The Pennsylvania Department of Revenue has drafted proposed amendments to Pennsylvania’s Realty Transfer Tax Regulations, which should be made available for public comment in the coming months. Following the public comment period and any further revisions by the Department, the Independent Regulatory Review Commission will vote later this year to approve or reject the amendments. While the Department characterizes the proposed amendments as improving the clarity and effectiveness of existing regulations, as currently drafted they would impose tax on additional transactions not currently taxable and require parties to real estate transactions to accept increased uncertainty and embrace nonstandard contractual terms in common transactions like leases and entity sales to avoid inadvertently triggering transfer tax. The effects of the proposed amendments (as currently drafted) include the following:
Current Law. The Realty Transfer Tax statute provides that a lease with a term of 30 years or more is subject to Realty Transfer Tax. For the 30-year test, renewal and extension terms are included if the lease includes either (1) the rent to be charged during the renewal or extension term, or (2) a method for determining the rent during the renewal or extension term (e.g., CPI increases). The existing regulations provide that “[r]enewals or extensions at the option of the lessee at fair rental value at the time of the renewal or extension are not included in determining the term of a lease.” As a result, it is common for parties to enter into a lease for 29 years with extension terms at fair market value rent.
Proposed Change. The proposed amendments narrow the exception for renewal and extension terms at fair market value rent by providing that an agreement to determine fair market rent using appraisals constitutes a “method” for calculating the rental charge and therefore the renewal or extension term would be included in the lease term for purposes of the 30-year test. If this change is adopted, the rent during an extension or renewal term will need to be at “fair market value” without identifying any process (such as appraisals) to be used to determine fair market rent.
Analysis. This seems to be an overly narrow interpretation by the Department that will operate to the detriment of Pennsylvania’s rental real estate market by introducing an unnecessary element of uncertainty in determining rent in extension or renewal terms.
Acquired Real Estate Company Rules
Current Law. If 90% or more of the interests in a “real estate company” (a closely-held entity primarily engaged in the business of holding, selling or leasing real estate) are transferred within three years, transfer tax is imposed. This rule has given rise to “89-11” transactions in which 89% of the interests in a real estate company are transferred currently, and the remaining 11% of the interests are transferred more than three years later. The parties typically negotiate put and call options for the remaining 11%, including strike prices for the options.
Proposed Change. The proposed amendments provide that options to purchase interests in a real estate company will be deemed to be exercised if the option fixes the terms of the purchase, including the purchase price. The Department will view the purchase price as fixed unless it is freely negotiable at the time the option is exercised. Establishing a method to determine the option price, even by appraisal, will be viewed as fixing the purchase price.
Analysis. The proposed change appears to be another step in the Department’s long march to curtail the use of 89-11 transactions. The proposed change goes too far: it would subject to tax an option to acquire 100% of the interests in a real estate company, even though the option might never be exercised. This is equivalent to taxing an agreement of sale for real estate when it is signed, rather than taxing the deed when the sale is consummated. It also seems to be overreaching for the Department to prohibit the option from establishing a method — like an appraisal — to determine fair market value. More fundamentally, since the option itself would not in fact transfer title to real estate, it would not meet the statutory definition of a taxable “document” and therefore impermissibly seeks to extend the Department’s taxing power beyond the reach of the statute. If the Department is determined to restrict the use of 89-11 transactions, it should do so more narrowly, more directly and within the limits of its statutory authority.
Current Law. Where real estate is transferred from an owner to a developer or contractor who is contractually obligated to improve the property and reconvey it to the owner, the transfers from the owner to the developer/contractor, and from the developer/contractor back to the owner, are exempt so long as no beneficial interest in the property is transferred to the developer/contractor.
Proposed Change. The proposed amendments provide additional requirements for a transaction to qualify as an exempt turnkey project. Most notably, the transfer from the owner to the developer/contractor must be solely for the purpose of providing the developer/contractor security for payment on the improvements to the real estate, and the developer/contractor’s interest must be limited to that of a secured creditor. The proposed amendment helpfully provides that if the owner defaults on payment, any document executed by the developer/contractor to take full equitable and legal title to the property pursuant to its security interest will be exempt from transfer tax as a confirmatory deed.
Transfers of Property Between Former Spouses
Current Law. The statute exempts from transfer tax any transfer between former spouses provided the property was acquired by one or both of the spouses before the entry of the final divorce decree.
Proposed Change. Under the proposed amendments, transfers between former spouses would be exempt only if made pursuant to the final divorce decree or a court ordered division or distribution of property incident to the divorce.
Please call Lafe Metz (412-562-1044) if you would like to discuss how these proposed changes may affect you or your business.