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FROM THE PBA REAL PROPERTY, PROBATE AND TRUST LAW SECTION NEWSLETTER — FALL 2008

New Realty Transfer Tax Regulations Raise a Ruckus

Philip B. Korb
Ballard Spahr Andrews & Ingersoll LLP, Philadelphia

On Nov. 15, 2007, the Pennsylvania Department of Revenue published new regulations to the Pennsylvania Realty Transfer Tax Act, which became effective Dec. 15, 2007 (61 Pa. Code § 91.111, et. seq.

From the moment the Regulations were published, the Department faced criticism. The most controversial change was its treatment of assignments of agreements of sale, which now can trigger multiple transfer taxes in a single transaction, including the common, non-abusive situation of an assignment without consideration by a company to its own affiliate. The Department has published a series of bulletins intended to convince the real estate community that the regulations were not a change of law, and were not intended to impair typical real estate transactions. Indeed, in its Special Edition Tax Update, Number 131, it stated: “The Department has never sought to impose tax on an intra-company assignment of a sale contract.”

However, in its subsequent, more detailed Realty Transfer Tax Bulletin, 2008-01, issued Jan. 3, 2008, and revised April 18, 2008, the Department confirms its intention to tax assignments to affiliates without consideration. The Department does offer a safe harbor method for structuring such assignments, but it turns out to be impractical and unworkable in the real world of real estate transactions.

Assignments of
Agreements of Sale

For a dozen years, the Department has chafed over the decision of the Pennsylvania Supreme Court in Allebach v. Comm., 546 Pa. 146 (1996). In that case, Mr. and Mrs. Allebach entered into an agreement to sell their land to a developer for $610,000. The agreement was flipped more than once, and the eventual buyer paid a total of $3,200,000, but only the original $610,000 was paid to the sellers, the grantors on the deed. The Department may have made a tactical mistake in pursuing, not the speculators but the sellers for transfer tax on the entire amount paid by the ultimate buyer, even though the sellers received only $610,000. The Court ruled against the Department, explaining that under the definition of real estate in the Realty Transfer Tax Act, 72 P.S. 8101-C, an agreement of sale is not real estate, and its assignment is not taxable. The Court advised the Department that if it wants to make such assignments taxable, it should ask the legislature to amend the statute.

The new Regulations begin by appearing to respect, for the most part, the Allebach decision. Regulation 91.132, “Bona Fide sale transactions,” limits the liability of a seller in such a case to the consideration it receives. Not unreasonably, it distinguishes between an agreement of sale with an unrelated third party, and a “seller’s affiliate,” which would be a transparent abuse, since it would not be a ‘bona fide’ agreement. Example 3 illustrates this ruse with a sale to a wholly-owned entity for $100,000, followed by an assignment of the agreement to a third party for an assignment fee of $500,000. In such case, the taxable value of the deed would be $600,000.

Feeling otherwise constrained by the Allebach decision, the Department seized upon the 30-year-old case of Baehr Bros. v. Commonwealth, 487 Pa. 233, 409 A.2d 326 (1979), as a means of attack. Baehr Bros. involved the liquidation of a corporation. The shareholders could have received the real estate of the company by a deed, and then deeded the real estate into a trust of which they were the sole beneficiaries. Each of those transactions would be exempt if done as two steps. To save time and paper, the shareholders transferred the real estate directly to the trust. When the Department sought to tax the single transfer, the Court ruled in favor of the taxpayers, explaining that since they could have avoided the tax had they structured the transaction as two steps, it would be fair to exempt the transfers where they simply collapsed two transfers into a single step. From this narrow ruling, the Department now claims that the Baehr decision actually requires it to examine transactions that are ostensibly single transfers to determine if they can be construed as if they were multiple transfers, and then tax each such transfer as if it were a separate taxable transaction.

For decades, Baehr Bros. has been the last resort of the desperate taxpayer, seeking sympathy from the Department and Courts. New Regulation 91.170 treats Baehr Bros., not as a shield, but as a sword. If the Department can characterize a single taxable transaction as if several taxable transactions had occurred, it will impose several taxes. The examples given show how the taxes would be calculated. Assume a property owner X entering into an agreement to sell Blackacre for $1,000,000 to Y, who assigns it to Z for an assignment payment of $500,000. At or before closing, Z pays a total of $1,500,000 ($500,000 to Y and $1,000,000 to X). The Department does not seek to extract a tax on $1,500,000 from X, as it did in Allebach. Instead, it claims that X and Y are jointly liable for the tax on $1,000,000 but Y and Z are jointly liable for a tax, not on $500,000 but on $1,500,000. It therefore claims that taxes are due on a total of $2,500,000.

Where this approach has become most controversial is in the common practice of real estate developers and nvestors to create single purpose entities (SPEs) to hold title to their real estate, as is often required by lenders, and often prudent for property owners. If Y acts as the buyer under an agreement of sale with X, and then, after due diligence is complete and the transaction nears closing, X creates a single purpose affiliated entity Z to be the title holder, it will assign the agreement of sale to Z for no or nominal consideration. The new regulations allow the Department to claim that two taxable transactions have occurred, and impose a double tax. If the purchase price of the property is $1,000,000, the Department could claim that two taxes are due, on a total of $2,000,000.

Despite its protestations in the December Update that purported to reassure taxpayers, the follow up Bulletin 2008-01 called for the Department to undertake a murky analysis of the intent of the buyer to determine whether a double tax should be imposed. It even offered as a cautionary example the case of poor “Gina”, the unfortunate victim of Bulletin Scenarios 2 (e) and (f), who enters into an agreement to buy a property, then consults with her lawyer who advises her to create a single purpose entity and to assign the agreement. The Department would subject innocent and unsophisticated Gina to a double tax. The Department explains that Gina could not have signed the agreement as an agent for the ultimate grantee because that entity had not been created, or even contemplated, at the time she signed the agreement.

The Department then issued, on April 18, a revised bulletin that makes clear the Department’s intention to reach intra-company assignments. New Scenario 3(a) posits a REIT that always enters into agreements in its name or in the name of its acquisition company, and then forms a whollyowned SPE to take title before closing. The Department’s response is unyielding: “Although the parties in this scenario have a common business practice of assigning sale contracts for real estate, that fact, in and of itself, does not create enough of a distinction to result in a different legal analysis or conclusion.”

Scenario 3(b) offers as a safe harbor a method for accomplishing such an assignment without paying a double tax. The initial agreement must state expressly that the nominal buyer is acting on behalf of a yet-to-be-formed SPE and “has no intent to obtain legal or equitable title.” When the buyer assigns to the SPE, that assignment must result in a “repudiation” and “novation” of the nominal buyer’s obligations. The financing must be in the name of the new SPE and the acquisition must be with the SPE’s funds, or funds it borrows.

It will be quite a challenge to coax sellers into agreeing to some of these provisions. Many sellers will refuse to release a buyer that assigns the agreement, especially if to a new entity with no assets, and will question the enforceability of an agreement in which the nominal buyer states expressly that it does not intend to buy.

Practitioners are left in a dangerous position, facing the risk of a double tax arising from a garden variety method of effecting a single acquisition. To avoid the issue, one could create a single purpose entity before entering into the agreement of sale and either have the SPE enter into the agreement or have the parent or acquisition company enter into the agreement expressly as agent or straw party for the identified SPE.

Alternatively, if the SPE is created after the agreement is executed, the parties could all agree to terminate the agreement and simultaneously enter into a new one between the seller and the SPE. If all the parties are cooperative, this will work, but it will not always be easy to accomplish. The parties’ bargaining positions may have changed, and circumstances will often require some revision to the new agreement, since many provisions, such as those listing contingencies that have since been satisfied, will no longer apply. The parties may then find themselves renegotiating the agreement, which will mean additional time, expense, and possible new issues.

Like-Kind Exchanges

The new regulations also address like-kind exchanges entered into under Section 1031 of the Internal Revenue Code. They include a provision stating that neither a qualified intermediary (QI), used in the typical forward exchange, nor an exchange accommodation titleholder (EAT), used in a reverse exchange, is the agent of the taxpayer. Reg. 91.153 (d). That provision, combined with the unclear taxation resulting from an assignment of an agreement for sale, raised the specter of multiple realty transfer taxes being imposed in Pennsylvania on like-kind exchanges of the sort entered into in every state of the Union.

The Bulletin is at least somewhat helpful in this area. It clarifies that in a forward exchange where the QI does not take title to the real estate, there only are two transfer taxes; one transfer tax on the sale of the relinquished property and another on the purchase of the replacement property. However, in a reverse exchange, the Department would still treat the EAT as acquiring and transferring the replacement property, which would result in an additional transfer tax If the EAT acquires the replacement property through a tiered disregarded entity structure and transfers all of the interests of the upper tier disregarded entity to the taxpayer, only one transfer tax would be imposed.

We have surely not heard the last word on these regulations. Their enforceability is certainly questionable. Rather than asking the legislature to amend the statute, as suggested by the Supreme Court, the Department has endeavored to sidestep Allebach by regulation. We can expect some combination of further regulations, litigation challenging the regulations, and legislation addressing the issues directly.

Philip B. Korb is a partner in the Real Estate Department of Ballard Spahr Andrews & Ingersoll LLP, in Philadelphia. He is a former chair of the Section.