California Court of Appeal Concludes Transfer Tax Not Applicable to Purchase of Realty Encumbered by Long-Term Leasehold

stand[ing] for the proposition that because “realty sold” is sufficiently similar to the phrase “change in ownership” contained in the same code and governing the analogous subject of reassessing property for property tax purposes (see [Revenue and Taxation Code] §§ 60, 61 & 62), courts can look to the definitions of “change in ownership” set forth in the property tax provisions to determine whether a particular type of transaction qualifies as “realty sold.” Slip Opinion at 7.¹

In 2011, the owners of the six-floor office building located at 731 Market Street entered into a 45-year leasehold for the ground floor with a CVS drug store and paid transfer tax on the creation of CVS’ 45-year leasehold. Subsequently, in 2015 the owners sold the entire property with the ongoing CVS leasehold remaining in place (with a remaining term of 41 years). The purchaser argued that because the ground floor was subject to CVS’ long-term leasehold, the ground floor did not constitute “realty sold” for purposes of San Francisco transfer tax; the creation of CVS’ long-term leasehold in 2011 was the only point at which there was “realty sold.” Since CVS remained the ongoing “owner” of the ground floor for property tax and transfer tax purposes, the purchaser argued that the principles of Thrifty, McDonald’s and Proposition 13 dictate that the 2015 sale did not cause a second transfer tax event.²

San Francisco disagreed, claiming that as a charter city, it was entitled to develop a broader definition of “realty sold” subject to transfer tax. San Francisco argued that the principles of Thrifty, McDonald’s and Proposition 13 only define “realty sold” under California’s general transfer tax ordinance set forth in Revenue and Taxation Code section 11911, and are inapplicable to San Francisco’s specific charter city transfer tax set forth in Article 12-C of San Francisco’s Business and Tax Regulations Code. San Francisco made the claim that its definition of “realty sold” in section 1102 of Article 12-C extends to both the CVS leasehold interest (created in 2011) and the entire property interest sold in 2015—including the ground floor.

The Court rejected San Francisco’s argument, noting that the transfer tax on “realty sold” under section 1102 of San Francisco’s Real Property Transfer Tax Ordinance (Article 12-C) was virtually the same as the transfer tax on “realty sold” under Revenue and Taxation Code section 11911 of California’s standard transfer tax provisions. The Court found that San Francisco had not made any modifications that might extend “realty sold” beyond the Proposition 13 change in ownership provisions relied on in Thrifty and McDonald’s. The Court’s rejection also noted that San Francisco’s claim would produce the absurd result of a duplicative transfer tax on the same “realty sold” acquired by two different “buyers.” Accordingly, the Court held that the scope of “realty sold” in the 2015 transaction was governed by Proposition 13, Thrifty and McDonald’s such that “realty sold” for purposes of San Francisco transfer tax did not include the portion of the property subject to CVS’ long-term leasehold.

California’s transfer tax has become a bigger issue for realty transactions as many California cities have recently taken action to substantially increase their transfer tax rates on large transactions to raise additional revenue.³ As the 731 Market Street case illustrates, significant savings can be achieved by carefully planning acquisitions and diligently analyzing the scope of the applicable realty transfer tax provisions. We have extensive experience in California transfer tax, as well as transfer tax in most other major U.S. cities, and welcome all real estate transfer tax questions.

^{1.   Shortly after the 1978 adoption of Proposition 13, California adopted Revenue and Taxation Code section 62(g) which specifies that a re-assessable change of ownership does not include a sale of realty encumbered by a long- term leasehold with a remaining term of 35 years or more. See also Property Tax Rule 462.100(b)(2)(A) and Assessors’ Handbook 401, Example 5-5, p. 36. The Legislature’s rationale was that property encumbered by a long-term leasehold of 35 years or more was substantively owned by the lessee, not the lessor. Thrifty and McDonald’s held that the same principles apply to California’s realty transfer tax such that the creation of such a long-term lease constitutes “realty sold” subject to transfer tax, while the creation of a shorter leasehold is not a sufficient property interest to be treated as “realty sold” for transfer tax purposes.}

^{2.  The purchaser agreed that the San Francisco transfer tax was applicable to the portion of the 2015 sales price applicable to the rest of the property, and that the impermissible duplicative transfer tax was only applicable to the portion of the property subject to the CVS leasehold.}

^{3.  Among those California cities recently increasing their rates are Hayward ($9.60 per thousand, up from $5.60 per thousand), San Jose ($19.40 per thousand on sales over $10 million, up from $4.40 per thousand), Oakland ($26.10 per thousand on sales over $5 million, up from $16.10 per thousand), Berkeley ($26.10 per thousand on sales over $1.5 million, up from $16.10 per thousand) and Richmond ($31.10 per thousand for sales over $10 million, up from $8.10 per thousand). The San Francisco transfer tax rate is currently at $30.00 per thousand for transactions over $25 million, however, there is a proposed ballot measure to double the rate to $60 per thousand for such transactions. Note the above stated transfer tax rates are inclusive of the standard County transfer rate of $1.10 per thousand.}