A recent California Supreme Court decision may not have made the headlines, but it creates a wrinkle that attorneys handling real estate matters — whether as part of a transaction, litigation, or estate planning — and clients involved in such matters need to know about.

LLCs and partnerships have long been preferred entities for holding real estate. For any number of reasons, the ownership of these entities may change hands. In 926 North Ardmore Avenue, LLC v. County of Los Angeles, the California Supreme Court held that a change in the ownership of the entity that owns real estate may require that the Documentary Transfer Tax (DTT) be assessed, even when the real estate itself does not change hands. Previously, attorneys have interpreted the DTT to apply only to transfers of the real estate itself, so this case broadens the scope of the DTT. While the tax imposed by the DTT is modest, this broadening of its application creates a trap for the uninformed.

The Case

A husband and wife created a family trust in 1972. It was funded with, among other things, an apartment building on Ardmore Avenue in Los Angeles. After the husband passed, all of the assets of the family trust were held for the benefit of his surviving wife. The couple’s two sons were the successor trustees. They formed 926 Ardmore Avenue, LLC to hold the Ardmore property. The LLC was wholly owned by a limited partnership, which in turn was wholly owned by the family trust. Through a series of transactions, 90% of the family trust’s interest in the limited partnership was sold to the sons’ respective trusts.

These transactions constituted a “change in ownership” of the Ardmore property for property tax purposes, and the L.A. County Assessor appropriately reassessed the Ardmore property. However, the L.A. County Recorder also levied the DTT against the LLC. The LLC paid the DTT, but sued L.A. County for a refund, and the case went all the way to the California Supreme Court.

Based upon the language of the DTT statute itself, the LLC argued that the DTT is a tax on written instruments that transfer ownership of real property, not on written instruments that transfer interests in entities. However, based upon a tortured interpretation of the DTT statute, the Court deduced that the Legislature intended that the DTT apply to transfers of interests in entities where the transfer also constitutes a “change in ownership” for property tax purposes.

Effect

The Court’s decision dramatically broadened the scope of the DTT. While the DTT is generally not a big-ticket financial consideration, this expansion means that the DTT will arise in situations where it previously did not, and creates a trap for the uninformed. For example, it is typical when forming a new business venture (whether as an LLC or a partnership) to discuss “exit strategy” with the principals. Exit strategy often involves the departing member selling its interest in the entity to the entity or to the remaining member(s). If the entity owns real estate, it is now prudent to address how DTT will be handled if it is assessed as part of effecting an exit strategy. Also, in situations involving a dispute between owners of an entity that owns real estate where the resolution includes one owner leaving the entity and transferring his interest, it is possible for DTT to apply to the transfer, and it is advisable to address how DTT will be handled.

The bottom line is this: Clients don’t like surprises, and even routine transactions can become contentious over small matters, like the DTT. Anticipating and addressing them ahead of time can mean the difference between a smooth closing and an unhappy client.

The DTT and other real estate tax matters can be complex, and have financial consequences that can impact the deal points between parties. If real estate tax issues may be present in your transaction, it is worthwhile to seek advice from a professional with real estate and tax expertise.