For many years, experienced commercial real estate (CRE) investors in Ohio have structured real estate purchases as an entity purchase and sale, often referred to as a “drop and swap.” This strategy is motivated by the buyer’s efforts to minimize real property taxes.
At times, a sale of commercial real estate results in a gain that may be double or even triple the original tax-assessed valuation of a property. Such gains will typically cause real estate taxes to likewise double or triple in amount since the county auditor will be notified of the increased sale price when the deed conveyance tax is collected and the deed is recorded. If the transaction can be closed as a “drop and swap,” that is, without payment of a conveyance tax, and thereby, no notice of the higher sale price to the county auditor, then the investor can avoid a significant increase in the property’s tax valuation and a commensurate real estate tax increase that the investor must pay annually.
Ohio Real Property Taxes
Real property taxes are a major expense for Ohio CRE investors since Ohio is among the top ten states in the nation with the highest real property tax rates, at an average of 1.52%. At first impression, this average may seem deceptively low, however, many urban-area tax rates hover between 2.00% to 3.10%. Neighboring states like Kentucky and Indiana have average real property tax rates of just 0.78% and 0.81%, respectively, or nearly half of Ohio’s real property tax rate.
To compound this major cost, real property taxes are paid annually, and are not just a one-time expense like a buyer’s title insurance premiums or a seller’s deed conveyance tax. Further, real estate taxes almost always increase over time and rarely, if ever, decrease.
HB 126: Restrictions on Valuation Complaints by Boards of Education
For the foregoing reasons, CRE investors are focused on managing real property taxes and a new Ohio law is having a direct impact on slowing tax growth.
Ohio’s public education system is the primary beneficiary of the state’s real property tax with the local board of education (BOE), typically receiving between 50% to 80%+ of real property tax revenues. House Bill 126, which went into effect on July 1, 2022, was aimed at restricting the ability of Boards of Education (BOEs, if you will) to affirmatively file valuation complaints to increase tax revenues for BOEs at the expense of CRE investors.
Prior to the enactment of HB 126, there had been a virtual epidemic of valuation cases filed by boards of education across the state to increase an investors’ taxes any time a deed conveyance tax indicated that a transfer took place at a sale price greater than the current tax valuation of the underlying property. This practice by BOEs was rampant and out of control.
Our legislative system reacted to enact several significant restrictions on the ability of boards of education to affirmatively file a valuation complaint to raise an investor’s real estate taxes including (a) meeting certain transactional thresholds, (b) adopting a resolution to authorize a complaint at a public meeting of the BOE, and (c) provide at least 7-days notice to the property owner of before the public meeting.
Enter the Drop and Swap Strategy
A drop and swap strategy combined with the benefits of the HB 126 restrictions on BOEs means that investors can feel confident in implementing their intended tax-saving measures and that their plans will not be up-ended by overly-aggressive BOEs so long as the parameters of each transaction and the law are understood by investor and its counsel alike.
In a drop and swap, the seller transfers or “drops” the property into a newly formed, single-member limited liability company in a conveyance that is exempt from Ohio conveyance tax. The seller then transfers 100% of the membership interests in the LLC to the buyer in exchange for the purchase price.
Such a structure has a two-fold advantage: First, the transaction avoids payment of a conveyance tax at the time the deed is recorded, which is typically a seller obligation, and therefore, a seller incentive. Secondly, and most importantly, the structure lessens the likelihood that the county auditor will increase the property’s tax valuation for real property tax purposes since generally, the transaction is invisible to the county auditor, which is a significant buyer motivator.
When CRE investors are considering use of a drop and swap or entity purchase structure, it is strongly recommended that the investor, first, consult with one of our experienced real estate attorneys who can advise on best practices to structure the drop and swap transaction to avoid the scrutiny of both the local BOE and the county auditor. There are certain attributes of a traditional purchase and sale transaction that should be avoided since they amount to tell-tale signs of a drop and swap real estate purchase and can generate unwanted scrutiny.
The attorneys at DBL Law have the experience and unique abilities to help you with your real estate needs in Ohio, Kentucky, Indiana and regionally, whether buying or selling real estate in an entity purchase transaction or otherwise, leasing, financing or challenging real property tax valuations on properties of all types. Excel Title provides complete title and closing services and Excel Exchanges provides qualified intermediary services and advises investors in tax-deferred 1031 exchanges. Please contact Drew Emmert at (513) 357-5289 or aemmert@dbllaw.com for more information.