Changes to Washington’s Real Estate Excise Tax Could Result in Surprise Tax Liabilities from Controlling Interest Transfers

Updated 9/18/2019, 9:15 PM

What Changed?

The Washington legislature recently enacted legislation that dramatically changes aspects of the state’s Real Estate Excise Tax (REET). Unless real property is classified as timberland or agricultural land, the REET rate structure will be changing on January 1, 2020. The current flat rate of 1.28% for the state portion of the REET will be replaced with a graduated rate.

The new rates will be:

• 1.1% on the first $500,000 of the selling price;
• 1.28% on the portion of the selling price between $500,000 and $1.5 million;
•  2.75% on the portion of the selling price between $1.5 million and $3 million; and
•  3% on the portion of the selling price over $3 million.

Flat rates for the local portion of the REET will remain; they generally vary from .25% to .5%, depending on the city or county in which the real estate is located.

Also beginning on January 1, 2020, the “controlling interest” transfer period expands from 12 months to 36 months. This expanded period could significantly increase the risk of inadvertently triggering REET liability with multiple transfers of minority ownership interests in entities that own real property in Washington.

The new legislation also authorizes the Washington Department of Revenue (“DOR”) to disregard the structure of a transaction or series of transactions designed to avoid REET liability, and to determine the proper treatment based on the substance of the transaction(s). For example, the DOR may treat multiple sales as a single sale based on an appearance that the parties engaged in a plan intended to reduce the tax rate.

What Is a Controlling Interest Transfer?

There must be a “sale” for there to be REET liability. The current definition of a “sale” includes the direct transfer of an interest in Washington real property and “the transfer or acquisition within any twelve-month period of a controlling interest in any entity with an interest in real property located in this state for a valuable consideration.”

A DOR regulation attempts to simplify the above definition by outlining the following components of a taxable controlling interest transfer:

1. The transfer or acquisition of a controlling interest occurs within a 12-month period (expanded to 36 months beginning 1/1/2020);
2. The controlling interest is transferred in a transaction or series of transactions by one person, or the controlling interest is acquired by a single person or group of persons acting in concert;
3. The entity has an interest in Washington real property;
4. The transfer is made for valuable consideration; and
5. The transfer is not otherwise exempt.

The REET issues often involved in controlling interest transfers include:

1. whether a taxable transfer occurs if multiple owners acquire their ownership interests during a 12-month (or 36-month) period,
2. the amount of REET due when there is a controlling interest transfer, and
3. if a controlling interest transfer is exempt from the REET.

Multiple Owners Acquiring Ownership Interests

A controlling interest in a corporation is 50% or more of all voting stock. A controlling interest in any other type of entity is 50% or more of the capital, profits, or beneficial interest in the entity. If two or more persons acquired, together, more than 50% of the interests in an entity during a 12-month period (or a 36-month period beginning 1/1/2020), the DOR generally presumes persons are acting in concert when there is a relationship where one person has control or influence over the other through common ownership. If there is no common control, the DOR will look for a united purpose for the transfers.

REET Measure on Controlling Interest Transfers

The statutory term “total consideration paid” encompasses anything of value, including a direct transfer of compensation, but also the amount of any lien, mortgage, contract debt, or other encumbrance. Thus, a transfer in exchange for debt relief or release of a lien constitutes valuable consideration.

Notwithstanding the type or amount of consideration exchanged, the measure of the REET when there is a controlling interest transfer is the “selling price,” which is the full market value of the underlying real property. The tax on a controlling interest transfer is NOT measured by the selling price of the ownership interests in the entity nor is it measured by the proportionate interest in the underlying real property represented by the ownership transferred.

If there are multiple transfers of minority interests within a 36-month period that comprise a controlling interest transfer, this involves the issue of applying the proper rate and dividing liability for the REET between minority interest holders – especially if the market value of the real property fluctuates during the relevant period. Unanswered questions regarding the new legislation include how to allocate REET liability among the transferors/transferees in a transfer of controlling interest occurring over time.

Exempt Transfers

There are numerous exclusions from the REET, and the DOR construes them narrowly. Also, there are some exceptions to the exclusions. The exclusions applicable to controlling interest transfers include transfers by gift, inheritance, and devise; transfers to a revocable trust; and transfers involving a “mere change in form or identity where no change in beneficial ownership has occurred.”

Transfers involving a mere change in form or identity could include the following:

1. a transfer for purposes of entity formation or liquidation that does not involve the recognition of gain or loss for federal income tax purposes;
2. a transfer by an individual or tenants in common of an interest in real property to an entity if the entity receiving the ownership interest receives it in the same pro rata shares as the individual or tenants in common held prior to the transfer; and/or
3. a transfer by an entity of its interest in real property to its wholly owned subsidiary or vice versa.

Expanded Period Impacts

The DOR and the Washington Secretary of State have not yet issued any guidance regarding changes to controlling interest transfers. Pursuant to the recently-enacted legislation, beginning January 1, 2020, entities with Washington real property will not only be required to annually report to the Secretary of State the transfer of a controlling interest, but also the transfer of “an interest that amounts to at least one-third of a controlling interest” (i.e., 16.67% beneficial interest), or the grant of an option to acquire said interest.

Given the reporting requirements, entities with Washington real property and multiple owners (including indirect beneficial owners) would be wise to closely track transfers of ownership interests. Without any issued guidance at this point regarding the additional 24 months added to the controlling interest period, there is a possibility that the DOR or Secretary of State will require entities to consider transfers made prior to 2019. If multiple transfers of ownership interests were made, the entity should also consider the relationships between the parties. We recommend contacting a tax professional familiar with REET issues if there are any questions concerning the aggregation of multiple transfers.

Notably, the newly-enacted legislation has not changed the requirement to submit a REET affidavit to the DOR when there is a controlling interest transfer, including controlling interest transfers that are exempt from REET.

Additional Guidance

The new legislation encourages the DOR to provide additional guidance on the new tax avoidance provision described above, and it is expected the DOR will also provide guidance on other REET matters. Currently, the DOR anticipates adopting a rule interpreting the tax avoidance provision during the second quarter of 2020, and a meeting to receive public comments is scheduled next month on October 16^th. Other REET guidance from the DOR is anticipated throughout 2020. It would be helpful if such guidance provides a structure for allocating REET liability for controlling interest transfers involving minority interest holders and addresses whether the expanded 36-month period encompasses interest transfers prior to 2019.

If you have any questions regarding Washington’s Real Estate Excise Tax, please contact a member of Clark Nuber’s State and Local Tax Group.

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