State rules change could be costly for real estate holding companies
In a change of course, the New Hampshire Department of Revenue Administration recently proposed new rules designed to impose New Hampshire’s real estate transfer tax twice on any transfers of real estate into or out of any real estate holding company.
The first tax is on the real estate going into the entity and the second tax is on the shares or interests issued in return by the entity. The net result will be a tax of 3 percent of any conveyance in which an individual takes the commercially prudent step of placing real estate into a business entity. Not exactly the medicine designed to cure the ills of a struggling real estate market.
Beyond the obvious inequities of taxing the same parties to the same transaction twice, the DRA amended these same rules a mere six months ago specifically in order to avoid this type of double taxation. Finally, the rules redefine real estate holding companies in a manner that is admittedly more reasonable than the current definition, but seemingly in conflict with the existing law.
The proposed rules define “real estate holding companies” as any businesses that derive either the majority of their revenue or the majority of their assets from real estate. Examples would be hotels, real estate management companies, homebuilders and other developers.
In most commercial real estate activity, the real estate is owned by an entity that usually meets the definition of a “real estate holding company.”
The real estate holding company concept was created in 1997 in order to close a perceived loophole in the real property transfer tax. At that time, a person could contribute real property to a corporation in exchange for stock — a transaction that did not generate any real estate transfer tax. Then that person could sell the stock rather than the real estate itself, to another person, who could liquidate the business and receive the real estate in exchange for the stock. These transactions did not generate any real estate transfer tax, even though they involved the transfer of title to a third person.
The real estate holding company concept was introduced to tax transfers of interests in these businesses as if the real property owned by the business were being transferred.
In 2001, a further perceived loophole was closed that had permitted the creation, dissolution or reorganization of a real estate holding company without triggering any real estate transfer tax.
The proposed changes
After the 1997 and 2001 amendments, it was hard to argue that there remained any significant “loopholes” available to real estate holding companies from the real estate transfer tax, particularly concerning their creation and termination. The real estate of a real estate holding company could not be conveyed directly or indirectly, through sale or liquidation and escape tax. Yet those are exactly the areas targeted by the proposed rules — in polar contrast to the rules that went into effect in March.
Now DRA proposes to tax the contribution of real property to a real estate holding company in exchange for an interest in the company as two distinct taxable transactions. First, tax the transfer of the real property into the business; second, tax the transfer of the ownership interest in the business back to the former owner of the real property.
The rules create the same double-taxation scenario upon the distribution of property from a real estate holding company.
For example: Individual X owns land that he wants to subdivide, develop and sell. As a prudent businessperson he intends to conduct this business in the form of a limited liability company. X establishes “ABC LLC,” contributes his land, worth $700,000, and in exchange becomes sole owner of ABC.
Under the current rules, even though X still owns the land indirectly through the LLC, the contribution of the land to ABC, generates a real property transfer tax liability of 1.5 percent of value of the land, or $10,500. Under the proposed rules, the corresponding transfer of sole ownership of ABC to X also generates a real property transfer tax liability at 1.5 percent value of the land, or another $10,500.
We doubt that many sophisticated parties, for whom the loophole was closed in 1997, will be caught by this double tax. Most will prudently take title to the real estate in the entity in the first place. However, those individuals who already have real estate owned individually, who desire to put it into an entity for business planning or liability management reasons, face a double tax.
It seems unlikely that in closing the loophole back in 1997, the Legislature intended to impose double taxation on the unwary.
The proposed rules also amend the definition of real estate holding company as entities that are “principally” engaged in the business of owning, holding or selling real estate. While this definition differs from the clear language of the statute that created the definition discussed above, it builds some flexibility into the statutory rule. Service-based enterprises, such as law firms and accounting firms, often have no substantial assets other than the real estate from which they operate, and because more than 50 percent of their assets was real property, they were arguably real estate holding companies. The proposed rule, if finalized, will eliminate this result.
The double-taxation of a specific class of taxpayers by the DRA without a specific statutory instruction to do so, appears to be irrational, possibly unconstitutional. Rather than giving the ailing real estate market a shot in the arm, DRA proposes a swift kick in the shins. Any business that is or could be classified as a real estate holding company should confer with legal counsel to discuss the available ways to avoid being caught in this expensive trap, even if the proposed rule is adopted. nhbr
Dodd Griffith, a shareholder and director of Gallagher, Callahan & Gartrell, and heads its Corporate, Finance and Tax Practice Group. David H. Phillips is an associate with the firm, where he practices in the areas of taxation, employee benefits and estate planning.