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Jan 1994

NYS transfer tax affects real estate workouts. (New York State) (Estates & Trusts)

by Taicher, Jaime

    Abstract- Owners of distressed real estate properties in New York State need to consider the implications of the Gains Tax imposed by the state on the transfer of real property. For such owners, the minimization of this Gains Tax is a primary consideration, particularly when the distressed property is subject to a workout or the loans taken out to finance them are subject to a restructuring. Factors that must be considered when planning how best to mimimize this tax include the availment of a mortagage enclosure, the use of a deed in place of a foreclosure, Chapter 11 bankruptcy and the transfer of equity resources to a debtor organization. Tax planning in each case must be geared toward the determination of how the Gains Tax should be allocated once a controlling interest in the property has been transferred.

Gains Tax

The Gains Tax is computed as 10% of the excess of the consideration for the transfer over the transferor's original purchase price of the property. The tax is imposed on the transfer of commercial property located in New York State, where the "consideration" for tile transfer is $1 million or more. The transferor's "original purchase price" is the amount paid to acquire the property plus capital improvements and certain lees paid to dispose of the property.

Pursuant to New York State Tax Law (Sec. 1440.1), "consideration" is defined as the price paid to acquire an interest in real property and includes the amount of any mortgage, lien, or other encumbrance, whether the underlying indebtedness is assumed or taken subject to. Consideration includes the cancellation or discharge of an indebtedness or obligation. Thus, the tax may be imposed using the mortgage balance as the consideration amount where the lien exceeds the property's fair market value. Therefore, by taxing indebtedness rather than market value, the Gains Tax may be imposed even though there is no economic profit.

Mortgage Foreclosure

The consideration generally equals the foreclosure bid price plus any continuing liens on the property. If the lender is the successful bidder, the consideration will be the higher of the bid price or the amount of judgement in foreclosure as established by the referee. There is a risk New York would seek to include in consideration the full judgement that could have been obtained by the lender, rather than the reduced foreclosure judgment. In a foreclosure sale, the mortgagee is not personally liable for any Gains Tax due by the mortgagor. If the proceeds from the foreclosure sale are insufficient to pay the Gains Tax liability, the mortgagor remains liable for the payment of the tax. The county clerk may record a conveyance without payment of the Gains Tax.

The consideration generally equals the amount of the mortgage debt canceled plus any remaining liens on the property. There are pre- transfer audit procedures the transferee may follow to avoid personal liability for the Gains Tax created by a deed in lieu of foreclosure. Unlike a foreclosure sale, however, payment of the Gains Tax is a prerequisite to the recording of the deed conveying the property. Accordingly, the consideration on such a transaction will include the amount of Gains Tax the lender is willing to pay as a cost of the transaction.

A conveyance pursuant to a plan under the liquidation provisions of the Bankruptcy Code triggers a transfer of real property. The Second Circuit Court of Appeals found that imposition of the Gains Tax is not forbidden under Bankruptcy Code Sec. 1146(c), which provides that a transfer under a reorganization may not be taxed under any law imposing a stamp tax or similar tax (995 Fifth Avenue Associates. L.P.|U.S. Sup. Ct.. No 92-363. filed 8/27/92) as affirming in part and reversing U.S. Bankr. Ct.. SDNY No. 88B 10237 (TLB). 116 Bankr. 384. July 13, 1990). The consideration on a bankruptcy conveyance equals the amount of indebtedness discharged plus any remaining liens on the property. Under a bankruptcy conveyance, the payment of tax is needed to record the deed.

A potential Gains Tax is triggered upon the transfer of a "controlling interest" in an entity owning New York real property. A "controlling interest" is considered 50% or more of the capital, profits or beneficial interest in an entity. The consideration in this type of transfer, shall be calculated as an apportionment of the fair market value of the real Property held by the controlling interest. Fair market value is determined by appraisal and is not reduced by mortgages on the property. A purchase of a controlling interest does not have a corresponding deed recording event to serve as an enforcement device for the payment of Gains Tax.

Recent Developments

In an advisory opinion dated December 28, 1992 (Feiner, Petition No. M921021B), New York issued some guidance which results in some planning opportunities, where the transferee was the lender. New York concluded the amount of consideration, when a controlling interest is transferred, is based on the fair market value of the underlying property interest. The advisory opinion specifies that a bank may use fair market value by acquiring control of the partnership or corporate entity that owns the real property.

On April 15, 1993, New York Governor Mario Cuomo signed budget legislation which includes provisions that significantly impact the Gains Tax in workout situations. The legislation should ease the harsh and unfair results that occur when the amount of consideration is deemed to equal debt forgiven, rather than the fair market value of the property transferred.

1) New York State Tax Law Sec. 1440(d) as amended redefines the amount of consideration received by a debtor where real property is transferred to a secured lender in a foreclosure or deed in lieu of transfer. The consideration is limited to the fair market value of the underlying property. (The amendment does not address the concept of fair market value in the case of transfers in bankruptcy.)

2) The definition of "original purchase price" ("OPP") is amended to include advertising and marketing costs other than those included in customary brokerage fees paid by the transferor. OPP also would include mortgage recording taxes paid to finance purchases, capital improvements, transfers of title to a cooperative housing corporation, interest paid allocable to construction periods, and costs incurred to acquire a real estate exemption trader Sec. 42 I-a of the New York Real Property Tax Law.

3) The transferee in a deed in lieu of transter will not be liable for any Gains Tax resulting from the transfer (Tax Law Sec. 1447.3(b)). This extends the liability exemption which previonsly only applied to foreclosures. This relief will not apply to the extent of any money paid by the mortgagee to the transferor.

The Budget Act provisions relating to the Gains Tax apply to transfers on or after April 15, 1993.

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