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Tuesday, Mar 21, 2023

SPECIAL REPORT: Prized Possessions

The 21-unit apartment complex at 926 N. Ardmore Ave. looks as unassuming as its low-slung east Hollywood neighbors. But the beige midcentury modern building is at the center of a legal battle that could fundamentally alter how properties change hands in California.

In a case now before the state Supreme Court, the complex’s co-owners are fighting Los Angeles County over the assessment of a “transfer tax” on a deal the co-owners maintain is exempt because the property itself never changed hands. Instead, the ownership stakes were transferred through a chain of holding companies and trusts.

Typically, the county struggles to assess taxes on similar transactions – and collect its 0.0011 percent tax on the transfer of real estate paid by homeowners and investors alike when they sell their properties. (The city has its own 0.0045 percent transfer tax.) Transfer taxes are not the only potential losses for cities and counties: Each transaction can also trigger a reassessment for property tax purposes.

Because transfer deals similar to Ardmore can avoid being recorded, there is no way to tell how much tax revenue is lost. One USC study suggests it could be billions of dollars in property taxes a year.

Government agencies came to rely more heavily on transfer taxes after the 1978 approval of Proposition 13, which limits property tax rate increases. The city of Los Angeles last year collected $204 million in transfer taxes.

The Ardmore case is a bellwether test to determine if decades of transfer tax precedent hold up. If not, real estate investors might want to set aside extra cash for the tax man.

“A lot of taxpayers are going to get blindsided here,” said Peter Michaels, an attorney in Oakland who represents the Alliance of Taxpayer Advocates. “Most won’t have the slightest idea that they have exposure to this tax.”

The Hollywood apartment owners, who controlled the property through an entity known as 926 N. Ardmore Avenue LLC, hope that won’t be the case. Their attorney, Lemoine Skinner, said he expects the high court to reverse the lower courts, which he claims overstepped their jurisdiction in 2014 when they ruled that legislative intent allowed for a broad interpretation of “change of ownership.”

“What happened at the trial court and court of appeal was judicial legislation,” said Skinner, an attorney at Westwood’s Goodson Wachtel & Petrulis.

The importance of the case to both sides is clear. More than a dozen counties in the state have joined Los Angeles in asking the lower court rulings be upheld. On the property owner side, nearly every major taxpayer advocacy group and several trade associations have lined up to ask, at the very least, for a clarification of transfer tax rules.

“It’s a case of transcendent importance,” Skinner said.

Empty coffers

Part of the reason the case claims such outsized attention is that it has the potential to upset the state’s static tax assessment laws, which haven’t changed much in nearly 40 years.

California adopted its Transfer Tax Act in 1967 to replace a similar federal system. The statute allows counties and cities to impose taxes beginning at $1.10 per $1,000 of an acquisition price. An even bigger change swept in a decade later: Proposition 13. The voter-approved ballot measure rolled back property taxes by about 57 percent and limited hikes to 2 percent a year. Most important, the measure effectively capped rates far below market value because no matter whether real estate markets rose or fell, properties would only be reassessed when sold.

This slashed county and city revenues across the state, while property owners who gamed the system through tax loopholes compounded the problem, said Lenny Goldberg of the California Tax Reform Association, which seeks to revamp Proposition 13.

Goldberg calls the system surrounding property taxes nonsensical. He estimated that on top of already depressed assessment values, thousands of properties in California each year change ownership through loopholes that prevent increases in assessed value and allow owners to duck transfer taxes.

“There’s example after example of properties that are paying a small percentage of their value,” he said.

Some property owners – particularly in the commercial and industrial sectors – have also used creative corporate structures to further skirt tax assessment. Los Angeles County Assessor Jeffrey Prang said the creators of Proposition 13 did not intend for the measure to give way to complicated, evasive legal structures.

“There are all kinds of ownership devices that may have not been so common when Prop. 13 was put into place, that are very common now, that have the net effect of helping property owners avoid a reassessment,” Prang said. “The devil is in the details, but for the most part we agree that these legal efforts to transfer property to avoid reassessment are inequitable.”

Given the private nature of the transfer of partnership interests, it might not be possible to calculate how many commercial real estate transactions were structured in a way that would allow them to avoid transfer taxes.

To be sure, there have been some high-profile deals that appear to have not met the threshold for paying the tax.

In one that did draw the attention of government officials, billionaire computer magnate Michael Dell purchased the Fairmont Miramar Hotel & Bungalows in Santa Monica in 2006, structuring his deal so that no single entity breached that half-ownership mark.

Although the county challenged the Fairmont deal in court as one that should be subject to a transfer tax, it lost. Dell’s creative workaround could give tax consultants a roadmap for skirting the new definition of an ownership change.

More recently, Boston Properties Inc.’s $500 million May purchase of a 49.8 percent stake in CA Colorado Center LLC, which owns the Colorado Center office complex in Santa Monica, might have avoided a taxable event.

The numbers represented by these deals can be huge.

The city of Los Angeles charges $4.50 per $1,000 on top of the county tax of $1.10 per $1,000 on real estate transfers. Other cities in the county charge rates ranging from $1.10 to $4.50 per $1,000 – collectively funneling to the county tens of millions of dollars a year.

These bills can add up quickly for those that do record their transfers.

Douglas Emmett Inc. and Qatar Investment Authority in March purchased four offices in Westwood, with 1.72 million square feet, for about $1.34 billion. The transaction’s transfer tax came out to $7.5 million. When the 26-story CBRE tower downtown sold in May for $313.6 million, the deal called for $1.8 million in transfer tax. And when the House of Bijan store on Rodeo Drive in Beverly Hills sold in July for $122 million, the county transfer tax added an extra $134,200.

Even these large transfer tax assessments don’t completely make up for lost property tax revenue.

According to a study by USC’s Program for Environmental and Regional Quality, the county could potentially double its property tax intake if it were to assess all commercial properties at market value. While the county will collect about $3.9 billion this year on commercial properties, the USC report projected it could gain up to $3.3 billion more if these properties were assessed at fair market value going forward. At least part of that determination of value is established by recorded property transfers.

Money maneuvers

The assessment in the Ardmore case is minute compared with that of larger commercial properties – just $11,000 – but the dispute over whether the tax should be applied has the potential to redefine the status quo.

In 2009, the owners of the Ardmore complex shifted control of the building to two trusts controlled by heirs. They claimed the transfer did not count as “realty sold,” the standard that typically triggers a transfer tax assessment, because it was done through an underlying LLC.

This type of maneuver has been used for decades to skirt assessments. But in 2010, a change to the California tax code allowed county recorders to view change of ownership statements filed with the state’s Board of Equalization – exactly the documents necessary to identify transactions that trigger transfer tax.

Acting on new information that revealed details of Ardmore’s ownership switch, the Los Angeles County registrar/recorder sent a tax bill in 2011.

Ardmore paid, but later appealed. That led to the drawn-out litigation, which explores the definitions of “change of ownership” and “realty sold” – designations that LLCs and trusts often use to avoid the transfer tax.

The trial court sided with the county. Then, in a court ruling breaking with years of precedent, a panel of appellate judges also ruled in 2014 that legislative intent allowed for a broad interpretation of “change of ownership.”

“The Legislature has signaled – both through the acts it has taken and the acts it has not – that the transfer tax should be interpreted to apply … where a transfer in legal entity interests results in change of ownership,” the appellate court said in its written opinion.

Skinner, attorney for the Ardmore property co-owners, contends the court’s ruling upsets decades of precedent and creates confusion for property owners and tax experts alike.

“Obviously there are doctrines that can fill in the gaps, but taxpayers need to know when property transfers are subject to taxes and when they’re not,” he said. “This should be a question for the Legislature to decide.”

Attorneys representing the county did not respond to requests for comment. The county’s registrar recorder, Dean Logan, declined to comment on the case.

New scenarios

The California Supreme Court’s decision in Ardmore will make an impact no matter the outcome.

“Either they reach a decision that creates a roadmap for the assessment of transfer tax in the state or they reverse,” said Michaels, the Alliance of Taxpayer Advocates attorney. “If overturned, those entities would be able to recoup the assessed taxes.”

If that happens, it could also prompt state legislators to clarify statutory language defining “change of ownership.”

Or, if the state doesn’t take action, counties and cities could follow the lead of places such as San Francisco, Berkeley, and San Mateo, which created voter-approved ordinances to shore up transfer tax provisions.

“The most convenient analysis for the court to reach would be to say counties have to go to voters for approval like they did in San Francisco,” Michaels said.

Even with oral arguments months away in the Ardmore case, some tax experts and attorneys are already looking for workarounds if the new ownership standard is upheld.

But with Ardmore’s outcome uncertain, attorney Dena Cruz at Bryan Cave in San Francisco counsels clients who are closing property deals to exercise caution and act as though a transfer tax will be assessed.

“I advise clients, you better escrow some funds for the transfer tax – or you might get burned,” she said.

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