District of Columbia v. Design Center Owner, LLC

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DISTRICT OF COLUMBIA COURT OF APPEALS
Nos. 21-TX-0473 & 21-TX-0627
DISTRICT OF COLUMBIA, APPELLANT,
V.
DESIGN CENTER OWNER (D.C.) LLC, et al., APPELLEES.
Appeals from the Superior Court
of the District of Columbia
(2018-CVT-000803 & 2018-CVT-000804)
(Hon. Maurice A. Ross, Trial Judge)
(Argued September 22, 2022 Decided December 29, 2022)
Ashwin P. Phatak, Deputy Solicitor General, with whom Karl A. Racine,
Attorney General for the District of Columbia, Loren L. AliKhan, Solicitor General
at the time, and Caroline S. Van Zile, Principal Deputy Solicitor General at the time,
were on the brief, for appellant.
John Chamberlain, with whom William M. Bosch was on the brief, for
appellees Design Center Owner (D.C.) LLC, Washington Design Center Subsidiary
LLC, Office Center Owner (D.C.) LLC, and Washington Office Center LLC.
Michael F. Dearington, with whom Sean W. Glynn and Jackson D. Toof were
on the brief, for appellees The Museum of the Bible, Inc. and WOC LLC.
2
Before DEAHL, Associate Judge, and THOMPSON and GLICKMAN,∗ Senior
Judges.
DEAHL, Associate Judge: This appeal is about the extent to which the District
can tax a particular type of commercial real estate transaction. It directly concerns
a $250 million purchase of real estate, with appellees—the buyers and sellers of the
real estate, whom we refer to collectively as the taxpayers—successfully arguing in
the trial court that they did not need to pay taxes on about 70% of that amount.
Adding to the importance of this issue is that it has started to arise in other taxation
disputes, as more entities have begun structuring their commercial real estate sales
in a manner similar to how the taxpayers here structured their sales, in an apparent
effort to lighten their tax burdens.
We start by outlining some basic propositions necessary for understanding the
issue presented. First is that the District generally taxes the sale of real estate as a
percentage of the total sale, usually around 3%, divided equally between the buyer
and seller. D.C. Code §§ 42-1103, 47-903. It does so through two different taxes,
called transfer and recordation taxes, and those taxes are levied against both the
value of the land and the improvements, such as buildings, thereon—whatever real
∗
Judge Glickman was an Associate Judge of the court at the time of argument.
He began his service as a Senior Judge on December 21, 2022.
3
estate is being transferred. Second is that the District generally does not tax either
the formation or termination of ground leases of less than thirty years. Id.§§ 42-1101(3)(B), 47-901(3). A ground lease is an agreement between a landowner
and (usually) a developer where, in exchange for rent payments, the landowner
permits the developer to build improvements on the land and use it for a specific
term of years, often decades. At the end of the lease term, the landowner not only
regains exclusive rights to the land but also acquires any improvements that remain.
Both the lease’s inception and its termination are generally not taxable events so
long as the lease is for less than thirty years, despite there being some transfer of
long-term property interests at both points in time.
This appeal concerns the sale of land encumbered by a ground lease, where
the buyer paid both for the land and for the early termination of a ground lease
encumbering it, thereby immediately acquiring title to both the land and its
improvements. The parties agree that the land sale is taxable, but disagree about
whether the payment for early termination of the ground lease is. That question
matters a great deal, as illustrated by this case: In the $250 million transaction at
issue, the buyers and sellers apportioned about $76 million to the land sale—the tax-
assessed value of the land alone, on which they paid taxes—but treated the remaining
~$174 million as consideration for the early termination of ground leases
4
encumbering that land and did not pay taxes on that sum. The District seeks to tax
the entire value of the transaction, arguing that what the buyer in this scenario is
really purchasing is fee simple title to the land and all of its improvements, so that
the District may tax it like any other sale of land plus improvements. The taxpayers
counter that, under the relevant statutes, the District may tax only the land transfer,
because ground lease terminations are not themselves taxable. The trial court agreed
with the taxpayers and granted summary judgment in their favor.
We reverse. The District is correct that the taxpayers have not satisfied their
tax obligations by paying taxes on the land sale alone, as that fails to account for the
buyers’ acquisitions of the improvements on the land, for which taxes are due. We
agree with the taxpayers (and the trial court) to the limited extent that the early
termination of a ground lease is not itself a taxable event. But these transactions
were more than just transfers of land and the early termination of ground leases
encumbering it. The buyers also acquired—and unquestionably paid a substantial
amount for—the sellers’ reversionary interests in the improvements on the land; the
transfers of those reversionary interests were taxable and yet entirely unaccounted
for in how the taxpayers structured their sale and tax payments. The taxpayers in
effect, albeit silently, lumped the value of those reversionary interests together with
the consideration paid for the early ground lease terminations and thereby
5
improperly reduced their tax burdens. Because the Superior Court’s order granting
summary judgment for the taxpayers did not recognize the taxable transfer of those
reversionary interests, on which the taxpayers failed to pay taxes, we reverse its order
and remand for further proceedings. We agree with the trial court’s conclusion that
penalties are not warranted in this case, however, and uphold that portion of its order.
I.
This case stems from the sale of two adjacent properties in Southwest D.C.
The first, located at 300 D Street SW (the Design Center site), now houses the
Museum of the Bible. The second, located at 409 3rd Street SW (the Office Center
site), is the site of a large commercial office building. As of June 2012, both
properties were owned by Vornado Realty via two of its subsidiaries: Design Center
Owner (D.C.) LLC and Office Center Owner (D.C.) LLC. These subsidiaries, in
turn, had entered into commercial ground leases with two subsidiaries of their own:
Washington Design Center Subsidiary LLC and Washington Office Center LLC.
As Vornado’s expert witness explained during discovery, a commercial
ground lease “is an arrangement by which the lessee (often a real estate developer
or operator) leases real property, usually for an extended term, in order to install
improvements and operate the property for the production of income.” Those
6
improvements are key to this type of leasehold agreement. To the landowner, a
ground lease “enables the property to be developed without cost.” Stuart M. Saft,
Commercial Real Estate Transactions § 8.2 (3d ed. July 2022 update). For their
tenant, a ground lease permits erection of a profitable improvement “without a large
capital expenditure [for the land].” Id. Perhaps as a result, ground leases do not
always follow the common law rule that “[w]hen a lessee of land erects a permanent
building . . . [the lessor’s] ownership attaches immediately.” Hebrew Home for the
Aged v. District of Columbia, 142 F.2d 573, 574 (D.C. Cir. 1944). Instead, “many
ground leases provide that the improvements are the tenant’s property and that the
fee owner can acquire them only if they are left on the property after the ground lease
terminates.” Saft, supra, § 8.12. 1
The two ground leases in this case, which originated in the early 1980s, were
largely identical. Both involved initial lease terms in the range of twenty-five to
twenty-nine years, and each included options for two successive ten-year extensions.
Both required the lessees to construct and operate “the Improvements described in
1
This appears to be the typical structure of ground leases in the District of
Columbia. As the D.C. Bar’s practice manual explains, improvements constructed
under a ground lease “are owned for tax purposes by the ground lessee. At the
conclusion of the leasehold estate, by expiration or termination, ownership of the
improvements customarily reverts to the ground lessor.” District of Columbia Bar
Association, District of Columbia Practice Manual 1054 (28th ed. 2020).
7
the Improvement Covenant.” And finally, both stated, in almost identical language,
that:
Fee simple title to any additions, alterations, restorations,
repairs and replacements to the existing Improvements and
all Improvements hereafter erected or located on the Land
shall be in Lessee. Notwithstanding the foregoing, the
terms of this Lease shall apply to all Improvements . . .
[and] the same shall be surrendered to and shall become
the full and absolute property of Lessor at the expiration
or earlier termination of the Lease Term.
In other words, these ground leases departed from the common law rule and placed
initial ownership of any buildings on the property with the tenants; the landowners
merely held a reversionary interest that would convert to a present interest upon the
extinction of the leasehold estate.
In 2012, the Vornado companies agreed to sell the two properties to Hobby
Lobby Stores, Inc., for a combined $250 million ($50 million for the Design Center
site and $200 million for the Office Center site). 2 The parties executed two sales
To break that down further, of the $50 million purchase price for the Design
2
Center site, roughly $37 million was apportioned to the land transfer and $13 million
to the termination of the ground lease; of the $200 million purchase price for the
Office Center site, roughly $39 million was apportioned to the land transfer and $161
million to the termination of the ground lease. Of note, while the land of the two
adjacent sites was of roughly the same value under that apportionment, the value
apportioned to the termination of the Officer Center ground lease was more than ten
times that apportioned to the termination of the Design Center ground lease.
8
agreements requiring the Vornado companies to deliver “[a] deed . . . conveying the
fee estate in the Land and Improvements” in both properties to Hobby Lobby and
“terminat[e] the Ground Lease[s]” with their lessee subsidiaries. A single Vornado
executive signed the purchase agreements on behalf both the Vornado lessor
companies and their lessee subsidiaries. Prior to closing, Hobby Lobby assigned all
of its “rights, interests, liabilities, and obligations” under the contracts to two
subsidiaries: WOC, LLC and Museum of the Bible, Inc.
At closing the following month, the parties completed the transaction by
executing two sets of documents. The first—styled “Special Warranty Deeds”—
were signed by the Vornado lessor companies and the Hobby Lobby companies.
They conveyed “in fee simple, all of that certain land situate . . . described on
Schedule 1 attached hereto, together with all improvements situated thereon and all
rights, titles and interests appurtenant thereto.” Schedule 1 of the deeds, which
contained the legal description of the properties, likewise referred to “[a]ll that
certain lot or parcel of land together with all improvements thereon.” And Schedule
2 of the deeds, which described the exceptions to the buyer’s fee simple ownership,
made no reference to the ground leases with the Vornado subsidiaries. Copies of
these special warranty deeds were recorded with the District.
9
In addition, the parties executed a set of documents styled “Termination of
Ground Lease and Memorandum.” Unlike the special warranty deeds, these
documents identified the Hobby Lobby companies as the lessors of the two
properties and stated that they were parties to “that certain Ground Lease” with the
Vornado lessee subsidiaries. They provided that, for “good and valuable
consideration, the receipt and sufficiency of which are acknowledged, Lessor and
Lessee agree . . . [that] the Ground Lease and the Memorandum are hereby
terminated.” Copies of these lease termination memoranda were likewise recorded
with the District. Like the purchase agreements, both the special warranty deeds and
these lease termination agreements were signed by a single Vornado executive on
behalf of all four Vornado companies.
While the parties placed enough money to pay transfer and recordation taxes
on the full $250 million transaction cost into escrow, both Vornado and Hobby
Lobby took the position that only the value of the land itself—and not the
consideration paid for the termination of the ground leases—was taxable.
Accordingly, when they submitted the two special warranty deeds for recordation,
their accompanying Form FP-7/C filings reported a total purchase price of just $76
million. This amount was the “the assessed value of the Land for real property tax
purposes,” which the parties’ purchase agreements had allocated toward “Fee
10
Owner’s fee title to the Property.” This resulted in a tax bill of about $1.7 million. 3
The purchase agreements allocated the remaining $174 million of the total
transaction “to termination of Leasehold Owner’s leasehold title.” Consistent with
their interpretation of the tax statutes, the parties filed no Form FP-7/C when they
recorded their lease termination memoranda, and accordingly paid no transfer or
recordation taxes.
Six years after this transaction closed, it came under the scrutiny of District
tax officials during what they describe as a routine audit. Those officials took a dim
view of the position that only $76 million of a $250 million transaction was taxable.
Upon the audit’s completion, the District’s Office of Tax and Revenue (OTR) sent
the taxpayers Notices of Proposed Audit Changes concluding that “the taxable
consideration reported . . . has been understated” for the Office Center and Design
Center sites. The notices calculated tax deficiencies of approximately $4.7 million
and $317,000, respectively, and further informed the taxpayers that these
deficiencies “[are] subject to an accuracy-related penalty.” Of note, the notices
3
The taxes on the land itself were discounted below the standard rate. For
reasons immaterial to the issues before us, the Museum of the Bible applied for and
was granted a partial exemption from the recordation tax on the Design Center
property sale.
11
referred both to the special warranty deeds and the lease termination memoranda,
identifying these instruments by document number.
After several back-and-forths with the taxpayers, and having “carefully
considered all the information presented,” OTR issued Notices of Final Assessment
of Tax Deficiency. Like the initial notices, these final assessments identified tax
deficiencies of approximately $4.7 million and $317,000 for the two properties.
Additionally, OTR assessed accuracy-related penalties (40% for the Office Center
site and 20% for the Design Center site), as well as interest. All told, the bill came
to just over $11 million. And, like the audit notices, the final assessments referred
to both the special warranty deeds and the lease termination memoranda, identifying
these instruments by document number.
The taxpayers paid this assessment under protest and filed an appeal of that
assessment in the Superior Court. See D.C. Code § 47-3303. Their petitions raised
two principal arguments: that the District “lacks statutory authority to assess transfer
and recordation taxes on ground-lease terminations,” and that these assessments
were so inconsistent with the District’s prior conduct that they constituted a denial
of the taxpayers’ rights to equal protection of the law. Following extensive
discovery, the Superior Court granted the taxpayers’ motion for summary judgment,
12
finding that they were not required to pay transfer and recordation taxes on the
ground lease terminations and that, even if they were, accuracy-related penalties
would not be warranted. 4
On the question of taxability, the court identified two principal reasons for
concluding that the ground lease terminations were not taxable events. First, the
court observed that applicable statutes condition payment of the taxes on the
submission of a “deed” for recordation. See D.C. Code § 47-903(a)(1) (imposing
transfer tax “at the time the deed is submitted to the Mayor for recordation”); id
§ 42-1103(a)(l) (imposing recordation tax “[a]t the time a deed, including a lease or
ground rent for a term (with renewals) that is at least 30 years, is submitted for
recordation”). “Deed,” in turn, has a statutory meaning of “any document,
instrument, or writing” in which real property or an interest therein “is conveyed,
vested, granted, bargained, sold, transferred, or assigned.” Id. § 47-901(3) (transfer
tax); id. § 42-1101(3)(A) (recordation tax). Applying the expressio unius canon of
statutory construction, the court reasoned that because each of these actions—
convey, vest, grant, bargain, sell, transfer, and assign—refers to an act of
conveyance, taxable deeds are only those instruments by which a real property
4
Because it resolved their claims on statutory grounds, the Superior Court
declined to address the taxpayers’ constitutional arguments.
13
interest is transferred from one party to another. Because the lease termination
agreements did not transfer real property interests to the Hobby Lobby companies,
but rather simply terminated an encumbrance on the property held by the Vornado
lessees, the court concluded that they were not “deeds” subject to the transfer and
recordation taxes.
Second, the trial court found that even if the term “deed” were construed to
include ground lease terminations, those same statutory definitions expressly
exclude “a lease or ground rent for a term (including renewals) that is less than 30
years.” D.C. Code § 47-901(3) (transfer tax); id. § 42-1101(3)(B) (same as to
recordation tax). Here, both parties agreed that the ground leases for the Office
Center and Design Center sites had just 17 years (including renewals) remaining in
their terms when they were terminated in 2012. And, during discovery, the District’s
representatives testified that a lease term is determined by considering the portion of
the term remaining, not by looking to the length of the term when the lease was
entered. Accordingly, the court concluded that the lease termination agreements had
too little time remaining in their terms to be “deeds” subject to the District’s transfer
and recordation taxes.
14
On the question of accuracy-related penalties, the trial court found that even
if it had not granted summary judgment to the taxpayers on the issue of tax liability,
it would still conclude that the District had erred in assessing penalties. While the
taxation statutes permit penalties for various types of underpayment, they
specifically direct that “[a] penalty shall not be imposed . . . if the taxpayer shows
that there was reasonable cause for the underpayment and that the taxpayer acted in
good faith.” D.C. Code § 47-4221(a). The trial concluded that penalties were not
warranted “and that there is no genuine issue of material fact as to this issue.” The
District now appeals.
II.
We review summary judgment rulings de novo, “conduct[ing] an independent
review of the record . . . in considering whether the motion was properly granted.”
Expedia, Inc. v. District of Columbia, 120 A.3d 623, 630 (D.C. 2015) (citation
omitted). The taxpayers and the District offer competing views about the nature of
this $250 million transaction underlying their divergent positions about its taxability.
The taxpayers view the transaction as consisting of two distinct steps—the land sales
and the ground lease terminations—and their position, adopted by the trial court, is
that the latter step is not taxable. The District, conversely, zooms out and takes a
15
more aerial view of the transactions. It asserts that, as to each property, there was a
single transaction transferring ownership of the land and buildings to new owners,
“plainly meeting the definition of ‘deed or other document,’” so that the entire
transaction is taxable.
They are both partly right, though the District’s view is closer to reality. The
District is correct that the taxpayers did not account for a substantial and taxable
transfer of property interests that they were bound, but failed, to pay taxes on.
Namely, the buyers acquired the sellers’ vested reversionary interests in the
improvements on the land, and the value of that transfer was taxable yet entirely
overlooked in how the taxpayers apportioned the $250 million purchase price. At
the same time, it is not quite right—as the District asserts—to say the entire $250
million purchase price was taxable. Surely some (even if insubstantial) portion of
that amount was in fact paid for removing the 17-year ground lease encumbrances
on the land. 5 That amount, whatever its fair value, is not taxable, just as a typical
5
Removal of that encumbrance alone would not have resulted in the buyers’
coming into possession of the improvements on the land, absent their acquisition of
the sellers’ reversionary interests in those improvements, and it was the latter
transfer of reversionary interests that was taxable but unaccounted for in how the
taxpayers structured their sale and tax payments.
16
ground lease, or the termination or assignment thereof, is not taxable so long as less
than 30 years remain on the term.
How much of the $174 million ostensibly paid for termination of the ground
leases was, in reality, taxable consideration for the value of the reversionary interests
in the buildings on the land rather than removal of the encumbrances on it is an
intensely factual question. We remand that question to the trial court.
A.
We begin by detailing the parties’ respective views about the taxability of this
$250 million transaction, and why we disagree with the taxpayers’ narrow view of
their tax obligations. While we do not wholly agree with the District’s view either,
we detail our more minor disagreements with it in the next section.
The taxpayers frame this as a two-step transaction, dovetailing with the two
sets of instruments they executed: the special warranty deeds effecting the land
transfer, and the ground lease termination memoranda removing the encumbrances
on the land. The taxpayers acknowledge that the land transfer was taxable, and they
paid transfer and recordation taxes on the portion of the sale that they deemed to be
consideration for the land alone (about $76 million, the tax-assessed value of that
17
land). But they maintain that the second step of the transaction, the ground lease
terminations, was not taxable.
In the taxpayers’ view, when a ground lease places title to improvements in
the lessee, that title is not “transferred” back to the landowner upon the ground
lease’s termination, and so it is not taxable. Rather, any transfer of a property interest
takes place when the ground lease is first executed. At that time, the ground lease
fully vests the lessee with a possessory interest in the land and an ownership interest
in any improvements thereon. Simultaneously, the lessor is vested with “a reversion
in fee simple absolute,” entitling them to repossess the land and acquire “full and
absolute” ownership of those improvements upon termination of the ground lease.
Thus, the taxpayers argue that when the ground lease termination memoranda were
signed in 2012, there was no transfer of the buildings that had been constructed on
the properties. “None was necessary, because the ground leases established all rights
and interests in the properties at the conclusion of the leases.” As their expert put it
during discovery, all that occurred when the ground leases were terminated was the
“automatic[] conver[sion]” of the lessors’ already-vested future ownership interests
into present ownership interests.
18
The District says that is a bogus construct, both overly formalistic and
detached from the “reality of these transactions.” Instead, it views this $250 million
deal as a coordinated transaction in which both land and buildings alike were “sold
to . . . two [Hobby Lobby] companies that previously had no interest in them . . . in
exchange for a combined $250 million.” Under that framing, the remaining details
are just semantics. “[N]o matter what mechanism—however unusual or clever—the
parties use[d] to effectuate such a transfer,” the result was the ownership of both
land and the buildings passing from Vornado to Hobby Lobby. And that transaction,
the District argues, falls squarely within the scope of the tax statutes. As the
District’s counsel put it during oral arguments, “differentiating between the special
warranty deeds and the ground lease terminations here is an artificial distinction.”
We largely agree with the District’s view. The taxpayers’ accounting of the
transaction does not reflect reality, for reasons beyond its formalism. It entirely
ignores a massive taxable transfer of property interests that occurred in this
transaction. The taxpayers fail to explain how the Hobby Lobby companies—
entities that previously had no connection to either site—came into possession of the
future interests in the improvements in the first place. It was the Vornado lessor
companies who had the vested reversionary interests in the buildings on the land
before this $250 million deal, and who stood to take ownership of those buildings
19
upon the ground lease terminations. But it was the Hobby Lobby companies who
held those reversionary interests after the deal. That transfer is completely missing
from the taxpayers’ analysis. So how was it effected? While we doubt the particular
mechanism matters much, it appears that transfer came by way of the special
warranty deeds executed as the first step of this transaction. According to their
terms, those deeds transferred not only the sellers’ fee simple interests in the land
but also their reversionary interests in the buildings to new owners. That transfer of
the reversionary interests in the buildings was taxable, but the taxpayers apportioned
none of the $250 million to the transfer of those reversionary interests and
improperly failed to pay any taxes on it.
Recall that the purchase agreements executed by the taxpayers contained two
commitments in exchange for the $250 million purchase price: (1) deliver “the fee
estate in the Land and Improvements,” and (2) “terminat[e] the Ground Lease[s].”
(emphasis added) The special warranty deeds executed at closing accomplished this
first step. By their terms, these instruments conveyed from the Vornado lessor
companies to the Hobby Lobby companies “in fee simple, all of that certain land . . .
together with all improvements situated thereon.” (emphasis added) This latter
grant of “all improvements situated thereon” cannot refer to some present possessory
interest in the buildings. By the terms of the ground leases, the lessors had none:
20
“[f]ee simple to . . . all Improvements [] erected or located on the land [was] in
Lessee.” Instead, it refers to the lessors’ reversionary interests: their right to “full
and absolute” ownership of the improvements erected on the two sites “at the
expiration or earlier termination of the Lease Term.” 6 And so when the Vornado
lessors and Hobby Lobby companies executed the special warranty deeds, these
instruments conveyed both the lessors’ present ownership interest in the land and
their future ownership interest in its improvements.
In short, the special warranty deeds conveyed reversionary interests to the
improvements on the land that the taxpayers did not account for when attempting to
satisfy their tax obligations. With that in mind, we now explain how the District’s
transfer and recordation tax statutes apply to this transaction.
B.
As properly understood, this case boils down to a dispute over how to tax a
transaction in which the parties (1) transferred present ownership interests in two
plots of land, (2) transferred vested reversionary interests in the lands’
6
Our statutes term such a property interest an “estate in expectancy” and
permit its sale or transfer “in the same manner as estates in possession.” D.C. Code
§§ 42-508, -515.
21
improvements, and (3) then terminated two ground leases encumbering the land and
its improvements. To resolve that question, we turn to the text of the relevant
statutes.
The District requires that within 30 days of the execution of “a deed or other
document by which legal title to real property, an estate for life or a lease or ground
rent (including renewals) for a term that is at least 30 years, or an economic interest
in real property is transferred,” a copy of that “deed or other document” be submitted
to the District’s Recorder of Deeds. D.C. Code § 47-1431(a). That act—submitting
a deed for recordation—is what triggers the assessment of the two taxes, which are
typically calculated as a percentage of the consideration paid for the transfer. See id.§ 42-1103(a)(1) (recordation tax); id. § 47-903(a)(1) (transfer tax). 7 A “deed” is
defined as “any document, instrument, or writing (other than a lease or ground rent
(including renewals) that is less than 30 years) . . . whereby any real property in the
District, or any interest therein (including an estate for life), is conveyed, vested,
granted, bargained, sold, transferred, or assigned.” Id. § 47-901(3) (transfer tax);
7
In the event that either no or nominal consideration is paid for the transfer,
the taxes are assessed as a percentage of the fair market value of the property. D.C.
Code §§ 42-1103(a)(1)(A), 47-903(a)(1)(B). For leases or ground rents of more than
30 years, the taxes are based on the average annual rent over the term of the lease.
Id. §§ 42-1103(a)(1)(B)(i), 47-903(a)(2).
22
see also id. § 42-1101(3) (recordation tax). Putting those provisions together, any
time parties execute any instrument by which any interest in real property is
“conveyed, vested, granted, bargained, sold, transferred, or assigned,” they must
record a copy of that instrument with the District and pay the appropriate transfer
and recordation taxes, unless a statutory exemption applies.
In this case, the parties executed two relevant sets of instruments to effect this
transaction: a pair of ground lease termination memoranda and a pair of special
warranty deeds. The ground lease termination memoranda are not taxable deeds
under the tax statutes, but the special warranty deeds are, as explained in turn below.
And, as further explained in Part II.B.2 below, the special warranty deeds conveyed
substantial and taxable property interests that the taxpayers failed to pay taxes on,
making some assessment by OTR appropriate.
1. The terminations of the ground leases themselves are not taxable.
We agree with the taxpayers and the trial court on the limited proposition that,
as the trial court put it, the ground lease termination memoranda were not taxable
“deeds” within the meaning of the tax statutes. The memoranda did not “convey,
vest, grant, bargain, sell, transfer, or assign” any real property. See id. § 47-901(3)
(transfer tax); id. § 42-1101(3)(A) (recordation tax). They simply terminated the
23
lessees’ possessory interests and thereby converted the lessors’ preexisting
reversionary interests into present interests. Neither of these acts—terminating a
property interest or converting a vested future interest to a present one—is a transfer
or conveyance as contemplated by the taxation statutes.
While the District counters that the termination of the ground leases “had the
effect of transferring ownership in the buildings from the subsidiary-sellers to the
new owners,” that is not quite right. The buyers already had a vested reversionary
interest in the buildings—they attained those interests via the special warranty
deeds—and the termination of the ground leases merely removed encumbrances on
those preexisting reversionary interests.
To illustrate the point, the District concedes that ground lease terminations are
not taxable when they occur naturally, at the end of a lease term. Consider a ground
lease with just one month left on its term; under the District’s view, if the landowner
pays the lessee even a modicum amount to terminate the lease early, the entire value
of any buildings on the land would be a taxable sale, whereas none of that value
would be taxable if the parties simply waited the month for the lease to terminate.
That does not make much sense. There is no cogent reason to think that the natural
termination of a ground lease does not convey or transfer a taxable interest in real
24
property but that its early termination does. No matter how the termination comes
about, the result is the same: the landowners’ reversionary interests become present
interests. It would be anomalous to say that one is a taxable transfer of real property
but not the other. 8
To be sure, as the District stresses and the taxpayers do not dispute, there may
be exceptions to the rule that ground lease terminations are not taxable when the
ground leases themselves are entered into with a purpose to evade taxes. For
instance, one could imagine companies entering into a ground lease with the purpose
of evading taxes by purposefully structuring a lease to terminate immediately after
a land sale. But there is no suggestion of such an artifice here, where these ground
leases were in place several decades before the transaction at issue. And such a
subterfuge would not depend upon the early termination of a ground lease; it could
be accomplished through naturally expiring lease terms as well. In any event, that
8
The District attempts to differentiate these two scenarios by arguing “the
natural expiration of a ground lease does not involve a separate document.” That is
a hollow distinction that makes little sense as a practical matter, as it could be easily
circumvented by enterprising parties. For instance, parties could simply write into
any ground lease a series of early termination points that either party has the ability
to opt out of, so that if they ever want the lease to terminate early (perhaps after a
sale to a third party), that could be accomplished with no need for any taxable
writing, by doing nothing at all. That view embraces the same type of empty
formalism that the District rightly criticizes the taxpayers for advancing.
25
stratagem can largely be thwarted by taxing the transfer of the reversionary interests
in the buildings, as we now discuss.
2. The special warranty deeds are taxable and include the transfer of
reversionary interests that the taxpayers failed to account for.
The special warranty deeds are a different matter. By their terms, they
“grant[ed] . . . convey[ed] and confirm[ed] unto Grantee, in fee simple, all of that
certain land situate . . . together with all improvements situated thereon.” Such an
act of conveyance falls squarely within the scope of the taxation statutes. The
taxpayers do not dispute that point, but instead go awry by failing to recognize that
these deeds transferred two distinct property interests: a present and fee simple
interest in the land (on which they paid taxes), and a future reversionary interest in
its improvements (on which they did not). Their purchase agreements demonstrate
that they did not account for the transfer of those reversionary interests in the
improvements. They arrived at their $76 million figure for the taxable portion of
this exchange based on “the assessed value of the Land for real property tax
purposes,” by itself. The balance of the $250 million total transaction cost was
allocated “to termination of Leasehold Owner’s leasehold title to the Property under
the Ground Lease.”
26
That does not account for a substantial part of the transaction. The special
warranty deeds were instruments used to transfer vested reversionary interests, and
a reversionary interest, like other future interests, is a legally cognizable interest in
real property. See, e.g., Restatement (First) of Property § 153(1) (1936) (“[A] future
interest is an interest in land.”). As discussed, the District’s transfer and recordation
tax statutes apply broadly to any instrument used to convey “any real property in the
District, or any interest therein.” D.C. Code § 47-901(3) (emphasis added); see also
id. § 42-1101(3)(A)(ii). The transfers of these reversionary interests via the special
warranty deeds were therefore taxable, and the taxpayers’ failure to pay these taxes
when they recorded the special warranty deeds made some assessment by OTR
appropriate.
Our holding, that a transfer of a reversionary interest is taxable but the
termination of a ground lease is not, not only harmonizes the relevant statutes, but
also has the further benefit of resolving the various policy concerns raised by the
parties. For its part, the District warns that an inability to tax ground lease
terminations would “open a massive loophole,” permitting unscrupulous landowners
to avoid transfer and recordation taxes through creative transfer schemes. But no
matter what process is used, ownership of both the land and improvements
necessarily changes hands at some point during the sale of any real property. The
27
transfer and recordation tax statutes thus apply to that transfer in whatever form it
takes. So long as the District can tax the fair value of any transfer of reversionary
interests, the loophole it posits closes.
The taxpayers, meanwhile, complain that the District’s position marks an
unjustified and unexplained change in policy because “the District had never sought
to tax a ground lease termination before this case.” Before the trial court, the
taxpayers went so far as to argue that their treatment by the District’s tax officials
was discriminatory and raised constitutional concerns. But, as we have explained,
that argument ignores the novelty of this case. A ground lease termination alone is
not a taxable transfer, but simply a termination of the lessee’s interest and the
conversion of lessor’s interest from future to present. It was only because the ground
lease termination here was preceded by a transfer of the reversionary rights
underlying the ground lease that the District sought to assess transfer and recordation
taxes. The District is simply addressing a new type of transaction—not at issue in
the past cases the taxpayers identify—that involves not only the termination of
ground leases but a prior transfer of the reversionary interests underlying them. 9
9
The same reasoning disposes of the taxpayers’ warning that if early ground
lease terminations are taxable, a lessor could be faultlessly on the hook for taxes
whenever their lessee breaches the lease agreement and thereby causes an early
termination of the lease. Such an event, like the natural expiration of a lease, would
28
C.
That leaves the question of what portion of the $250 million was taxable,
beyond the already-taxed $76 million paid for the land transfer. We cannot answer
that question on this record, because neither the parties nor the trial court ever sought
to answer it. They instead treated the remaining $174 million as a unitary mass—
taxable or not as a whole. Both all-or-nothing approaches are mistaken, as we have
explained, so that this $174 million needs to be broken down into its taxable and
nontaxable components. We remand for the trial court to assess what portion of that
$174 million represents the fair value paid for the nontaxable termination of the
ground lease encumbrances on the land, and what portion of it represents the fair
value paid for the taxable reversionary interests in the improvements on the land. 10
Before we explain why it at least tentatively seems likely that the vast bulk of that
amount was paid for the reversionary interests to the buildings on the land, we must
first address each party’s contention that their opposing party waived any right to
such a remand. We detect no such waiver by any party.
not be taxable because it does not ordinarily involve the transfer of any taxable real
property interest, placing it outside the scope of the District’s transfer and
recordation tax statutes.
10
The trial court will likely find it necessary to reopen discovery to resolve
this factual question, though we ultimately leave that to the trial court’s discretion.
29
The threshold question is whether any party’s all-or-nothing litigation posture,
both in the trial court and on appeal (i.e., that the $174 million was all taxable, or all
not) effectively waived any entitlement to a remand now. The District suggests the
taxpayers should not be able to discount that $174 million even by a marginal sum
representing the fair value of the ground lease terminations because it was the
taxpayers’ burden to show what portion of that $174 million was paid for the early
termination of the ground lease and they have failed to do that. The taxpayers retort
with the flipside of that argument, that it was the District’s obligation to show that
the taxpayers had not fairly apportioned the $250 million between the land sale and
ground lease termination, 11 and its chosen line of attack was to argue that ground
lease terminations are themselves taxable, a view we have now rejected. So it is the
District that has waived an apportionment challenge, in the taxpayers’ view. Neither
argument is persuasive. Both in the trial court and on appeal, all parties took broad
positions that the $174 million was either taxable, or not taxable, in toto. Those
positions fairly included the lesser arguments that some portion of that amount was
taxable, and some not.
11
Part of this argument is that the reversionary interests to the buildings “run
with the land,” so that the District really should have argued that the taxpayers failed
to properly apportion the $250 million between the land and the ground lease
terminations. That might be right, but in our view it is immaterial. This was a
sufficiently complicated, novel, and non-transparent transaction that we would not
penalize the District for failing to foresee our precise holding today.
30
As for how that $174 million should have been apportioned, that is a factual
question we leave for the trial court on remand. When pressed at oral argument, the
taxpayers averred that the District’s tax assessments for the land—amounting to the
$76 million that the taxpayers paid taxes on—incorporated the value of any
reversionary interests in the buildings. That is mistaken and inconsistent with the
record evidence. Even the taxpayers’ statement of undisputed material facts is to the
contrary, as it describes the $76 million as “the current tax assessed value of the [two
plots of] land,” not their improvements or any reversionary interests therein.
The District, conversely, claims that roughly all of the $174 million was paid
for the value of the buildings on the land, and virtually none of it was paid to
terminate the ground leases thereon. That appears to be closer to the truth for a
couple of reasons. First, when Vornado marketed these properties, it advertised the
Office Center real estate as being worth $210 million and the Design Center real
estate as being worth $46 million. It is hard to explain that $164 million delta
between adjacent properties of roughly the same size unless most of that value came
from the buildings, rather than from the land itself. 12 Second, and relatedly, recall
12
Indeed, this reality is reflected in the property tax assessments relied on by
the taxpayers, which value the land at the Design Center and Office Center sites at
roughly $37 and $39 million, respectively.
31
that of the $174 million paid for the termination of these ground leases, roughly $161
million was paid for termination of the Office Center site ground lease, while only
about $13 million was consideration for termination of the Design Center ground
lease. See supra note 2. Again, that twelve-fold discrepancy suggests that the vast
bulk of the $174 million was really being paid for the buildings on the Office Center
site, and not for the termination of either ground lease.
Those preliminary indications aside, these are intensely factual questions, on
which we have a sparse factual record and no trial court findings. We therefore
reverse the Superior Court’s order and remand for the trial court to explore these
factual questions in the first instance.
III.
Finally, we address the issue of penalties. Recall that the OTR’s final tax
assessments included accuracy-related penalties of 40% of the underpayment on the
Office Center site and 20% of the underpayment on the Design Center site. The
Superior Court disallowed these penalties, finding that even if the taxpayers were
required to pay transfer and recordation taxes on the entire $250 million transaction,
penalties would be inappropriate in light of the taxpayers’ reasonable cause and good
faith. We agree.
32
As relevant here, the applicable statute provides that “[t]here shall be added
to a tax imposed by this title an amount equal to 20% of the portion of an
underpayment which is attributable to . . . [n]egligence . . . or [a] substantial valuation
misstatement.” D.C. Code § 47-4211(b)(1). Where the underpayment “is
attributable to a gross valuation misstatement,” that penalty increases to 40%. Id. §
47-4211(b)(2). “Negligence” consists of “a failure to make a reasonable attempt to
comply with the provisions of this title or to exercise ordinary and reasonable care
in the preparation of a tax return without the intent to defraud.” Id. § 47-4211(a)(1).
And a “substantial” value misstatement is one that misstates the actual valuation by
at least 200%, while a “gross” value misstatement is one that misstates the actual
valuation by at least 400%. Id. §§ 47-4211(a)(2), (4).
A separate statute directs OTR to waive any accuracy-related tax penalties in
situations where “the taxpayer shows that there was reasonable cause for the
underpayment and that the taxpayer acted in good faith.” Id. § 47-4221(a). While
we have never interpreted this provision, its meaning is easy enough to grasp. As
the statute itself explains, “[r]easonable cause generally exists if, based on all the
facts and circumstances, the taxpayer exercise[d] ordinary business care and
prudence in determining his or her tax obligations.” Id. § 47-4221(c). Like
analogous requirements found in federal statutes, “[t]his standard is objective.”
33
United States v. Bittner, 19 F.4th 734, 741 (5th Cir. 2021) (discussing 31 U.S.C.
§ 5321(a)(5)(B)(ii)(I)); see also Lefcourt v. United States, 125 F.3d 79, 84 (2d Cir.
1997) (discussing 26 U.S.C. § 6724(a)). “Good faith,” by contrast, refers to one’s
subjective intent—i.e., “[a] state of mind consisting in [] honesty in belief or
purpose.” Good Faith, Black’s Law Dictionary (11th ed. 2019); see also Good Faith,
Webster’s Third New International Dictionary 978 (2002) (“[A]bsence of fraud,
deceit, collusion, or gross negligence.”). Thus, § 47-4221 directs OTR to waive
accuracy-related penalties if the taxpayer can demonstrate that their underpayment
was both (1) objectively reasonable, and (2) subjectively honest.
With that understanding, we agree with the Superior Court’s conclusion that
no penalties were warranted here. As to the objective prong, the taxpayers acted
with reasonable cause in addressing a convoluted and novel issue. The correct
application of the transfer and recordation tax statutes to this transaction is a
tremendously difficult question—one that we determine no party got quite right—
and the taxpayers’ interpretation was not an unreasonable position to take on a
difficult issue of first impression. As the District’s own Recorder of Deeds
acknowledged, the District has never before taken a position on the taxability of
ground lease terminations, and she agreed that “reasonable people could disagree
34
about whether a specific ground lease termination is covered by the[] statutes.” 13
While we have concluded that the taxpayers’ position was wrong in certain key
respects, “ordinary business care” does not require prefect clairvoyance as to every
close legal question to be resolved.
Moreover, the record makes clear that the taxpayers’ position was the result
of reasonable efforts to assess their proper liability—the “most important factor”
when determining reasonable care under similarly drafted federal statutes. Bittner,
19 F.4th at 742; see also Treas. Reg. § 1.6664-4(b)(1) (“Generally, the most
important factor is the extent of the taxpayer’s effort to assess the taxpayer’s proper
tax liability.”). The record in this case makes clear that the taxpayers did not stumble
into their position blindly. During discovery, they identified a phalanx of attorneys
who “provided counsel in connection with the purchase of the Office Center
Property and the Museum Property,” including several who specifically advised on
“the payment of recordation and transfer taxes upon the closing of the transactions.”
As the District itself puts it, “[b]oth Vornado and Hobby Lobby . . . [were]
13
The District attempts to soften this concession, arguing that the Recorder of
Deeds never offered an opinion on whether these ground lease terminations were
taxable. That might be true, but the Recorder’s point still stands: the taxation statutes
do not directly address ground lease terminations, and reasonable minds can differ
on this interpretive question.
35
represented by capable and experienced attorneys.” While that alone is not
dispositive, it is indicative of good business care: “When an accountant or attorney
advises a taxpayer on a matter of tax law, such as whether a liability exists, it is,” at
least generally, “reasonable for the taxpayer to rely on that advice.” United States
v. Boyle, 469 U.S. 241, 251 (1985).
The taxpayers likewise demonstrated their subjective good faith. As evidence
to the contrary, the District points to the taxpayers’ decision to place enough money
into escrow to cover transfer and recordation taxes on the full $250 million
transaction. But that simply shows an understanding by the taxpayers that their
position, even if reasonable and adopted in good faith, was not necessarily sure to
prevail in the event the District took a different view. Indeed, when the District
pressed Vornado’s corporate representative on this exact point, he testified that
“[w]e know every transaction that’s ever occurred can be challenged,” and that while
the parties believed that such a challenge would be meritless, “they would put money
into escrow in case.” While the District suggests that a taxpayer uncertain of their
tax obligations should err on the side of caution and simply pay any doubted amounts
under protest, good faith does not require preclearance. When one pays all that they
genuinely believe that they owe, that meets the good faith standard.
36
IV.
For the foregoing reasons, we reverse the Superior Court’s order granting
summary judgment to the taxpayers, affirm that portion of its order declining to
impose underpayment penalties, and remand for further proceedings consistent with
this opinion.
So ordered.