company (or a sufficient interest to cross the 75% change in control threshold). The City takes the position that the tax will be triggered when the legally binding commitment is entered into, not when the remaining interest in the real estate company is actually transferred. Although this interpretation accelerates the time transfer tax is due, it also means that taxpayers who structure 89/11 transactions prior to the July 1, 2017 effective date should not be taxed, even if the second leg of the transaction is not consummated until after the effective date.
Tax practitioners are already arguing that giving a buyer an option to buy the remaining 26% interest in a real estate company after six years have passed should not be viewed as a "legally binding commitment" since an option merely gives the buyer the right to purchase, and is not "binding" on the buyer (who is free to walk away without penalty). Similar issues are raised if the original owner of the real estate company is given the right to "put" the remaining interest to the buyer. Officials in the City Law Department have indicated that they intend to issue regulations dealing with the new provisions prior to the July 1 effective date. They have also expressed the view that an option to buy the remaining 26% interest in a real estate company at a fixed purchase price, or on the basis of a fixed formula, should be viewed as a "legally binding commitment." An option to buy the remaining interest for appraised fair market value presumably would not be a legally binding commitment, however.
Under current law, a partnership or other entity that is primarily engaged in the business of holding, selling or leasing real estate will be considered a "real estate company" if either
- it derives 60% or more of its annual gross receipts from the ownership or disposition of real estate or
- 90% or more of its tangible assets (exclusive of actively traded assets) consists of real estate.
The ordinance expands the foregoing asset test by lowering the percentage of assets from 90% to 50%, and by stating that for purposes of this test the term "real estate" is not limited to real estate located within Philadelphia. Thus, you cannot avoid real estate company status by owning real estate both in and outside of Philadelphia within the same partnership.
The expanded definition of real estate company appears to have been motivated by a desire to prevent the "stuffing" of partnerships and other entities with other types of tangible assets in order to avoid real estate company status. Stuffing transactions are not nearly as useful as 89/11 transactions, so this change will likely not have a large impact.
The final change made by the new ordinance will further restrict the use of non-cash consideration given for the sale of property. Under the old law, a buyer could purchase at least some portion of the real estate in a form other than cash. The tax on the sale would then be computed on the value of the real estate rather than the amount being paid. In such a transfer, it was common for the price paid for commercial property to be many times more than its computed value. Under the new law, the tax base would never be less than the amount of cash paid and the fair market value of the non-cash consideration.
The City's thirst for revenue has led it to impose an extraordinarily high realty transfer tax. Aside from the effect of depressing real estate values and deterring businesses from locating in Philadelphia, this excessive tax rate has spawned creative strategies for avoiding or deferring the tax. This, in turn, has led the City to amend its ordinance a number of times to eliminate real or perceived loopholes. As a result, the City's transfer tax now contains fewer and more limited exclusions from the tax, as well as broader concepts of "real estate company" and "change in control," than are contained in the State's realty transfer tax statute.
The major impact of the new ordinance will be to make it much more difficult to avoid the City's 3.1% realty transfer tax. It remains to be seen if a new "74/26" will be used in the future. In the future, it will require greater creativity, and perhaps a greater tolerance for risk and uncertainty on the part of real estate buyers and sellers, to avoid the City's excessive realty transfer tax.