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‘Big, big money:’ Legal loopholes help property owners avoid taxes, fees

August 12, 2018

‘Big, big money:’ Legal loopholes help property owners avoid taxes, fees

CLEVELAND, Ohio – In April, a Canadian real estate company bought one of downtown Cleveland’s largest apartment buildings, the 407-unit Sphere on East 12th Street.

But no purchase price appears in public records. The sale didn’t produce a conveyance fee, a government-imposed charge on real estate transfers that would have brought in $160,000 to $200,000 on a likely $40 million to $50 million transaction.

Though it’s possible to guess at the price based on a $35.9 million mortgage filing, the cloaked nature of the sale means that Cuyahoga County is missing key data to determine what the property is worth. That makes it harder for the county to raise property taxes on Sphere, which the county’s fiscal office values at only $8.6 million, and tougher for appraisers to treat the building as a benchmark for establishing values for similar downtown properties.

And it’s all completely legal.

In these opaque transactions, real estate investors buy the entity, a limited liability company, that owns a building rather than purchasing the property outright. Such entity sales conceal details about ownership changes and, in turn, limit tax dollars that otherwise would flow to school districts, local governments, libraries and other public beneficiaries.

Entity sales are commonplace in Ohio. But there’s no way to know just how often they happen – or how many millions of tax dollars are at stake every year.

“It’s significant. Big, big money,” said one appraiser, who asked to remain anonymous in order to speak freely. “But it’s impossible to kind of ballpark track. You just don’t know.”

When a buyer purchases a house in Ohio, there’s typically documentation of that sale. In most cases, there’s a conveyance fee, equal to $4 for every $1,000 in value in many counties. And the sale generates a data point, a piece of information that a county auditor or fiscal officer will consider during every-three-year reappraisal cycles to adjust the tax value of that home – and to inform decisions about how much comparable homes are worth.

The process is similar for commercial real estate, from office buildings to power plants, warehouses, shopping centers and apartment complexes. But sophisticated investors and, occasionally, wealthy homebuyers sometimes take additional steps that eliminate those up-front conveyance fees – and push off, if not totally avoid, future hikes in their property-tax bills.

Since the investors are buying a limited liability company, such transactions technically are not deemed real estate sales. County auditors and other public officials describe this sort of activity as an “LLC loophole.”

It’s a loophole that, during an era of scarce resources and state cuts to local-government funding, those auditors want to close.

“The only way our system works right is when everybody is paying their fair amount,” said Matt Nolan, who serves as auditor for Warren County, near Cincinnati.

A draft legislative bill to apply conveyance fees, which largely flow to county general funds, to entity sales involving real estate circulated among legislators and attorneys in the state early this year but wasn’t formally introduced in the General Assembly. It’s being workshopped by the County Auditors’ Association of Ohio and the Ohio State Bar Association.

“Our overarching concern with the bill was that it was overly broad,” said Mike Sikora, a Cleveland-area attorney who is part of a bar association council examining the issue. “It just didn’t take into account real-life scenarios.”

Some developers readily described entity sales as ways to avoid or reduce taxes.

Others said their motivations for structuring deals this way are about different factors – privacy, financing, existing contracts – and don’t necessarily keep money out of public coffers. They expressed concern that changes to state law, however well-intentioned, will make real estate investment more difficult and less appealing in a state where many communities still haven’t rebounded from the Great Recession.

And some real estate experts say any fuss about entity sales is the wrong debate.

One lawyer described the transactions as a symptom of, or response to, a significant problem – a state property-tax system that’s dysfunctional, unconstitutional and unfair, where schools and commercial property owners constantly do battle over what buildings are worth and where taxes in some communities are prohibitively, and deal-killingly, high.

“There’s all sorts of reasons why people do this and probably will do more of it,” said the attorney, who, like many industry professionals interviewed for this story, asked not to be identified. “I think it’s a lot of much-ado-about-nothing, except for the fact that we do have a broken system. And it’s the leading indicator of the broken system.”

Raising the stakes

In 2016, someone left a copy of a regulatory filing at the Athens County Auditor’s office. The document revealed that in November 2012, a company tied to a California investment firm, IRA Capital, obtained a loan for a $48.3 million purchase of the Summit at Coates Run, an 856-bed student-housing complex near Ohio University.

That transaction – an entity sale – occurred in December 2012. A deed was filed, so the auditor’s office collected its 50-cent-per-parcel transfer fee. But there was no conveyance fee, which would have totaled $193,000, most of it earmarked for the county’s general fund.

And the property-tax stakes were much greater.

In 2012, Athens County appraised Summit at Coates Run at nearly $13.8 million. But late that year, a mortgage appraisal found the property was worth almost $49 million, according to the regulatory filing. That’s a gap of more than $35 million in market value – or $12.3 million in taxable value, based on the way Ohio property taxes are assessed.

That’s a difference of more than $680,000 a year in property taxes.

When Athens County Auditor Jill Thompson saw that regulatory filing, she was stunned. She didn’t realize such entity sales were legal – or that, by accounts from appraisers, attorneys and real estate brokers, they’ve proliferated in some parts of the state in recent years.

The Athens Township Board of Trustees quickly filed a challenge with the Athens County Board of Revision over the value of Summit at Coates Run. And the board agreed to boost the appraised value of the building to $49 million for the 2015 tax year.

But that victory was late. The adjustment didn’t make the county whole for revenues it missed in 2013 and 2014, when the public appraisal of the property was much lower.

And the victory was short-lived. Soon after, pointing to falling occupancy, the property owner successfully petitioned to reduce the value of the building to $29.5 million.

Critics say such transactions don’t only hurt local governments and public schools, which continue to rely on property taxes despite Ohio Supreme Court rulings that the state’s method of funding schools is unequal and unconstitutional. When some commercial real estate owners underpay property taxes, others consequently overpay under Ohio’s complex system.

Tax experts say the impact on homeowners is slight, since residential properties are classified differently under Ohio law. Still, there is some spillover due to special tax levies that apply across all types of real estate.

“If you buy a home, the value gets bumped up to the purchase price,” an appraiser said.

But with entity sales involving commercial properties, “even if a tax attorney finds out about it and goes after it, oftentimes there’s a settlement. So the valuation doesn’t go up fully to the purchase price. The taxpayer’s kind of getting hosed on this,” the appraiser added.

Well-hidden sales also distort market data. If landlords sell 10 apartment buildings in a city, and five of the transactions are entity sales, then the local county auditor will be working with only 50 percent of the data while trying to establish values for similar properties.

“That could very significantly skew our data so that our values aren’t correct,” Thompson said, “That affects every taxpayer.”

Journalists, school-district attorneys and real estate professionals turn up details about some entity sales by sifting through mortgage records, federal regulatory filings, subscription-only real estate databases and other sources. But many transactions leave no paper trail. Even lawyers who specialize in tracking down these deals say the majority never become public.

“Most properties are not multimillion-dollar properties,” said David Seed, a Cleveland attorney who represents school districts. “And if you can structure an entity sale on a modest property, you have the potential to secure a long-term tax break.”

Avoiding extortion

In Cleveland’s Superior Arts District, at the eastern edge of downtown, GBX Group used entity purchases to keep things quiet during four years of buying up neglected buildings and parking lots.

Privacy is a major impetus for forming and selling limited liability companies, said Drew Sparacia, chief executive officer at the Cleveland-based firm, which owns and renovates historic buildings and advises other real estate investors on complicated tax issues and legal strategies.

In some cases, businesspeople don’t want anyone knowing they’ve purchased a house. In others, developers try to gain a critical foothold in a neighborhood without paying a premium for property – or tipping off speculators or competitors.

“It does work to avoid the transfer taxes. It does work to delay a revaluation on the real estate,” Sparacia said. “But a lot of the time, for us, that’s not the motivation.”

Without the invisibility offered by entity purchases, he said, Superior Avenue wouldn’t be poised for redevelopment, with apartments, other businesses an­­d revamped artist enclaves set to join GBX’s recently opened headquarters on East 21st Street. If GBX’s purchases had been more public, Sparacia said, property prices quickly would have escalated to “extortion value.”

In some of these deals, investors purchase a longstanding limited liability company.

That approach carries notable benefits: Preserving existing contracts, such as leases and agreements on rates for utilities or janitorial services; keeping or ensuring the highest value of tax credits and other financial incentives already allocated for a building’s redevelopment; and holding on to existing loans. Those are prospects that can save a buyer both money and time.

“The difficulty with this issue is there are so many factors that come into play in these situations,” Sikora said, noting that entity buyers also could be paying for more than mere real estate, if they’re purchasing a well-known brand or a complex business, such as a hotel.

There are risks, as well. Buying an existing company means taking on its liabilities, from debts to lawsuits to unresolved environmental problems at a property. And entity sales often are costlier and ­­more complicated than straightforward, everyday real estate deals.

That’s why some investors take a slightly different approach, in which a seller places a building in a newly formed limited liability company just before the sale. The buyer, seeking to avoid leftover baggage, purchases that new entity. This second method is cleaner than purchasing a long-running entity but less private, since it generates some public records.

Industry experts were hard-pressed to say when entity sales, which occur nationwide, started. But they’ve grown in popularity over the last eight years.

That’s particularly true in the hot apartment market, where building prices have been climbing, and landlords can’t pass along property-tax increases to their tenants the same way that some office and shopping center owners can.

Local investors, including Sparacia, said they expect Cuyahoga County to reassess their buildings as they pull permits for renovations or take out mortgages, which offer some indication of what a property is worth. And executives at major apartment companies based in Northeast Ohio said it’s difficult to keep transactions under the radar here.

“In Cleveland, word gets out for the most part,” an appraiser concurred. “It’s a lot less likely to be picked up in a rural market like a Zanesville or an Ashland.”

No simple fix

A handful of states have laws intended to lift the veil from entity sales or to ensure that transfer taxes or conveyance fees broadly apply to sales of stock or partial ownership stakes in companies that primarily own real estate. The success of those laws varies.

In California, for example, properties are reassessed for tax purposes only when a sale takes place – a tax-capping practice that dates back decades. An ownership change occurs when a single investor buys more than 50 percent of an entity. So savvy commercial real estate buyers purchase smaller stakes in entities that own buildings, avoiding transfer taxes and revaluations.

Many states, including Michigan, have focused on transfer taxes. That’s what the draft legislation in Ohio did, limiting its scope to transfer fees that even some auditors acknowledge are a mere fraction of the missed upside in property taxes on building sales as prices climb.

As auditors and attorneys research the issue, it seems unlikely that a revised bill will be introduced in the General Assembly this year.

Sikora said there are too many questions, about who would be subject to, and exempt from, expanded transfer fees and whether the price someone pays for a company, or a partial stake in a company, that owns a building really equates to the worth of the real estate.

“Changing law or making law is an involved process,” he said, “so we want to make sure that we get it as close to right as we possibly can.”

John Monroe, vice president of the Mansour Gavin law firm in Cleveland, says the debate over the “LLC loophole” is wrongheaded. A real estate and land-use attorney who helps clients structure complicated deals, Monroe said public officials should turn their focus away from entity sales and onto two things: better appraisals and broader tax reform.

“I’m not sure I see the need to close a loophole versus valuing property correctly,” he said, opining that some properties in Northeast Ohio are dramatically undervalued while others are sharply overvalued, with little apparent logic. “Two, if you want to, change school funding. And three, we should be looking at overall tax policy on a statewide basis.”

Investors and their attorneys also argue that real estate, development and the broader economy will suffer if legislators shine light on entity sales and, in turn, attempt to increase tax burdens on commercial property.

But Seed, the Cleveland lawyer who represents school districts in property-tax disputes, points out that real estate investors are transparent when they want value reductions. When a shopping center loses major tenants or a building sells at a much-reduced price, buyers quickly appeal to local boards of revisions to lower their assessments and property-tax bills.

Why, Seed said, shouldn’t the process be equally plain when values are climbing?

Or, as an appraiser said, “Ninety-nine percent of the people who buy a house, the tax will go to the purchase price. Shouldn’t that be the same with commercial property?”

Nolan, the Warren County auditor, has been heavily involved in discussions about what sort of approach Ohio should take to entity sales. He described the draft legislation as a “bare-bones” first attempt at tackling a topic that’s messy, nuanced and fraught. If and when a formal bill finally pops up, he expects significant pushback.

And that’s logical, said Nolan, who is also an attorney with a small practice.

As a public official, he says real estate investors are taking advantage of inadequate laws, avoiding fees and skewing property-tax data. As a lawyer, though, if he had a client buying sizable real estate in Ohio, he’d be hard-pressed not to tell them to snap up the LLC.

“Frankly, I would advise somebody to do it that way right now,” he said. “It would be almost malpractice not to, for a large property. They’re doing their job, following the law.”

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