A legal maneuver known as the "drop-kick" is allowing wealthy individuals and large corporations to bypass real estate transfer taxes, resulting in significant revenue losses for states. This strategy involves transferring property into a shell company and then selling the company itself, a transaction that often falls outside the scope of traditional property tax laws.
Policy experts are now urging states to close this loophole by adopting what are known as controlling interest transfer taxes. This legislative fix would ensure that the substance of a property sale is taxed, regardless of how the deal is structured, promoting a fairer tax system for all property owners.
Key Takeaways
- A tax strategy called the "drop-kick" allows sellers to avoid real estate transfer taxes by selling a company that owns a property, instead of the property itself.
- This loophole is primarily used by wealthy individuals and corporations, creating an unfair advantage over average homebuyers.
- States are estimated to be losing tens of millions of dollars in tax revenue annually due to these transactions.
- The most effective solution is a "controlling interest transfer tax," which taxes the sale of a majority stake in a property-owning entity.
- Only a handful of states have implemented robust laws to effectively close this loophole.
Understanding the 'Drop-Kick' Tax Strategy
In most property transactions, the buyer pays a real estate transfer tax, which is a one-time fee imposed by the state or local government. Currently, 33 states and the District of Columbia levy this type of tax to fund public services like schools, infrastructure, and emergency services.
However, these taxes typically apply only to the direct sale of real estate. The "drop-kick" method circumvents this by changing the nature of the asset being sold. It's a two-step process that transforms a real estate deal into a corporate transaction.
Step One: The 'Drop'
The process begins when a property owner transfers, or "drops," their real estate into a newly created legal entity, such as a limited liability company (LLC). This is often a simple administrative step and is usually not a taxable event. The LLC now legally owns the property, and the original owner holds all the shares of the LLC.
Step Two: The 'Kick'
Next, the owner "kicks" or sells the shares of the LLC to the buyer. From a legal standpoint, this is not a real estate sale; it is the sale of a company. Because no property deed changes hands directly, the transaction does not trigger the real estate transfer tax in most states. The buyer acquires the company and, with it, indirect ownership of the property.
Why This Matters
This method creates a two-tiered tax system. While an average family buying a home must pay the transfer tax, a corporation purchasing a multi-million dollar office building can use the drop-kick strategy to pay nothing. This disparity undermines public trust and deprives communities of essential funding.
How States Lose Revenue from Property Sales
The financial impact of the drop-kick loophole is substantial. While exact national figures are difficult to calculate due to the private nature of these transactions, estimates suggest that states are losing tens of millions of dollars in tax revenue each year. High-value commercial real estate deals are where this strategy is most prevalent.
For instance, a report from the Las Vegas Review-Journal highlighted several major property sales on the Las Vegas Strip where no transfer taxes were paid because the deals were structured as corporate acquisitions rather than direct property sales. This lost revenue could have funded critical public services in Nevada.
A Tale of Two Approaches
States have tried different ways to address this issue, with varying levels of success. Nevada attempted to close the loophole by making the "drop" taxable if it could be proven the entity was created to evade taxes. However, proving intent is extremely difficult in court, making the law largely ineffective.
In contrast, states like Connecticut and New York have adopted a more direct approach. They focus on the "kick"—the actual transfer of control over the property—making their laws much harder to circumvent.
The Solution: Controlling Interest Transfer Taxes
Tax policy experts agree that the most effective way to close the drop-kick loophole is to implement a controlling interest transfer tax. This tax is designed to treat the sale of a controlling stake in a property-owning entity the same as a direct sale of the property itself.
"Closing the drop-kick loophole isn't about creating a new tax; it's about enforcing the tax that was always intended to be paid. It ensures that the rules that apply to hardworking families also apply to those with the resources to hire creative accountants."
A controlling interest is typically defined as owning 50 percent or more of an entity. When a buyer acquires this level of ownership, they effectively gain control over the underlying real estate. A controlling interest tax applies the standard real estate transfer tax to the fair market value of the property at the time of this transfer.
This approach is superior because it focuses on the economic reality of the transaction rather than its legal form. It acknowledges that selling a company that owns a building is, for all practical purposes, the same as selling the building itself.
Crafting Effective Legislation to Close the Loophole
Simply enacting a controlling interest tax is not enough. The legislation must be carefully designed to prevent new avoidance schemes. According to policy analysts, an effective law should include several key components:
- A Broad Definition of 'Controlling Interest': The threshold should be set at 50% or more. Setting it higher, at 60% for example, would allow buyers to acquire 59% of a company and still avoid the tax while having effective control.
- Application to All Legal Entities: The law must apply to all forms of ownership, including LLCs, partnerships, and trusts, to prevent sellers from simply using a different type of shell company.
- Strong Anti-Abuse Rules: To stop savvy tax planners, the law needs rules to address schemes like selling smaller portions of a company over time (serial transactions) or coordinating sales among multiple related buyers (acting in concert).
- A Clear Tax Base: The tax should be based on the property's true value. A best practice is to tax the greater of the sales price, the property's recent fair market value, or its full assessed value for property tax purposes. This prevents undervaluing the transaction to reduce the tax bill.
- Limited Exemptions: Exemptions should be narrow and specific, such as for transfers between spouses or for very low-value properties, consistent with existing real estate tax laws.
States Leading the Way
Currently, only a small number of states have implemented comprehensive controlling interest transfer taxes that effectively shut down the drop-kick loophole. These include Connecticut, Maine, New Jersey, and New York. Their statutes serve as models for other states looking to ensure tax fairness.
The Path Forward for Fairer Tax Systems
The continued existence of the drop-kick loophole sends a damaging message: that there is one set of rules for ordinary citizens and another for the wealthy and well-connected. This perception erodes faith in civic institutions and the fairness of the tax system.
By closing this loophole, states can restore fairness, increase revenue for public services, and level the playing field in the real estate market. Re-evaluating and strengthening real estate transfer tax laws to include controlling interest provisions is a critical step toward a more equitable system.
Legislators in the majority of states that have yet to act have an opportunity to ensure that all property transactions contribute their fair share to the communities that make those properties valuable in the first place.
