Brokers tell clients to sell before transfer tax deadline

Thinking about selling a commercial property? Do it now.

That’s the advice brokers are giving to their clients across the board, after the city of Los Angeles passed a new transfer tax that would apply to all commercial and residential properties that sell for more than $10 million.

“If you plan on selling in the near future, if you can avoid the tax, you’re going to want to avoid it,” said Newmark’s Kevin Shannon.

On April 1, sellers of commercial property will face an additional 4 percent tax on any sales above $5 million, according to an L.A. ordinance on track to pass as a ballot proposition. Any sales above $10 million will face a 5.5 percent tax. Any revenues generated by the taxes will skirt the city’s general fund and go straight into a fund for affordable housing development and rent relief measures.

The ULA measure is a terrible law

And the spec home part isnt even the worst part. In Development deals, taxes are functionally paid up front, lowering existing land values

So that one-story strip mall is going to stay. Owner won’t sell to tear down & build housing

So dumb https://t.co/J5nDqpfYl8

— Bobby Fijan (@bobbyfijan) November 17, 2022

Commercial brokers, developers and investors interviewed by TRD shared a similar sentiment of frustration for the proposed tax. Though advertised colloquially as a “mansion tax,” the tax is set to have a profound effect on the commercial industry, with brokers suggesting it will lead to pricing reductions across the board, as interest rates have already dragged down valuations.

“It’s a perfect storm,” Travis Traweek, a broker at Stepp Commercial, said. “People already want to leave L.A., with the eviction moratorium, interest rates and rent control issues.”

“Bit of a spike”

Brokers don’t expect transactions to dry up completely after that April 1 deadline, though the number of deals are already on the decline, given rising interest rates.

“If they’re not transacting, they’re out of business,” Tony Azzi at Marcus & Millichap said of investment firms. “They can’t sit on the sidelines.”

But commercial investors may start to look elsewhere to transact. Multifamily investors, for example, may look to other cities in L.A. County, or even Orange or Riverside counties, where rents have dramatically increased over the last couple of years, Azzi said.

Though sellers will be able to avoid the tax if they sell a property before the April 1 deadline, any investor has to underwrite that extra cost into their calculations, since they’ll have to pay it when they want to cash out of the asset.

“It’s a drag on all values,” Shannon said. “It makes it harder to transact.”

The city of L.A. may see a “little bit of a spike” in transactions just before the transfer tax is implemented, but it’ll be muted, given it’s hard to get a deal done in the current rate environment, Shannon added.

But, there’s precedent for an uptick in transactions ahead of a new transfer tax. In 2019, the state of Washington implemented its own real estate excise tax — 3 percent on any sales above $3 million. Ahead of that transfer tax, Seattle saw “record velocity,” Shannon said.

“I suspect there might be a higher than average amount of sales in the city of L.A. in the first quarter than prior years,” said Patrick Schlehuber, who runs acquisitions at industrial REIT Rexford Industrial Realty, though it might not be a perfect comparison, given industrial sales have been robust since the pandemic started.

The tax also comes as office transactions have dramatically slowed, as a result of a lackluster return to the office, declining office values and stubbornly high vacancy rates.

“It hurts every asset class,” Shannon said.

Finding a loophole

Investors are already trying to figure out ways to skirt the transfer tax, by transferring properties through a joint venture or various LLC measures, according to sources familiar with the ordinance.

Law firm Gibson Dunn has affirmed that L.A. is likely to interpret the tax as “applying to a transfer of interests in a legal entity that results in a change in ownership of real property,” meaning a transfer from one LLC to another.

Whether the tax will apply to foreclosures and deeds in lieu of foreclosures still remains to be seen, according to Gibson Dunn. Both those types of sales are exempt from California’s state transfer tax.

“Sellers might get creative,” Jordan Asheghian at Marcus & Millichap said. Azzi, his partner, added that there was no guarantee and he wasn’t advocating anything illegal.

Total proceeds

Affordable housing organizations selling property may qualify for an exemption, according to the ordinance. Also, the proceeds from the tax are set to go towards “purchasing existing buildings” and “cutting red tape” to create more affordable housing.

“We’re for increasing funding measures for affordable housing, and this bill passing should create that,” said John Drachman, a co-founder of Waterford Property Company, which develops affordable, workforce and market-rate housing. “But it’s nuanced.”

It all depends on how many sales actually go through, Drachman said, and how much revenue is actually generated.

The city of L.A. is projecting the tax will generate between $600 million and $1.1 billion annually — an amount that will “fluctuate” depending on the number of property sales. And if sales dip — as they already are — the city may see revenue for new affordable housing programs dwindle.

Based on 2021 to 2022 real estate sales, one of the most active real estate years, the ordinance could generate around $900 million a year in revenue.

This year’s transactions won’t hit close to last year’s, brokers said.

And some investors, particularly ones that don’t have experience investing in L.A. or California, may shy away from deals in the future.

“It’s not going to attract additional investment in L.A.,” Shannon said of the tax. “It’s another negative factor.”

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