Real estate transactions – Perennial tax issues

Due to the ECB’s low interest rate policy and high demand, investments in real estate are currently experiencing a real boom. According to the Handelsblatt newspaper, transaction volumes in German commercial real estate grew by around 19 percent to approx. EUR 73 billion in 2019. In addition to the business and legal aspects, tax considerations play a significant role in investment decisions. Tax risks can become deal breakers. The way in which real estate transactions are structured creates the basis that is decisive for the future tax burden (e.g. a non-commercial partnership, extended trade tax reduction). There are basically two types of real estate acquisition: On the one hand, the company owning the property can be acquired (known as “share deal”). On the other hand, it is also possible to acquire just the property from a company (known as “asset deal”).

Tax liability of the purchaser

In a share deal, the buyer acquires the shares in a real estate company. He assumes all the past tax obligations of the real estate company for which the latter is still legally liable at the time of purchase.

In an asset deal, the purchaser acquires only the property. In this case, the purchaser’s liability is governed by Section 75 AO (German Tax Code). This liability is limited both in scope (including trade tax, VAT) and in time. A prerequisite for the liability of a purchaser under Section 75 AO is the transfer of ownership of a company and/or a sub-unit managed separately within the company as a whole. According to established case law, this definition shall also include the acquisition of a property and the simultaneous takeover of existing rental or lease agreements.

Tax due diligence in the event of either an asset deal or a share deal reveals the potential tax risks. Comprehensive and individually tailored tax clauses in the purchase contract protect the buyer from an unexpected tax burden.

VAT on asset deals

In the event of a real estate transaction in the form of an asset deal, the first step is to review whether it represents a non-taxable transfer of an entire business [Geschäftsveräußerung im Ganzen (GiG)], or a supply of immovable property being subject to VAT. The transfer of an entire business applies when a company, or a separately managed sub-unit within the company is transferred  as a whole. For example, the transfer of an entire business occurs when a rented property is sold and the buyer takes over the rental contracts. Since the transfer of an entire business is not subject to VAT, no VAT is charged on the purchase price. However, the buyer inherits the VAT legal position of the vendor, i.e. he continues the relevant input VAT adjustment period under Section 15a UStG (VAT Act). For this reason, the submission of documentation under Section 15a UStG is indispensable preferably prior to the conclusion of the purchase agreement.

If no transfer of an entire business occurs, the real estate transaction is a supply of immovable property, which in principle is exempt from VAT. From a seller’s perspective, the VAT option is often to be recommended in order to avoid input tax adjustments in case of a  VAT exempt sale. In this case, in addition to the purchase price, VAT is payable by the purchaser to the tax office (known as “reverse charge procedure”). At the same time, the purchaser can deduct the input tax. The risk of output revenues which do not allow deduction of input tax, with the result that the input tax on the purchase price is not deductible, is therefore borne by the purchaser. In order to avoid this risk, the purchaser will generally not want to opt for VAT and will prefer to make the purchase of the property VAT exempt.

Since there is a whole bunch of different options transferring real estate, it is often not easy to decide whether the transfer of an entire business occurs in a given case or not. The large number of rulings from the European Court of Justice (ECJ) and the Federal Financial Court (BFH) and the financial courts (FG) additionally makes reviewing this difficult. In practice, the contracting parties in most cases agree on a treatment of the transaction being subject to VAT or not after a risk assessment (in particular of possible additional retrospective VAT payments, or interest on retrospective charges), and add compensation arrangements to the contract to cover the event of a different assessment by the tax authorities.

Trade tax

When structuring a real estate transaction, the trade tax is of significant importance. Real estate companies may either not be subject to trade tax as asset management companies (e.g. a non-commercial partnership) or take the option of the extended trade tax reduction, with the result that the generated rental income, among other things, is not subject to trade tax. Application of the extended trade tax reduction requires the exclusive leasing of property on land owned by the company throughout the entire tax period.

For both the application of the extended trade tax reduction, and in the case of asset management activities, operational facilities have a considerable impact on the future trade tax burden of real estate companies. If the leased property includes any operational facilities – even if only to a limited extent – the application of the extended trade tax reduction is totally precluded. In a non-commercial partnership, the pre-requisites for the co-leasing of operational facilities are less stringent. However, even non-commercial partnerships can also tip over into business activities.

There are also additional topics such as the provision of special services outside of the simple property rental, commercial property trading, as well as the termination of real estate management during a tax period due to the sale of the last premises, which are particularly important for the applicability of the extended trade tax reduction.

Real estate transfer tax

Real estate transactions, whether in the form of an asset deal or a share deal, generally trigger real estate transfer tax. The level of the real estate transfer tax rate depends on the federal state in which the property is located. The real estate transfer tax rate varies between 3.5 percent (e.g. Bavaria) and 6.5 percent (e.g. North Rhine Westphalia).

In the case of share deals, the fact of so called consolidation of shares generally leads to the triggering of the real estate transfer tax. A popular structural instrument until now known as RETT blocker structures were designed to avoid real estate transfer tax. However, legislation is planned to tighten up the regulations on consolidations of share. There is currently discussion that an consolidation of holding over 90 percent, instead of the current 95 percent of the shares, will trigger real estate transfer tax after being held by the purchaser for ten years instead of the current five years. The legislative procedure for this change is planned to be completed in 2020.

Conclusion and outlook

The devil is in the detail. Particularly in real estate transactions, tax aspects often play only a minor role in practice. However, transactions can conceal considerable risks for buyers and sellers, often in the millions due to the high value of the investment. Therefore, it is advisable to seek a tax adviser early in the process of real estate transactions.