As first adopted by the Fiscal Year 2021 Budget Support Emergency Amendment Act of 2020 and made permanent by the Fiscal Year 2021 Budget Support Act of 2020 (collectively the ‘Act’), the District of Columbia has eliminated a long-standing exemption often used in the real estate industry effective for tax years beginning on or after Jan. 1, 2021. The exemption, historically utilized by many nonresident taxpayers not otherwise doing business in the District, permitted taxpayers to exclude the gain on the sale of property for purposes of the District’s Unincorporated Business Franchise Tax (UBT). The elimination of the exemption may significantly impact the tax liability of real estate investors, among other pass-through businesses, when selling District property.
Generally, most states do not impose income taxes on partnerships, or LLCs treated as partnerships, often referred to as unincorporated businesses. However, the District is one of the few jurisdictions to impose a franchise tax on unincorporated businesses. The current franchise tax rate for unincorporated businesses, whether foreign or domestic, is 8.25% of the taxable income of the entity.
For many years, a regulatory exemption substantially reduced, effectively to zero, the franchise tax payable on a sale of assets in connection with the termination and liquidation of an unincorporated business, often referred to as the ‘terminating business exclusion.’ The exclusion generally provided that the gain or loss from the sale or other disposition of property that results in the termination of an unincorporated business subject to the tax should be recognized and reported by the owners of the business rather than by the business entity. (See D.C. Mun. Regs. tit. 9, § 117.3).
While the Act does not modify the regulation itself, it does amend the definition of taxable income for unincorporated business purposes to include the gain from the sale or other disposition of any assets, including tangible assets and intangible assets, including real property and interests in real property, even when such a sale or other disposition results in the termination of an unincorporated business. (See D.C. Code § 47-1808.02(1)). Typically, a pass-through entity would own the investment, but the partners or shareholders would not be subject to taxation in the District. This modification essentially eliminates that strategy. Accordingly, the sale of District real property by an unincorporated business is subject to UBT as of Jan. 1, 2021.
Impact to the Real Estate Industry
Prior to the Act, investors in District assets generally structured their ownership in such a manner to utilize the terminating business gain exclusion. A typical structure utilized in the industry had each District property held by separate partnerships, and the owners of such partnerships located outside of the District. If a gain resulted from the sale of real property, which subsequently resulted in a liquidation of the property owning partnership, then such gain would be excluded from the UBT. If the business owners were nonresidents, or were entities carrying on business outside of the District, then the gain reported by the owners of the partnership were not subject to District tax.
The significance of the modification results in a major shift in the treatment of gains on sale of real property. Many real estate ownership structures prior to the Act consisted of an entity whose sole purpose was to terminate upon disposition of a property; the new guidance may trigger a material District franchise tax expense that was not anticipated during the acquisition phase of a taxpayer’s District property.
Addressing state and local tax matters can prevent the proliferation of state tax exposures and can even result in substantial tax and/or cash savings for firms that plan appropriately. Taxpayers that have invested in District property or have questions on other significant real estate tax strategies should speak to their tax advisers for more information.