Drop-Down LLC Transaction Constitutes Value for Real Estate Tax Purposes

A recent Ohio Supreme Court case, recognized that the price paid for the transfer of a 100% equity interest in the LLC owning a 264-unit apartment complex in Columbus, Ohio should be presumed to constitute the ad valorem tax value of the real estate owned by that entity. See Columbus City Schools Bd. of Edn. V. Franklin Cty. Bd. of Revision, Slip Opinion No. 2020-Ohio-253.

For years in Ohio, experienced real estate investors have been utilizing a tool known by drewvarious names, such as a “drop and swap” or an “entity purchase” to acquire commercial real estate in an effort to maintain a lower real estate tax valuation on the county tax records and, simultaneously, to keep the new sale price of the transaction from the scrutiny of county taxing authorities. This latter step would keep taxing authorities from noticing a new transaction often at a price that may be two or three times greater than the current tax valuation. Such steps were popular with CRE investors since it helped to keep real estate taxes, which in Ohio can range from about 1.0% to 4.0% of the tax assessed value, artificially low.

Public schools are the primary beneficiary of real estate taxes in Ohio with local boards of education (BOE) receiving from 35% to 60% of local real estate tax revenue. In this case, an inventive BOE counsel noted suspicious ‘no value’ real estate transfers and significant dollar value mortgage financing instruments being recorded against significant real estate assets despite no high dollar transfers being recorded. BOE counsel then filed a complaint against valuation to contest the value assigned to the real estate for tax purposes and sought to raise the tax assessed valuation of the apartment complex to $34 Million Dollars.

The Palmer House apartments were originally valued at $16,000,000 for real estate tax purposes in 2015. The Columbus City School Board of Education (BOE) filed a complaint at the Franklin County Board of Revision (BOR) to increase the tax value of the Palmer House to $34,000,000 based on a recorded mortgage that secured a $25,536,000 loan by estimating a 75% loan-to-value ratio. The BOE lost at the BOR level, then appealed the case to the Ohio Board of Tax Appeals (BTA). At the BTA, the BOE was able to produce through discovery a fully signed Purchase and Sale Agreement (PSA), Settlement Statement and a no-consideration deed to transfer the Palmer House from Palmer Square, LLC to Palmer House Borrower, LLC. A supporting affidavit filed concurrently with the deed explained that “[t]he conveyance of real property constitutes a capital contribution to the Grantee limited liability company.”  The BTA finally determined that the subject property was valued at $34,458,000.

Article 15 of the PSA provided the buyer with the option to structure the purchase as a “Drop-Down LLC sale.” The buyer elected the Drop-Down LLC structure and the parties entered into a first amended purchase agreement providing for, among other things, that in lieu of the seller conveying the deed to the real property to the buyer that the seller will sell and the buyer will purchase all outstanding membership interests in a newly-formed LLC, which will own the Palmer House at closing, in exchange for the purchase price. Prior to closing, the seller conveyed the apartment project to a LLC which it controlled and, at the closing, the seller exchanged 100% of the ownership interests in the Palmer House project to the buyer for the purchase price.

The Supreme Court concluded that the documentation in this case made it reasonable for the BTA to find that this sale reflected the parties’ intent to purchase and sell income-producing real estate, and likewise, supported the BTA’s finding that the transfer of entity ownership constituted a ruse for accomplishing the sale of commercial real estate.  Further, the Court concluded that the BTA had an adequate evidentiary basis for applying the sale-price presumption to the consideration set forth in the purchase agreement. The judgment of the BTA was affirmed.

Because of this case, it seems likely that Boards of Education will be emboldened to try to expose an “entity purchase” LLC transfer as a real estate transfer in the future.

There are many opportunities for real estate investors and local school boards alike to earn or save tax dollars and make smart real estate decisions with experienced real estate counsel in Ohio, Kentucky and Indiana. Feel free to contact Drew Emmert at AEmmert@DBLLaw.com or any of our real estate lawyers to assist you in your next real estate project.