On December 8, 2016 the City Council of the City of Philadelphia (Council) passed Bill No. 16081001 (Bill), which would amend Chapter 19-1400 of The Philadelphia Code regarding the City's Realty Transfer Tax, by closing certain loopholes. Notable proposed changes include amending the definition of "value" as it relates to acquired real estate companies as well as the definitions of "real estate company" and "acquired real estate company." The Bill has been sent to the Mayor's Office, where Mayor Kenney will either sign the Bill into law, do nothing (in which case the Bill will become law after 10 days), or veto the Bill (in which case the Council may vote to override the Mayor's veto). If the changes are enacted, they will become effective July 1, 2017.

Transfer tax overview

A transfer tax is a tax imposed on the privilege of transferring ownership of real property. The majority of states impose some sort of real property transfer tax. About half of the states impose a transfer tax only when the transfer of real property is effected using a deed. These states do not impose a tax when the transfer of real property is effected by means of a transfer of controlling interest in an entity that owns real property. For example, a state that only taxes deed transfers would not impose a tax on the sale of LLC A, owned by A, which owns a piece of land located in the taxing jurisdiction, to B; although B now owns LLC A, which owns the land, no deed has been recorded as part of the transaction. The scenario described is known as a "controlling interest transfer." Pennsylvania imposes its transfer tax on a controlling interest transfer only if the entity being transferred is a "real estate company," which is defined by statute. Most counties, including Philadelphia, follow the Commonwealth's rule. Philadelphia has special powers that enable it to modify its real estate transfer tax in ways different from the Commonwealth's.

Current law

Under current law, a "real estate company" under Philadelphia's Realty Transfer Tax law is defined as a company primarily engaged in the business of holding, selling or leasing real estate, whose ownership interest is held by 35 or fewer persons, and which either has 60% or more of gross receipts from real estate, or whose value is 50% or more comprised of real estate. The definition also includes any company owning 90% or more (directly or indirectly) of a real estate company.¹

Under Pennsylvania law, a controlling interest transfer is based on the "value" of the underlying real estate. "Value" is calculated by multiplying the assessed value of the real estate for Pennsylvania property tax purposes by a common level ratio.² The tax rate is applied to this amount to calculate the tax due.

To illustrate, suppose LLC A is owned by A, and that LLC A's only asset is real property in Philadelphia with an assessed value of $1 million. LLC A would be considered a real estate company. A sells 100% of LLC A to B for $2 million. Philadelphia would not look to the $2 million sales price. Instead, the base of the Philadelphia tax would be the $1 million assessed value, which is then multiplied by the common level ratio (currently 1.02), resulting in a value for transfer tax purposes of $1.02 million.

Bill amendments

The most significant change effected by the Bill is the way value would be calculated. Instead of using the prior computation, which was previously used and is applied by the Commonwealth, the value for Philadelphia purposes may not be less than the readily ascertainable market value of the underlying property. Further, the Bill would create a rebuttable presumption that, when ownership of a real estate entity is transferred, the consideration paid for the company is the value.³ Therefore, in the previous illustration, the value would be the $2 million paid for the company rather than the $1.02 million assessed value, multiplied by the common level ratio. Note that this change would increase the tax base in the illustration by nearly $1 million (but only for Philadelphia purposes; the traditional base presumably applies for purposes of computing the Commonwealth portion of the tax).

The Bill would also change the definition of a change of ownership of a real estate company. Under existing law, a change of ownership only occurred if 90% or more of the interests in the real estate company was transferred within three years, which includes any binding commitment to make a future transfer if the commitment was entered within that period. Therefore, under existing law, a transfer of 89% of the interests in a real estate company would not be taxable in Philadelphia, provided no additional transfers occurred within three years.

The Bill would lower the threshold and, if enacted, provides that a change of ownership will occur if only 75% or more of a real estate company is transferred within six years. Therefore, a transfer of 74% of a real estate company would not be taxable in Philadelphia, provided no additional transfers occurred within six years.

If enacted, not only will the Bill affect the tax base of real estate company transfers but it will likely also result in the Philadelphia Realty Transfer Tax applying to more transfers. If the Bill is enacted, its changes will apply to transactions occurring on or after July 1, 2017.

Implications

The lower percentage controlling interest transfer requirement and longer aggregation period will likely result in more companies being subject to the Philadelphia transfer tax. Once a transaction qualifies, the tax due is also likely to increase substantially because of the change in the computation of value. Those contemplating transactions affecting property located in the City of Philadelphia should monitor the enactment of the Bill and, if enacted, may want to consider accelerating transactions prior to the Bill's July 1, 2017 effective date. Complicating matters is that these changes only affect the Philadelphia portion of the transfer tax (for which the tax rate will increase to 3.1% of the taxable value, effective January 1, 2017.)

Even if the Bill is enacted and these changes occur to Philadelphia transactions, the Commonwealth's tax base on the same transaction remains unaffected (i.e., the Commonwealth's definition of real estate company and taxable value has not changed nor have the thresholds changed for a taxable ownership change) and will continue to be levied at the rate of 1% of the common level ratio value. Consequently, taxpayers could find themselves subject to the Philadelphia tax but not the Commonwealth's tax for some transactions.

EY's State and Local Tax Real Estate Team is monitoring the Bill's progress and intends to provide updates on the Bill as it moves through the enactment process. Please contact EY to discuss the implications of the Bill to any current or planned sales of entities owning real property located in the City of Philadelphia.

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ENDNOTES

¹ The Philadelphia (PA) Code Section 19-1402 (available on the Internet (last accessed on December 15, 2016)).

² Id.

³ City Council of Philadelphia, (Pennsylvania) Bill No. 160810 (available on the Internet (last accessed on December 15, 2016)).