On March 3, 2020, San Jose voters passed Measure E, which provides for a transfer tax on real property located in the City of San Jose. Beginning on July 1, 2020, the Santa Clara County Recorder’s Office began collecting the Measure E transfer tax on transfers of real property located in San Jose where the value of the consideration paid for the property is $2 million or more. For properties between $2 million and $5 million, the tax is $7.50 per $1,000. Between $5 million and $10 million the tax is $10 per $1,000. For properties $10 million and above, the tax is $15 per $1,000.
Applicability of Measure E to Transfer of Interests in Entities
Not only is the Measure E transfer tax applicable to transfers of property by deed, it also applies when a legal entity (such as an LLC) owns real property and there is a transfer of ownership or control in the legal entity pursuant to Revenue and Taxation Code section 64. To fully understand what a transfer of ownership or control means, it is important to understand the change in ownership rules under the Revenue and Taxation Code. The basic rule is that, unless an applicable exclusion applies, a change in ownership of real property will trigger a reassessment by the County Assessor’s Office and/or a transfer tax. However, under R&T Code section 62(a), individuals who own real property can transfer the property to a legal entity without triggering a change in ownership if the proportional ownership interests remain the same after the transfer. For example, if A, B, and C all own real property as tenants in common with A owning 60%, B owning 30%, and C owning 10%, the property can be transferred to an LLC without being considered a change in ownership if A owns a 60% membership interest in the LLC, B owns a 30% membership interest, and C owns a 10% membership interest.
For entities that own real property, the transfer of an interest in the entity generally does not result in a change in ownership the real property. In the above example, if C sold her 10% membership interest in the LLC to D, it would not be considered a change in ownership of the property. However, there are two major exceptions to this rule.
The first exception, under R&T Code section 64(c), is when there is a change in control of an entity. A change in control occurs when a person or other legal entity obtains more than 50 percent of the ownership interest in the legal entity. For example, if XYZ, LLC owns real property and ABC Corp. obtains a majority interest in XYZ, LLC, there is a change in control of XYZ, LLC pursuant to section 64(c) and therefore a change in ownership of the real property.
The second exception, under R&T Code section 64(d), is when there is a change in ownership of a legal entity where (1) the property was previously transferred to that entity, but the transfer was deemed not to be a change in ownership under R&T Code section 62(a) (i.e., proportional ownership interests remain the same after the transfer), and (2) shares or interest representing more than 50 percent of the total interest in the entity are subsequently transferred by any of the original co-owners in one or more transactions. In the example above with A, B, and C, the transfer of the property from A, B, and C to the LLC was not considered a change in ownership because the proportional ownership interests remained the same after the transfer. If A then sold her 60% interest to E then it would be considered a change in ownership because an original co-owner transferred more than 50 percent of the total interest in the entity.
Legality of Transfer Tax Based on Transfer of Interest in Entity
Questions have been raised on whether cities have the authority to tax the transfer of an interest in a legal entity, even if that entity owns real property, and whether the transfer tax should be limited to recorded documents. The California Supreme Court addressed these questions in 926 North Ardmore Ave., LLC v. County of Los Angeles (2017) 3 Cal.5th 319. R&T Code section 11901 et seq. is known as the Documentary Transfer Tax Act (the “Act”). Section 11911 of the Act authorizes counties and cities to impose a tax on “each deed, instrument, or writing by which any lands, tenements, or other realty sold within the county shall be granted, assigned, transferred, or otherwise conveyed to, or vested in, the purchaser or purchasers” if the amount paid is more than $100. In other words, when realty is sold for a net price of more than $100, the document effecting that sale is subject to the transfer tax.
The appellant in 926 North Ardmore Ave., LLC argued that an instrument that merely transfers an interest in a legal entity does not grant, assign, transfer, or convey “lands, tenements, or other realty sold” within the meaning of section 11911, and unless the subject matter of the instrument is real property, the instrument is not taxable. In other words, a purchase agreement for an LLC membership interest does not transfer or convey real property, it merely transfers the membership interest and the LLC continues to own the property. The appellant also argued that, based on other statutes within the Act, the transfer tax should be limited to recorded documents that show the parcel number and legal description of the property.
The Court examined section 11911 and related statutes in the Act and concluded that “a written instrument conveying an interest in a legal entity that owns real property may be taxable, even if the instrument does not directly reference the real property and is not recorded.” (926 North Ardmore Ave., LLC, supra, 3 Cal.5th at 332.) Accordingly, ordinances like Measure E that tax the transfer of ownership interests in a legal entity resulting in a change in ownership of the entity’s real property are permissible under California law.
Conflict of Measure E with Documentary Transfer Tax Statute
Another consideration worth exploring regarding Measure E is whether it impermissibly conflicts with the Act. Section 11911 of the Act authorizes cities and counties to enact ordinances that impose a transfer tax. However, Chapter 3 of the Act contains numerous exemptions to the transfer tax, including an exemption under section 11925 that states that “in the case of any realty held by a partnership or other entity treated as a partnership for federal income tax purposes, no levy shall be imposed pursuant to [the Act] by reason of any transfer of an interest in the partnership or other entity or otherwise” where (1) the partnership or other entity treated as a partnership is a continuing partnership pursuant to Internal Revenue Code section 708, and (2) the partnership or entity treated as a partnership continues to hold the real property. Section 708 of the Internal Revenue Code was amended in 2018 to end “technical terminations” of partnerships, so the only way a partnership is terminated under section 708 is if the partnership stops doing business, and changes in partnership interests no longer trigger a termination under section 708. Accordingly, under section 11925 of the Act, for LLCs that are treated as partnerships for federal tax purposes, the transfer of LLC membership interests should be exempt from the transfer tax authorized under section 11911.
Measure E is codified in the San Jose Municipal Code under Chapter 4.59. Measure E contains a partnership exemption under section 4.59.090 that is nearly identical to section 11925 of the Act, with one big difference. Section 4.59.090(D) essentially nullifies the partnership exemption for transfers of ownership interests in legal entities that would be considered a change in ownership pursuant to R&T Code section 64. In other words, Measure E allows the imposition of the transfer tax on LLCs that own real property and are considered partnerships for federal tax purposes when the transfer of LLC membership interests would trigger a change in ownership under R&T Code section 64. Thus, Measure E conflicts with the Act, its enabling statute, because as discussed above, pursuant to section 11925 of the Act, “in the case of any realty held by a partnership or other entity treated as a partnership for federal income tax purposes, no levy shall be imposed pursuant to [the Act] by reason of any transfer of an interest in the partnership or other entity or otherwise” for continuing partnerships that continue to hold the real property (emphasis added). Whether the City of San Jose has the authority to override the California Legislature by nullifying an exemption on transfer taxes provided by a state statute appears to be an open question.
With respect to Measure E, if you own an interest in a legal entity that owns property in San Jose (or another city in California with a transfer tax similar to Measure E), you should be aware that a sale of ownership interests in the entity may trigger the transfer tax. Contact qualified real estate counsel if you have questions about whether the sale of an interest in an entity will trigger the transfer tax, or if you would like advice on tax planning for a transaction.
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