The Maryland General Assembly overhauled the State’s tax structure in the recent 2007 Special Session enacted six bills and increasing State revenues by $77.1 million in fiscal 2008 and by $412.2 million beginning in fiscal 2009. State revenues from new recordation and transfer taxes on a transfer of a controlling interest in a real property entity which are estimated to be $14.1 million annually will contribute to that larger revenue stream beginning in fiscal 2009, and significantly will also result in an estimated $48.2 million in new local government revenues.

Tax Reform Act of 2007

Senate Bill 2 imposes recordation and transfer taxes on the transfer of real property with a value of $1.0 million or more when the transfer is achieved through the sale of a “controlling interest” in a specified “real property entity.”

Controlling interest is defined as more than 80% of the total value of the stock, or more than 80% of the total the interest in capital and profits of any other form of business entity, or more than 80% of the beneficial interest in a trust.

Real property entity means a corporation, partnership, association, limited liability company, limited liability partnership, other form of unincorporated form of doing business or trust that directly or beneficially owns real property that constitutes at least 80% of the value of its assets, and has an aggregate value of at least $1.0 million.

Effective July 1, 2008, the law imposes tax on transfers of controlling interests in a real property entity.

As described below, the new taxes will result in liability from 1.2% to 3% of the “consideration payable” in such a transfer (with the tax rate varying from county to county).

Exemptions From The Tax

The enactment exempts certain transfers. The transfer of a controlling interest in a real property entity is not subject to recordation tax: (1) if the transfer would have been exempt from recordation tax if it were a transfer by deed from the transferor to the transferee; (2) if the transfer is effected in more than one step and either (i) is completed over a period of more than twelve months, or (ii) is not made in accordance with an intentional plan to transfer a controlling interest; (3) if the transferee is an entity owned by the same persons and in the same proportions as owned the real property entity prior to the transfer; (4) if the transferor, transferee, and real property entity is owned by a common parent corporation or are such common parent corporation; or (5) if the transferee of the controlling interest is a Maryland nonstock corporation and registered with the Department of Aging as a continuing care retirement community.

The new tax also does not apply to: (1) entities owning land entirely subject to an agricultural use assessment; (2) a pledge of stock or other interest in a real property entity as security for a loan; or (3) the admission to the real property entity of additional shareholders, partners, beneficial owners or other members incident to raising additional capital if the “effective management” is “not substantially changed, and if none of the new members is expected to participate in the management.

How The New Tax Is Imposed

The new law requires a report be filed by the real property entity, with a $20 filing fee, whether or not tax is due, with the State Department of Assessments and Taxation (SDAT) upon the transfer of a controlling interest within 30 days of the final transfer.

The tax is to be imposed on the consideration payable for the transfer of controlling interest in the real property entity, reduced by the amount allocable to assets other than the real property. Consideration includes any mortgage, deed of trust, or other lien on the real property directly or beneficially owned by the real property entity and any other debt or encumbrance of the real property entity. The entity has the burden of establishing the consideration related to the real property and if it fails to do so the tax is imposed on the most recent assessed value of the property.

The Current System

The counties and Baltimore City are authorized to impose locally established recordation tax rates on any business or person conveying title to real property; or creating or giving notice of a security interest (i.e., a lien or encumbrance) in real or personal property, by means of an “instrument of writing” recorded among the land records. By way of example Baltimore City’s recordation tax is 1%.

The State and most counties also impose a transfer tax. The State transfer tax rate is 0.5% of the consideration payable for an instrument of writing conveying title to, or a leasehold interest in, real property (0.25% for first-time Maryland homebuyers). County property transfer tax may be imposed on instruments transferring title to real property and varies in rate. By way of example Baltimore City’s transfer tax is 1.5%. A distinction is made in the local codes between instruments transferring title such as a deed and certain leaseholds and instruments securing real property such as a mortgage. Except in Prince George’s County, most mortgages are not subject to the tax.

The 3% combined transfer and recordation tax rate in Baltimore City is among the highest in the country.

The Rationale

The high rate of tax has caused property owners to avoid the tax by selling equity interests in the entity that owns the real estate in lieu of recording a deed.

Several other jurisdictions around the country currently tax the transfer of the controlling interest in an entity owning real property, including California, Connecticut, Delaware, Illinois, Maine, New Jersey, New York, Pennsylvania, Virginia, and the District of Columbia.

Prior to the July 1, 2008 effective date of the new law, real property in Maryland can be effectively transferred without payment of transfer and recordation taxes by transferring controlling interest or ownership of the entity if the property is owned by a corporation, limited liability company, partnership or such entity. The sale of a property through the transfer of a controlling interest is not recorded in land records, and is therefore is not subject to transfer and recordation tax (i.e., no deed is being recorded).

State Revenues

The new enactment, based on a District of Columbia statute, requires SDAT to collect recordation (local) and transfer (State and local) taxes when real property is transferred by means of selling a controlling interest in a business entity that owns Maryland real property.

Because the law requires all transactions to be reported to SDAT, the State will now be able to track nonresidents involved in real property transactions. Nonresidents are required to pay income tax on the net gain from real estate transactions, but to the extent they were done through the transfer of controlling interest, the Comptroller had no mechanism with which to track these types of transactions. It is estimated that the income tax collected from nonresidents from these sales could be significant, due to the value of properties transferred in this manner.

Additionally the reports will provide SDAT with the purchase price or value of the property transferred (something SDAT has complained that it was not able to readily obtain) that the department will use for real property tax assessment purposes.

The law will also increase local recordation and transfer taxes by an estimated $48.2 million; revenue in excess of the $14.1 million in new State taxes.

Conclusion

With the new statute only days old and implementing regulations yet to be promulgated, this e-brief is not intended to be a comprehensive guide to this significant new tax, but rather is an alert that both opportunities may exist for real estate tax planning in advance of June 30, 2008 and new strategies should be explored with legal counsel for transferring real estate after that date.