Long-Term Leases In PA

The applicable regulations provide that “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” and “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,” 61 Pa. Code 91.193(b)(24). The regulation goes on to provide, however, that “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.”

In many cases, a lessee will want the lease to contain renewal options that, if exercised, would extend the term of the lease beyond 30 years. It is clear under the regulations that, if the parties want to avoid paying realty transfer tax, the rent for any renewal period must be “fair rental value at the time of the renewal.” This leads to an obvious question: What happens if the lessee and lessor cannot agree on what fair rental value is?

A competent legal adviser would typically suggest that the parties agree to appoint an appraiser or to some other practical dispute resolution mechanism. According to the Department of Revenue, however, any such dispute resolution mechanism was a prohibited “method for establishing the rental charges,” which meant that the renewal periods had to be added to the term of the lease for purposes of determining whether the lease had a term of 30 years of more. The only way the parties could avoid paying transfer tax was if they agreed to an option that, arguably, could not be enforced if the lessor and lessee did not mutually agree on the future rent.

Avoiding the Tax

This has presented real estate practitioners with a conundrum: how to create a practical, enforceable renewal option at fair rental value without triggering transfer tax? The Department of Revenue's position forced practitioners to choose between avoiding tax and providing a renewal option that the lessee would be able to enforce.

The consolidated cases of Saturday Family v. Commonwealth of Pennsylvania, No. 781 F.R. 2013 (Pa. Commw. Ct. Oct. 17), and Techspec v. Commonwealth of Pennsylvania, No. 782 F.R. 2013 (Pa. Commw. Ct. Oct. 17), involved a lease with an initial term of 29 years and 11 months. Under the lease, the lessee could renew the term for up to six periods of five years each. Each renewal was to be for fair market value as determined by the parties; however, if the parties were unable to agree on a value, the value would be determined by appraisal. The Department of Revenue assessed realty transfer tax on the lease, on the grounds that the renewal periods had to be added to the term of the lease because the arbitration provision “established a method” for determining the rent during the renewal periods. The Board of Appeals and the Board of Finance and Revenue both agreed with the Department of Revenue's position, and the lessee and lessor then filed petitions with the Commonwealth Court.

The court firmly rejected the Department of Revenue's long-held position regarding lease extensions. The court held that “the mere fact that the ground lease establishes a mechanism for determining the fair market value rent in the event that taxpayers cannot agree on a fair market value rent does not alter the salient fact that the ground lease provides that renewal periods shall be at fair market value rent.”

Conclusion

This decision is welcome news for practitioners who draft real estate leases, but uncertainty remains. It is unknown whether the commonwealth will appeal to the Pennsylvania Supreme Court or how the Supreme Court might rule in such a case. In addition, the Department of Revenue might try to amend its regulations in an effort to reinstate its long-held position on lease renewal options. Practitioners should proceed with caution, but it appears that the door may be opening for a bit more freedom in drafting fair market rental renewal options in leases where such renewal options would push the lease beyond 30 years.

*****
Martin J. Doyle and Stanley Kull are partners in Saul Ewing's real estate department. Reach them at [email protected] and [email protected], repsectively. Igor Pleskov is an associate in the firm. He can be contacted at [email protected]. This article also appeared in The Legal Intelligencer, an ALM sibling publication of this newsletter.

In a case decided on Oct. 17, 2016, the Commonwealth Court of Pennsylvania rejected a long-standing position taken by the Pennsylvania Department of Revenue dealing with when renewal periods must be added to the initial term of a lease for realty transfer tax purposes.

The Law

For purposes of the Pennsylvania realty transfer tax, a lease or occupancy agreement for a term of 30 years or more is considered “title to real estate” and is therefore a “document” subject to realty transfer tax. The transfer tax statute provides that “in 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 applicable regulations provide that “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” and “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,” 61 Pa. Code 91.193(b)(24). The regulation goes on to provide, however, that “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.”

In many cases, a lessee will want the lease to contain renewal options that, if exercised, would extend the term of the lease beyond 30 years. It is clear under the regulations that, if the parties want to avoid paying realty transfer tax, the rent for any renewal period must be “fair rental value at the time of the renewal.” This leads to an obvious question: What happens if the lessee and lessor cannot agree on what fair rental value is?

A competent legal adviser would typically suggest that the parties agree to appoint an appraiser or to some other practical dispute resolution mechanism. According to the Department of Revenue, however, any such dispute resolution mechanism was a prohibited “method for establishing the rental charges,” which meant that the renewal periods had to be added to the term of the lease for purposes of determining whether the lease had a term of 30 years of more. The only way the parties could avoid paying transfer tax was if they agreed to an option that, arguably, could not be enforced if the lessor and lessee did not mutually agree on the future rent.

Avoiding the Tax

This has presented real estate practitioners with a conundrum: how to create a practical, enforceable renewal option at fair rental value without triggering transfer tax? The Department of Revenue's position forced practitioners to choose between avoiding tax and providing a renewal option that the lessee would be able to enforce.

The consolidated cases of Saturday Family v. Commonwealth of Pennsylvania, No. 781 F.R. 2013 (Pa. Commw. Ct. Oct. 17), and Techspec v. Commonwealth of Pennsylvania , No. 782 F.R. 2013 (Pa. Commw. Ct. Oct. 17), involved a lease with an initial term of 29 years and 11 months. Under the lease, the lessee could renew the term for up to six periods of five years each. Each renewal was to be for fair market value as determined by the parties; however, if the parties were unable to agree on a value, the value would be determined by appraisal. The Department of Revenue assessed realty transfer tax on the lease, on the grounds that the renewal periods had to be added to the term of the lease because the arbitration provision “established a method” for determining the rent during the renewal periods. The Board of Appeals and the Board of Finance and Revenue both agreed with the Department of Revenue's position, and the lessee and lessor then filed petitions with the Commonwealth Court.

The court firmly rejected the Department of Revenue's long-held position regarding lease extensions. The court held that “the mere fact that the ground lease establishes a mechanism for determining the fair market value rent in the event that taxpayers cannot agree on a fair market value rent does not alter the salient fact that the ground lease provides that renewal periods shall be at fair market value rent.”

Conclusion

This decision is welcome news for practitioners who draft real estate leases, but uncertainty remains. It is unknown whether the commonwealth will appeal to the Pennsylvania Supreme Court or how the Supreme Court might rule in such a case. In addition, the Department of Revenue might try to amend its regulations in an effort to reinstate its long-held position on lease renewal options. Practitioners should proceed with caution, but it appears that the door may be opening for a bit more freedom in drafting fair market rental renewal options in leases where such renewal options would push the lease beyond 30 years.

*****
Martin J. Doyle and Stanley Kull are partners in Saul Ewing's real estate department. Reach them at [email protected] and [email protected], repsectively. Igor Pleskov is an associate in the firm. He can be contacted at [email protected]. This article also appeared in The Legal Intelligencer, an ALM sibling publication of this newsletter.