In a decision that could save some commercial property owners hundreds of thousands of dollars in taxes, the Court of Appeal for the First Appellate District of California held in 731 Market Street Owner, LLC v. City and County of San Francisco (Cal. Ct. App., June 18, 2020, No. A154369) that the City and County of San Francisco cannot impose a documentary transfer tax on the value of an assigned landlord-interest in a lease when the lease has a remaining term of at least 35 years.  The 35-year cutoff considers both the remaining initial term of the lease and unused extension options.

In 2011, 731 Market Street Owner, LLC (“731 Owner”) and CVS Pharmacy (“CVS”) entered into a lease for space in the commercial building located at 731 Market Street; the lease included an initial 20-year term, subject to several lease extension options which allows CVS to extend the lease term by an additional 25 years.  In 2015, 731 Owner conveyed the property and assigned its leasehold-interest to its buyer.  In connection with the sale, 731 Owner paid to San Francisco a documentary transfer tax that included an amount attributable to the present value of 731 Owner’s anticipated rental income for the remaining 41 years of the lease.  731 Owner then sought a partial refund from San Francisco for the portion of the transfer tax attributable to the value of its leasehold interest.  After San Francisco declined to issue the partial refund, 731 Owner filed a complaint against San Francisco for declaratory relief.  The trial court held that 731 Owner did not owe a transfer tax for the assignment of its leasehold interest to the buyer, and awarded 731 Owner a refund for $286,922.00.  San Francisco appealed, and the appellate court affirmed the trial court’s decision.

The issue in the case was simply whether the assignment of the landlord’s interest in the CVS lease in 2015 was a taxable event.  The court held that it was not a taxable event because CVS remained in possession of the premises, and because the property was subject to a lease that had at least 35 years remaining in its term (including unused extension options).

San Francisco may impose a documentary transfer tax on “each deed, instrument or writing by which any lands, tenements, or other realty sold within the City and County of San Francisco shall be granted, assigned, transferred or otherwise conveyed to, or vested in, the purchaser or purchasers. . .”  pursuant to San Francisco Business and Tax Regulations Code § 1102 (emphasis added) (the “Real Property Transfer Tax Ordinance”).

The Real Property Transfer Tax Ordinance does not define “realty sold,” but states that the scope of “realty” is determined by the definition or scope of the term under state law.  The appellate court, using state law regarding reassessing property for property tax purposes as guidance, analogized “realty sold” with “change in ownership.”  The court found that “[t]he 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 logic behind this distinction is that when property is encumbered by a leasehold interest with at least 35 years remaining, it is, for purposes of reassessing property taxes, the tenant that is deemed to hold the equivalent of the fee interest in the property.  In analogizing the “change of ownership” interpretation with the “realty sold” provisions of the Real Property Transfer Tax Ordinance, the court found that “the 2015 sale of the underlying property subject to CVS’s lease did not result in a change in ownership and therefore did not constitute ‘realty sold’ to trigger the transfer tax.  At the time of the 2015 transaction, CVS maintained all the same rights under the original lease, which had a remaining term of more than 35 years. . . . Because CVS’s primary ownership interest in the leasehold never changed hands up to and including the time of the 2015 transaction, there was no ‘realty sold’ under the [Real Property Transfer Tax Ordinance].”

What does this mean for commercial property owners?  Significant tax savings.  The transfer tax rate fluctuates depending on the value of the property at issue, and the costs are typically allocated contractually amongst the parties in a transaction.  In San Francisco, the tax rate is 0.75% when the value of the property is between $1,000,000 and $4,999,999 and increases to 2.25% when the value of the property is between $5,000,000 and $9,999,999; the tax rate can climb to as high as 3% when the value of the property exceeds $25,000,000.  Depending on the length of the remaining term of the lease and the present value of anticipated rent, this ruling may save hundreds of thousands of dollars for commercial property owners.