Facts: A limited liability company (LLC) owns a parcel of real estate. The LLC enters into a purchase agreement with an investor to sell the real estate to an entity owned by the investor. Before any of the obligations under the purchase agreement are fulfilled, the purchase agreement is mutually terminated.

Instead, the investor and their spouse, through themselves and various entities, enter into a purchase agreement to acquire 100% of the membership interests in the LLC. However, no person or entity acquires more than 50% interest in the LLC. Likewise, no individual with an ownership interest in the entities indirectly acquires more than a 50% interest in the LLC. Title to the real estate remains vested in the LLC.

On closing the sale of the membership interests in the LLC, the county assessor reassesses the property. The property’s assessed value is set at the property’s current market value. The LLC, now controlled by the investor, pays the property taxes based on the reassessed value.

Claim: The LLC seeks a property tax refund, claiming the county wrongfully reassessed the property since reassessment of property owned by an LLC is triggered only if the transfer of LLC membership results in any one individual or entity acquiring more than a 50% interest in the LLC.

Counter claim: The county claims the reassessment was proper since the primary intent of the sale of 100% of the membership interests in the LLC was to avoid property tax reassessment.

Holding: A California court of appeals held the LLC was entitled to a property tax refund since no one individual or entity acquired more than a 50% ownership interest in the LLC and thus the property owned by the LLC was not subject to reassessment. [Ocean Avenue LLC v. County of Los Angeles (June 3, 2014)_CA4th_]

Proposition 13 restricts local revenues — again

Proposition 13 has gaping loopholes which California’s legislature continually fails to close, as exemplified by the Ocean Avenue case. For the purposes of reassessment, a property’s assessed value is the basis for the amount of property taxes its owner is obligated to pay. However, that value is static (but for the annual maximum increase of 2%) from the moment it is set, unless reset at the market value of the property on a change of ownership. [Calif. Constitution Article 13A §§1(a)]

Fairly straightforward, right? But it does create a corruptible ambiguity: what actually constitutes a change of ownership?

A change of ownership is the transfer of the ownership of real estate. [Calif. Revenue & Tax Code §60]

However, the change of ownership of an LLC (or other legal entity) does not constitute a change of ownership of the real estate owned by the entity, unless a single individual or entity acquires more than 50% of the membership interest in the LLC. [Rev & T C §64]

Thus, an entity vested in title to real estate may strategically divide the sale of its membership interests to successfully transfer ownership of a property for all purposes, except the vesting, outside of the porous radar of Prop 13.

To the benefit of buyers of property vested in corporations, LLCs and partnerships, this strategic maneuvering deprives communities of millions in tax revenue.

In stark contrast to income properties vested in LLCs, homebuyers are bound to shell out property taxes based on the current value of a home on the date they buy it. The average homebuyer operates outside of the world of sellers with LLC vestings. Even if a homeowner were to find such a seller, most homebuyers are typically unable to fractionalize their acquisition of ownership into less than 50% ownership interests.

Additionally, an LLC vesting for a homeowner causes the homeowner to lose the right to:

  • claim a homeowner’s exemption;
  • transfer the assessed value on to a replacement home in retirement; or
  • pass ownership without reassessment to family members.

Related article: Prop 13 renders homeownership less attainable

Parsing and dividing ownership

The division of an individual’s investments among different entities is permissible conduct. Thus, an individual may acquire de facto control over the ownership of a property through separate controlled entities and avoid reassessment. Yes, it is a shell game, but it’s presently permitted.

Consider the allotment of ownership interests in this particular case. Membership interests in the LLC owning the property were sold as follows:

  • 49% to a trust benefitting the investor’s spouse;
  • 42.5% to a limited partnership (LP) which was owned by the investor; and
  • the remaining 8.5% to an LLC, the majority of which was also owned by the investor.

In cunning Prop 13 fashion, the investor’s multiple interests effectively acquired about 48% ownership interest in the property. Meanwhile, the spouse purchased a separate 49% ownership interest through wealth vested in a trust arrangement for the benefit of the spouse.

Together, the spouses acquired over 97% of the ownership interest in the LLC owning the property. However, the transfer of interests to spouses under these circumstances is considered separate. [Board of Equalization Property Tax Rule 462.180]

When the spouses in this case collectively purchased 97% of the member ownership interests in the LLC, their interests were not combined. Thus, for tax reassessment purposes, though a majority ownership interest in the LLC was transferred to two spouses, a change of ownership of the property did not occur as no person or entity acquired more than 50% of the membership interest in the LLC.

A known flaw

Abuse of Prop 13 is not unknown to county assessors. When a transfer of LLC interests owning a property has been strategically manipulated to evade property taxes, is there any way for a county to enforce assessment?

No. At present, California sanctions these abuses.

In this case, the county attempted to expose the baffling exploitation behind this web of investment interests by calling upon the substance over form doctrine. The doctrine, frequently used in federal income tax interpretations, considers the entire transaction, going beyond the final documented results of the sales transaction to determine its underlying objective and economic reality. [Commissioner v. Court Holding Co. (1945) 324 US 331]

In Ocean Avenue LLC, the property in question was initially agreed to be sold to a single entity owned by the investor. However, the purchase agreement was scrapped immediately before closing. Instead, a new arrangement — a replacement — was agreed to on the same day the original purchase agreement was cancelled.

The new terms of the purchase gave the investor full control over the property vested in the LLC by way of assigning 100% ownership of the membership interest in the LLC to separate persons — individuals and entities affiliated with the investor. The arrangement neatly circumvented a property tax reassessment and the consequential property tax increase.

Here, the existence of the aborted purchase agreement indicated the investor’s ultimate intent was without doubt to purchase the property. Though the purchase agreement was not the final binding document agreed to by the parties, it fully revealed their objectives.

However, the substance over formreasoning did not prevail. The investors were shielded from reassessment since federal income tax analysis was not applied to a transaction governed by more specific and contrary state property tax laws.

Potential for equitable conversion

This case also poses questions about how applicable the principle of equitable conversionis to tax reassessment cases. The doctrine, when applied to real estate, holds a buyer is granted equitable title to the property upon entering a purchase agreement. The buyer is then bound to complete the purchase of the property at a later date.

Here, the county argued the initial agreement to acquire the property was enforceable. Thus, the property was originally transferred in whole to the investor’s initial purchasing entity, triggering property tax reassessment.

However, equitable conversion is enforceable only when the terms of the agreement are met by the seller and buyer. Here, both parties failed to satisfy the terms of the agreement. Instead of enforcing it, they mutually terminated the agreement in favor of a new one with preferable tax results for the buyer.

Further, the initial agreement did not meet the state’s definition of a transfer since it did not grant the investor’s initial purchasing LLC entitlement to revenue from the operations of the property until the date of closing. [Rev & T C §60]

So, what is the takeaway here, dear reader?

Prop 13 garners a lot of vociferous support from many members of the real estate community. However, it does have its known deficiencies, most notably its disproportionate impact on new homebuyers who subsidize existing homeowners through payment of higher property taxes. Let’s not also forget the way Prop 13’s so-called tax haven (for some) locks homeowners in place by discouraging them to relocate for fear of increased property taxes – an effect which inevitably impacts unemployment rates in a market that otherwise rewards mobility and optimism.

Moreover, Prop 13 is also the perfect conduit for property tax avoidance by investors — and it is 100% legal. Though county assessors may be privy to the ways Prop 13 is exploited, their hands are tied. As long as Prop 13 rules, investors may dodge property tax increases and legacy owners avoid paying their pro rata share of local taxes. All the while, first-time and move-up homebuyers disproportionately shoulder the burden of paying for local governmental services.

Related articles:

Addressing the Prop 13 partisans

Volume 7 of the first tuesday Realtipedia, Real Estate Matters (Chapter 33: “Reassessing” California’s property tax)

When will the loophole close?

Some small relief may be found in recent California legislation. Assembly Bill 2372, currently awaiting further amendment, proposes to redefine a change of ownership in property vested in a corporation, partnership, LLC or other business entity.

Under the bill, the cumulative transfer of at least 90% of the interest in an entity owning real estate through one or more transactions triggers reassessment, whether or not one individual or entity obtains majority control.

The proposed amendments do prevent members of an LLC, like the ones in Ocean Avenue, from tactfully dividing all membership interests in the LLC to transfer full ownership and sidestep reassessment of LLC-vested properties.

However, requiring the acquisition of at least 90% ownership interest does nothing to prevent investors from acquiring majority ownership in a property-owning entity — up to 89% — while still circumventing property reassessment. The seller need only retain a meager 11% ownership in the entity and reassessment is swiftly avoided.

Thus, in its current configuration, this bill offers only minor improvements, leaving Prop. 13’s loopholes wide open.

Stay tuned to the first tuesday journal as we report on the progressions in this contentious issue.

Related article: Has hell frozen over? Tax payer group drops opposition to Prop. 13 changes