Commonwealth Court Explains How to Avoid Realty Transfer Tax When Drafting a Renewal Clause in a Long-term Commercial Lease.

Posted By Cliff Tuttle | January 2, 2017

No. 1,296

SATURDAY FAMILY LP v. COMMONWEALTH; TECHSPEC INC. v COMMONWEALTH, Nos. 781 F.R. 2013, 782 F.R. 2013

SUMMARY:  To avoid real estate transfer tax on a long-term lease, it is necessary to make the initial term less than 30 years and to price any renewals at fair market value at the time of the renewal.

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On December 28, 2011, Landlord and Tenant entered into a ground lease for a period of 29 years and 11 months.  The tenant was granted an option to renew for a period of up to 6 periods of 5 years each for a fair market value rent to be established on the renewal date to be established by agreement of the parties taking into account the values of similar properties in Westmoreland County.  If the parties cannot agree, a procedure was established for a determination through an appraisal.

The Department of Revenue issued a Realty Transfer Tax Notice of Determination, assessing $12,455.23 in state and local transfer tax, stating that the “Lease exceeds 30 years with a formula in place” to determine the rent for each extension.  A lease for a period exceeding 30 years is declared to be the equivalent of a sale under the Tax Code and thus subject to Pennsylvania Real Estate Transfer Tax. The Commonwealth Court summarized the applicable Tax Code provisions as follows:

” Section 1103-C.1 of the Tax Code provides that “[i]n determining the term of a lease, it shall be presumed that a right or option to renew or extend a lease will be exercised if the rental charge to the lessee is fixed or if a method for calculating the rental charge is established.”

The Department’s regulation pertaining to exclusions from realty transfer tax similarly provides that a real estate lease is excluded from the realty transfer tax unless the lease is for a term of 30 or more years. 61 Pa. Code § 91.193(b)(24)(i). It also provides:

In determining the term of a lease under this paragraph, it shall be presumed that a right or option to renew or extend a lease will be exercised if the lessor and lessee cannot renegotiate the rental charges for the renewal or extension period unconditionally. A lessor and lessee cannot renegotiate a rental charge unconditionally if it is fixed at a set amount for the period or a method for establishing the rental charges is established. Renewals or extensions at the option of the lessee at fair rental value at the time of the renewal or extension are not included in determining the term of a lease.

61 Pa. Code § 91.193(b)(24)(v) (emphasis added). The parties in this matter disagree as to whether the regulation, particularly the last sentence, should be interpreted to exclude the renewal period from the term of the Ground Lease for purposes of determining whether the term of the Ground Lease is 30 or more years, because the rental charge for a renewal period would be based on the fair market value.

Section 1101-C of the Tax Code (emphasis added). Finally, Section 1103-C.1 of the Tax Code^[6] provides that “[i]n determining the term of a lease, it shall be presumed that a right or option to renew or extend a lease will be exercised if the rental charge to the lessee is fixed or if a method for calculating the rental charge is established.”

The Department’s regulation pertaining to exclusions from realty transfer tax similarly provides that a real estate lease is excluded from the realty transfer tax unless the lease is for a term of 30 or more years. 61 Pa. Code § 91.193(b)(24)(i). It also provides:

In determining the term of a lease under this paragraph, it shall be presumed that a right or option to renew or extend a lease will be exercised if the lessor and lessee cannot renegotiate the rental charges for the renewal or extension period unconditionally. A lessor and lessee cannot renegotiate a rental charge unconditionally if it is fixed at a set amount for the period or a method for establishing the rental charges is established. Renewals or extensions at the option of the lessee at fair rental value at the time of the renewal or extension are not included in determining the term of a lease.

61 Pa. Code § 91.193(b)(24)(v) (emphasis added). The parties in this matter disagree as to whether the regulation, particularly the last sentence, should be interpreted to exclude the renewal period from the term of the Ground Lease for purposes of determining whether the term of the Ground Lease is 30 or more years, because the rental charge for a renewal period would be based on the fair market value.

“Section 1103-C.1 of the Tax Code provides that “[i]n determining the term of a lease, it shall be presumed that a right or option to renew or extend a lease will be exercised if the rental charge to the lessee is fixed or if a method for calculating the rental charge is established.”

The Department’s regulation pertaining to exclusions from realty transfer tax similarly provides that a real estate lease is excluded from the realty transfer tax unless the lease is for a term of 30 or more years. 61 Pa. Code § 91.193(b)(24)(i). It also provides:

In determining the term of a lease under this paragraph, it shall be presumed that a right or option to renew or extend a lease will be exercised if the lessor and lessee cannot renegotiate the rental charges for the renewal or extension period unconditionally. A lessor and lessee cannot renegotiate a rental charge unconditionally if it is fixed at a set amount for the period or a method for establishing the rental charges is established. Renewals or extensions at the option of the lessee at fair rental value at the time of the renewal or extension are not included in determining the term of a lease.

61 Pa. Code § 91.193(b)(24)(v) (emphasis added). The parties in this matter disagree as to whether the regulation, particularly the last sentence, should be interpreted to exclude the renewal period from the term of the Ground Lease for purposes of determining whether the term of the Ground Lease is 30 or more years, because the rental charge for a renewal period would be based on the fair market value.”

After recounting detailed arguments on both sides, the Court states that the language in the regulation set forth at 61 Pa. Code § 91.193(b)(24)(v), which governs the outcome, is clear. In the first sentence, it sets forth the presumption that a right or option to renew will be exercised if the parties “cannot renegotiate the rental charges . . . unconditionally.”

The second sentence goes on to state that the parties cannot renegotiate the rental charges unconditionally “if it is fixed at a set amount for a period or a method for establishing the rental charges is established.”

“The critical third sentence explains in clear language that if the rental charge is based upon the ‘fair rental value at the time of the renewal or extension,’ the extension period is not included in the total lease term. Id. These provisions operate concurrently and are not internally inconsistent, because the first two sentences essentially provide that if the parties set forth a method for establishing the rental charge for the renewal period, then they cannot renegotiate the rental charge unconditionally at the time of the renewal and the renewal period is included in determining the total lease term. The third sentence clarifies how a renewal term in a lease is to be treated if the lease provides that the rental charge for the renewal period shall be based upon the fair market value rent at the time of the renewal.”

In other words, if the rental charge is repriced at the time of renewal based upon fair market value, then the extension period is not counted as part of the initial lease term.  On the other hand, if a renewal option can be exercised  at a rental charge fixed in the lease, the renewal must be considered part of the lease term.

To illustrate, if a lease contains an initial term of 29 years and 11 months at $10.00 per square foot, followed by an option to renew at $12.00 for five years, the lease term exceeds 30 years and transfer tax applies.  But if the extension is based upon fair market value, which is determined under the language of the lease, then the extension is not part of the initial term and the transaction is not subject to realty transfer tax.

Determining the rent of renewals at fair market value might seem to be a problem, but in practice it is often easy.  In shopping centers and office buildings, the going rate at any given time is usually indicated by the rents negotiated with new tenants as the units turn over.  If a property is unique, the appraisal alternative is practical one.  Appraisals cost money, but so does the realty transfer tax.

In drafting a lease provision, it is advisable to follow the language of the regulation exactly. as the parties did in this case.

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CLIFF TUTTLE has been a Pennsylvania lawyer for over 45 years and (inter alia) is a real estate litigator and legal writer. The posts in this blog are intended to provide general information about legal topics of interest to lawyers and consumers with a Pittsburgh and Western Pennsylvania focus. However, this information does not constitute legal advice and there is no lawyer-client relationship created when you read this blog. You are encouraged to leave comments but be aware that posted comments can be read by others. If you wish to contact me in privacy, please use the Contact Form located immediately below this message. I will reply promptly and in strict confidence.

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