In a change of course, the New Hampshire Department of Revenue Administration (the DRA) has recently proposed new rules specifically designed to impose the New Hampshire 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 or out of the entity and the second tax is on the shares or interests exchanged in return by the entity. The net result will be a tax of 3% of any conveyance where an individual takes the commercially prudent step of placing their 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 company in a manner which is admittedly more reasonable than the current definition, but seemingly in conflict with the existing law.
The proposed rules target “real estate holding companies” defined as any businesses which derive either the majority of its revenue or the majority of its assets from real estate. Examples would be hotels, real estate management companies, home builders and other developers. In most commercial real estate activity, the real estate is owned by an entity which 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 which had permitted the creation, dissolution or reorganization of a real estate holding company without triggering any real estate transfer tax.
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 which went into effect this 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 which he desires to subdivide, develop and sell. As a prudent business-person he intended to conduct this business in the form of a Limited Liability Company: ABC, LLC. X establishes ABC, LLC, contributes his land, worth $700,000, and in exchange becomes sole owner of ABC, LLC. Under the current rules, even though X still owns the land indirectly through the LLC, the contribution of the land to ABC, LLC, generates a real property transfer tax liability of 1.5% of value of the land, or $10,500. Under the proposed rules, the corresponding transfer of sole ownership of ABC, LLC to X also generates a real property transfer tax liability at 1.5% 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 which are “principally” engaged in the business of owning, holding, or selling real estate. While this definition differs from the clear language of the statute which 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% of their assets was real property, they were arguably real estate holding companies. The proposed rule, if finalized, will eliminate this result.
DRA should reconsider its position on this subject. 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 which is or could be classified as a real estate holding company should confer with its legal counsel to discuss the available ways to avoid being caught in this expensive trap, even if the proposed rule is adopted.
* Dodd S. Griffith is admitted in New Hampshire.