California: Long-Term Lease Excluded from San Francisco Transfer Tax after Property Sale

Listen to a brief overview of state tax developments this week, including California, or read full California development below.

Detailed California Development

In a published decision, a California appeals court recently held that a transaction involving a sale that included a long-term lease with over 35 years remaining was not subject to San Francisco’s realty transfer tax.  The taxpayer, owner of a commercial building in San Francisco, leased part of its building to a retailer for 20 years, plus five successive options to extend the lease for additional five-year periods for a total term of 45 years. In 2011, the taxpayer paid City of San Francisco realty transfer tax after recording the lease, based on the value of the stream of rental payments due over the life of the lease. In 2015, the building was sold subject to the lease, which had a remaining term of 41 years. The taxpayer paid San Francisco realty transfer tax again, including about $287,000 that represented the then-present value of the stream of rent payments due over the life of the lease. Later, the taxpayer filed a refund claim for the transfer tax related to the lease, which San Francisco denied. The basis for the refund was that the transaction did not constitute “realty sold,” (which was not defined in the city/county ordinance), and therefore transfer tax was not due.  The matter went to trial, and the court concluded that the transaction did not trigger the tax as to the leasehold interest, because the transaction did not result in any “realty sold” under the ordinance. Therefore, San Francisco had impermissibly collected a “double tax” on the property. The City appealed the decision.

On appeal, the court noted that California Rev. & Tax. Code Sec. 11911(a) authorizes a county to impose a transfer tax. The state statute contains language substantially identical to that in the San Francisco ordinance, which states that “for the purposes of this ordinance, the determination of what constitutes ‘realty’ shall be determined by the definition or scope of that term under state law.”  Due to the similar language and the fact that the ordinance was adopted pursuant to authority found in state law, the court concluded that “state law” must be used to guide its construction of the ordinance. Because the statute did not define or directly address whether a particular type of transaction qualified as realty sold, the court looked to the definitions of “change in ownership” set forth in the property tax provisions. The “critical factor in determining whether the documentary transfer tax may be imposed is whether there was a sale that resulted in a transfer of beneficial ownership of real property.”

The property law statute provides that, unlike the creation of a lease of more than 35 years, a transfer of property subject to a lease with a remaining term of more than 35 years is not a “change in ownership.” The rationale behind this statutory exclusion is that “because the tenant with a remaining term of 35 years or more (including options) is deemed to hold the equivalent of the fee interest, a transfer by the landlord of its reversionary interest in property does not constitute a reassessable change in ownership because the landlord’s reversionary interest is not considered equivalent to a fee interest.”  Applying this rationale, the appeals court held there was no change in ownership that constituted “reality sold” in the transaction at issue. Specifically, other than substituting the new building owner as the lessor, the retailer maintained all the same rights as under the original lease, which had a remaining term of more than 35 years. As such, the court concluded that the lower court had properly held that the taxpayer was entitled to a transfer tax refund.  Please contact Gina Rodriquez at 916- 551-3132 with questions on 731 Market Street Owner, LLC v. City and County of San Francisco.

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Sarah McGahan

Sarah McGahan

Managing Director, State & Local Tax, KPMG US