In addition to Washington’s real estate excise tax (REET), transferors of ownership interests in entities that own real property in Washington must also factor in Washington’s capital gains tax when making such transfers. The Washington Supreme Court upheld the capital gains tax as a constitutional excise tax earlier this year. See Quinn v. State, 1 Wn.3d 453, 526 P.3d 1 (2023). The tax is a flat tax of 7% of all adjusted long-term capital gains over $250,000 allocated to the state. RCW 82.87.010.
Gains from the sale of real estate are generally exempt from Washington’s capital gains tax. RCW 82.87.050(1). The tax also does not apply to the sale or exchange of an interest in a privately held entity, if the gain or loss from such sale or exchange is attributable to real estate directly owned by such entity. RCW 82.87.050(2). But what does this mean in the context of multi-tiered ownership structures, where a party desires to sell membership interests in a subsidiary that owns real estate?
The law is not entirely clear. The Washington Department of Revenue (DOR) is thus currently undergoing rulemaking to clarify how the capital gains tax applies to the sale of interests in entities that hold real estate. RCW 82.87.050(2) exempts the sale of an interest in a privately held entity from the capital gains tax if the long-term gain or loss from the sale is attributable to real estate “owned directly” by the entity. (Emphasis added.) The DOR’s proposed rule defines the term “owned directly” as “the privately held entity in which the [taxpaying] individual has an interest legally owns the real estate.” WSR 23-19-070 at 9 (Sept. 18, 2023)
Practically, this means when an LLC that directly owns real estate is sold, the proportion of the value of the LLC attributable to an increase in the value of the real estate it owns is exempt from the capital gains tax. Id. at 9-10. For example, if a one hundred percent membership interest in an LLC is sold for $1 million and the LLC directly owns real estate with a fair market value of $1 million with an adjusted basis of $500,000, then the $500,000 gain will be exempt from Washington’s capital gains tax.
However, in order to be exempt, the property must be “owned directly” by the LLC being sold. Thus, if the LLC being sold is a parent company—with title to the real estate held by a subsidiary entity—the gain will not be exempt. The proposed rules provide somewhat of a workaround to avoid tax disadvantages to multi-tiered ownership structures. Id.at 10-11. Specifically, if a subsidiary directly owns real estate, the parent entity can liquidate the subsidiary, resulting in the parent company directly owning the real estate at the time the parent company is transferred. Id. So long as the subsidiary transfers title to the parent company, the parent company will “own directly” the real estate, and a sale of the membership interest in the parent entity would then be exempt from Washington’s capital gains tax.
The proposed rules also provide an exemption limitation on the amount an entity can claim under the real estate exemption. Id. When an entity is sold and the sale includes capital gain from the sale of real property, the exemption from the gain attributable to the real property cannot exceed the gain attributable to the entity transfer. For example, if a one hundred percent membership interest in an LLC is sold for $20 million, the seller’s adjusted basis in the LLC is $18 million, and the LLC directly owns property valued at $20 million with an adjusted basis of $5 million dollars, then the property exemption will be capped at $2 million, the gain on the sale of the LLC. The seller will not be able to exempt the full $15 million gain attributable to the real estate owned by the LLC. Essentially, the rules set a cap on the exemption for real property in the transfer of ownership interests to the gain from selling the entity, not the gain from selling the property.
Takeaways and Key Practice Pointers:
- The exact treatment of capital gains involving the transfer of ownership rights in an entity owning real estate remains somewhat murky. While the proposed rules clarify certain questions (for example, the fact that gains attributable to the sale of real estate directly owned by the entity are generally exempt), the sale of membership interests in entities that hold real estate through a subsidiary may still be subject to Washington’s capital gains tax.
- Before selling an ownership interest in an entity that holds real estate through a subsidiary, individuals should consider the ownership structure of the entity with both tax and legal advisors to discuss the implications in calculating long-term capital gains tax.