The New York State gains tax law and cooperative conversions.by Kranzler, Ronald
The gains tax on real property transfers ("Gains Tax") was enacted by the New York State Legislature and approved by the governor on March 28, 1983. The tax is 10% of the gain derived from the transfer of real property, which includes the acquisition of a controlling interest in any entity with an interest in real property, where the property is located in New York State and where the consideration for the transfer is $1 million or more. The sale of an individual's residence is exempt from the gains tax. The New York State Department of Taxation and Finance ("The Department") has taken the position that the gains tax is a transfer tax rather than a property or income tax. Therefore, the gains tax is payable in addition to any federal, state, or local income tax that may be payable by reason of the transaction.
The Date of Share Transfer Governs
When real estate is purchased by a cooperative housing corporation ("CHC"), the transfer of the real property to the CHC is not what triggers payment of the gains tax. Rather, it is the date on which shares of the CHC are transferred to tenant-stockholders that requires payment of the gains tax.
Transfers of shares after March 28, 1983, pursuant to a cooperative plan are exempt pursuant to the grandfather exemption only if they were sold pursuant to a written contract (e.g., subscription agreement) entered into on or before March 28, 1983. The taxpayer must substantiate the date the written contract was executed through independent evidence, such as the recording of a contract or the payment of a deposit. The fact that the real property was transferred to the CHC prior to March 29, 1983, or that the contract was entered into prior to such date is irrelevant for purposes of applying the grandfather exemption to transfers of shares pursuant to a cooperative plan.
The "Safe Harbor Estimates" issued in May 1986 is the preferable method used today to calculate the amount of gains tax due for cooperative conversions. The valuation of unsold units and the required timing of update submissions will vary in accordance with the plan's status (newly constructed and vacant, an eviction conversion plan or a non-eviction conversion plan). The Safe Harbor Estimate is most advantageous for the sponsor of a non-eviction plan who expects a lengthy sellout period.
Under the "Safe Harbor" method, the sponsor can value the unsold units at the lower of the insider price, pursuant to the offering plan, or 50% of the vacant Fair Market Value (FMV). Vacant FMV will be established based on the sales price of vacant units transferred at the initial closing. The sponsor of a non-eviction conversion plan is required to update his or her initial calculation of the gains tax, when the sponsor has sold 50%, 75%, and 100% of his interest (based upon units, shares or square footage) in the real property. Therefore, the actual sales price of a unit may be higher than the value (either 100% of the insider price or 50% of the vacant FMV), attributed to the unit on the preceding submission. The sponsor is not required to pay the gains tax due on sales in excess of the values used for unsold units in the preceding submission until the next required submission (i.e., 50%, 75%, or 100%).
Gains Tax Presents Problems
The gains tax imposed on the conversion to cooperative ownership has presented many problems for the taxpayer (realty transferor/sponsor). Two such issues that have become major items of contention between the sponsor and the Department during audit are: 1) the economic gain on commercial leases; and 2) the transfer of shares by the sponsor after March 28, 1983, pursuant to a cooperative conversion plan in which the real property was transferred to the CHC on or before March 28, 1983.
Economic Gain on Commercial Lease
In many cooperative conversions the CHC will purchase the entire building and enter into a lease (master lease) with the sponsor for the commercial space. The sponsor retains the existing lease agreements that were entered into with the commercial tenants, now sub-tenants. The Department has taken the position that the gross rents received by the sponsor from the subleases of commercial space in excess of rents paid by the sponsor to the CHC represent additional consideration for the transfer of the property to the CHC.
Example 1: Sponsor X currently receives $200,000 in annual rents from his commercial tenants. In accordance with the terms of the master lease, Sponsor X will pay rent of $100,000 per year for a period of 25 years to the CHC. The excess consideration or "net rents" to be received by the sponsor will be $100,000 per year ($200,000 - $100,000), for a period of 25 years, amounting to $2,500,000.
The Department's position appears to be inconsistent with Sec. 1440 of the New York State Tax Law, which states that the creation of a leasehold or sublease is a transfer of an interest in real property, and therefore subject to gains tax, only where it meets all of the following criteria:
1. The sum of the term of the lease or sublease and any options for renewal exceeds 49 years;
2. Substantial capital improvements are or may be made by or for the benefit of the lessee or sublessee; and
3. The lease or sublease is for substantially all of the premises constituting the real property. "Substantially all" is defined to mean 90% of the total rentable space, exclusive of common areas.
In the case of a cooperative conversion, where the entire residential portion of the building has been offered for sale, the commercial lease will rarely, if ever, represent substantially all of the property. Therefore, the lease for the commercial area is additional consideration received by the sponsor. It is the Department's position that the sponsor has divested himself of his complete interest in the real property in return for consideration, which in cooperative conversions may be comprised of the following elements:
1. The cash proceeds to be received as a result of the sale of the shares in the cooperative.
2. The payment of the indebtedness secured by a mortgage that was a lien on the real property conveyed.
3. The benefit of a favorable lease, that is, a lease in which contract rent is substantially less than economic rent. Each of the foregoing elements constitutes consideration as defined in Sec. 1440(1) of the NY Tax Law.
Sec. 1440(1) prescribes that the method used to determine the value of the favorable lease will be the present value of the right to receive the rental payments for the term of the lease. A 10% discount rate is presumed for gains tax purposes unless the taxpayer can demonstrate that 10% does not adequately reflect the discount factor in his particular circumstances.
Example 2: In Example 1, Sponsor X will receive "net rents of $100,000 per year for 25 years. The present value of the right to receive net rents of $100,000 per year for 25 years, assuming a 10% discount rate, would be approximately $908,000. The gains tax due on this additional consideration would be $90,800 (908,000 x 10%) and is due and payable on the date the master lease becomes effective, which is usually the closing date of the cooperative conversion.
In order to refute the Department's valuation, an independent appraisal of the leasehold would be helpful, but would not necessarily be an adequate rebuttal.
Due to the general confusion surrounding this aspect of the law, the Department has agreed to waive all penalties, but not interest, that would normally be imposed for late payments of gains tax that would be attributable to the economic gain on commercial leases.
Cooperative Conversions that Took Place on or Before March 28, 1983
If real property was transferred to a CHC on or before March 28, 1983, the transferor may still be liable for gains tax, if the aggregate consideration received on shares transferred to tenant-stockholders after March 28, 1983, exceeds $1 million.
The question as to whether the transfer of shares to individual unit purchasers pursuant to a cooperative conversion plan is a taxable event under Article 31-B of the New York State Tax Law, or whether the statute applies only to the transfer of the real property to the apartment corporation was raised in the case of Mayblum v. Chu. The Supreme Court of New York on May 11, 1984, stated that included within the definition of taxable transfers is an aggregation clause that provides that a transfer of real property shall also include partial or successive transfers pursuant to an agreement or plan to effectuate by partial or successive transfers a transfer that would otherwise be included in the coverage of Article 31-B. Transfers pursuant to a cooperative or condominium plan are specifically included in this aggressive clause.
The Supreme Court also stated that the transfer of shares to individual unit purchasers is the operative event and its designation is consistent throughout the statute.
Example 3: A sponsor transfers real property to a CHC on June 1, 1982. The apartment building is comprised of 100 units and is offered for sale under a non-eviction plan at the insider price of $50,000 per unit, plus a mortgage from the CHC of $1 million. The sponsor sells 50 units to insiders on June 1, 1982 at the inside price of $50,000 per unit. An additional 10 units are sold to outsiders on or before March 28, 1983 at the price of $75,000 per unit. The written agreements to purchase the 60 units sold were dated on or before March 28, 1983. After March 28, 1983, the sponsor sells the remaining 40 units at the price of $100,000 per unit. The consideration subject to gains tax is summarized as follows:
1. Cash consideration received
on the sale of forty (40) units
after March 28, 1983 $4,000,000
2. Add mortgage indebtedness:
The sponsor will be allowed a deduction for brokerage fees pertaining to the sales that took place after March 28, 1983, in addition to a pro- rata share of the original purchase price, cost of capital improvements and allowable selling expenses.
However, if the sponsor liquidated the corporation or dissolved the partnership that held the unsold shares of the CHC prior to March 29, 1983, the owners will be entitled to a step-up in basis to the FMV of the shares at the date of liquidation or dissolution.
Example 4: With reference to Example 3, assume the sponsor dissolved the partnership that held title to the real property on March 1, 1983, and distributed the remaining 40 unsold units to the individual partners in accordance with their respective ownership percentages. In addition, assume the sponsor purchased the building in 1975 for $500,000, incurred no expenses for capital improvements and paid allowable selling expenses of $100,000 upon cooperative conversion on June 1, 1982. The FMV per unit on the date of dissolution was $75,000 per unit, the actual average price that was paid by outsiders during the period of June 1, 1982 to March 1, 1983. The illustration in Exhibit 1 calculates the tax savings the sponsor will receive from the step-up in basis.
Tax planning for cooperative conversions must take place prior to the closing date to minimize the amount of gains tax due. Special care should be taken with regard to the calculation of the economic gain on commercial leases. If your client co-oped his or her building prior to March 29, 1983, you still must deal with the aggregation clause relating to sales after March 28, 1983. Exhibit 1 Omitted
Russell Kranzler and Ronald Kranzler, of Held, Kranzler
The CPA Journal is broadly recognized as an outstanding, technical-refereed publication aimed at public practitioners, management, educators, and other accounting professionals. It is edited by CPAs for CPAs. Our goal is to provide CPAs and other accounting professionals with the information and news to enable them to be successful accountants, managers, and executives in today's practice environments.
©2009 The New York State Society of CPAs. Legal Notices
Visit the new cpajournal.com.