The Los Angeles “Mansion Tax”: How the ULA Tax May Impact Commercial Real Estate Deals

Initiative Ordinance ULA: Basics

City of Los Angeles voters recently approved Initiative Ordinance ULA (the “ULA Tax”), which imposes an additional real property transfer tax effective April 1, 2023. The Ordinance establishes a 4% tax on all real property sales priced or valued from $5 million up to $10 million and a 5.5% tax on real property sales priced or valued at $10 million or greater. The ULA Tax is levied in addition to the existing City and County of Los Angeles documentary transfer taxes of 0.56% for total rates of 4.56% and 6.06%, respectively, making the latter rate among the highest in the country.

Despite its moniker—the “mansion tax”—the ULA Tax applies to transfers of any type of real property, from single family homes to office skyscrapers so long as the property is located in the City of Los Angeles and the transaction is not otherwise exempted.

The stated purpose of ULA Tax revenue is to fund various City efforts to increase the supply of affordable housing and reduce housing costs for homeless and low-income individuals.

Exemptions

The ordinance exempts certain transfers from the ULA Tax. Transfers to non-profit entities, Community Land Trusts, and Limited-Equity Housing Cooperatives are exempt, as these are the types of transactions the City is intending to encourage.

In addition, existing City exemptions may possibly still apply, such as certain bankruptcy and partnership transactions, as may existing State law exemptions, such as gift transactions or transactions to change a name.

Effect on Commercial Transactions

The ULA Tax applies to the total sales price or value of the property transferred, without reduction on account of any assumed debt, as opposed to a tax only on gains or net of assumed debt. Accordingly, the ULA Tax may have a chilling effect on transactions generating modest profit.

It remains to be seen how buyers and sellers will allocate this additional transaction cost. A seller of encumbered property with a high loan-to-value ratio would be particularly negatively impacted, as the net proceeds of the sale may not be sufficient to pay off the loan with an acceptable return if the property has not sufficiently appreciated in value or if there has been a market downturn.

Moreover, increased transaction costs are often passed on to the end user through raised prices. For example, if a seller must increase the sales price of a property to cover the new tax, the buyer may need to correspondingly increase rents to achieve a desired cap rate, which it may be required to maintain under its fund documents, or to achieve a desired debt yield, which may be required under its loan documents, since the property’s net operating income may need to increase to account for a larger loan amount.

Real estate prices and rents, however, do not rise purely at the discretion of the seller or landlord—they are subject to market realities such as demand constraints. Whether sellers will be able to cover the ULA Tax through higher sales prices and, if so, whether buyers will be able to pass along the price increase through higher rents will depend on the relative bargaining strength of each party. In a period of unstable interest rates, shifting office demand, and unprecedented residential demand, it is unclear which party will ultimately bear these materially higher costs.

Finally, active Los Angeles investors should note that existing City and County transfer taxes exclude transferred debt while the ULA Tax does not, which would discourage the assumption of existing debt, which can be an attractive option in a high-interest rate environment.

Incentivized Developments

While the ULA Tax can be expected to discourage some transactions, certain developments may be newly profitable. Proceeds from the ULA Tax may be used by the Los Angeles Housing Department to provide up to $50 million per project in financing for qualifying affordable housing projects without the need for additional City Council approval. This said, the variance on expected revenue from the ULA Tax is high, between $600 million and $1.1 billion, and the funds are to be used for a variety of activities, so it is unclear how much direct real estate project financing the City will be able to provide.

Challenge to the ULA Tax

On December 21, 2022, the Howard Jarvis Taxpayers Association and the Apartment Association of Greater Los Angeles brought suit in state court challenging the validity of the ULA Tax. Plaintiffs argue that the ULA Tax is a “specific tax” prohibited by the California Constitution on the grounds that ULA Tax revenue must be used for specific purposes. The litigation is currently pending.