Readers of this publication know that I have written extensively on the New York State Real Estate Transfer Tax (RETT) and the New York City Real Property Transfer Tax (RPTT). For those less avid readers, articles can be found here and here. A recent case winding its way through the New York courts highlights the intricacies of these taxes and serves as a cautionary tale to taxpayers and tax practitioners attempting to avoid transfer tax exposure.
By way of background, the RETT is imposed on conveyances of real property or interests in real estate at a rate of $2 per $500 of consideration paid, and the RPTT is imposed on transfers of New Yok City real estate or interests in real property when consideration exceeds $25,000. The RPTT rate varies between 1% and 2.625%, based upon the consideration paid and type of property conveyed. For instance, the RPTT rate for commercial real estate sold for more than $500,000 is 2.625%, resulting in an effectively combined New York State and City transfer tax of 3.025%, typically imposed on the seller. Both the RETT and RPTT have two noteworthy exemptions: the mere change of identity exemption and the controlling interest exemption. The mere change of identity exemption provides that New York transfer taxes do not apply to transactions in which the economic interest in the real estate remains the same. For example, if two taxpayers, each of whom is a 50% partner in a piece of real property, convey the property to a corporation in which the taxpayers are each 50% shareholders, the conveyance is exempt from the RETT and RPTT as a mere change of identity. The controlling interest exemption pertains to transfers of entity interests that hold underlying real property. Only entity interest transfers of 50% or more are subject to the RETT and RPTT. As a result, the sale of a 49% interest in a limited liability corporation holding New York City real estate is not subject to the RETT or RPTT. These transfer tax exemptions have become the subject of the recent litigation described below, leading to a divergence of treatment by New York State and New York City.
The facts of the case are as follows: On April 9, 2007, the petitioner and SLG acquired a 45% and 55% tenant-in-common interest in 2 Herald Square in New York City. On December 22, 2010, the petitioner and SLG transferred their respective 45% and 55% tenant-in-common interests in the property to a newly formed entity, Owner LLC. On the same day, the petitioner sold its 45% Owner LLC interest to SLG for $111 million of consideration, consisting of $25 million in cash and relief of 45% of the $191 million mortgage. The petitioner and SLG filed two sets of transfer tax returns with New York State and New York City. On the RETT and RPTT returns for the first transfer, both the petitioner and SLG claimed the mere change of identity exemption, as the parties retained their respective 45% and 55% interests in the underlying real property, albeit now through Owner LLC. On the RETT and RPTT returns for the sale of the 45% Owner LLC interest, the petitioner claimed the controlling interest exemption, because the interest conveyed was less than 50% of the entity. Subsequently, the New York State Department of Taxation and Finance and the New York City Department of Finance issued notices assessing transfer taxes, interest and penalties of $678,665 and $3,392,627 on the series of conveyances.
In appealing the New York State RETT assessment, an administrative law judge from the Division of Tax Appeals ruled in favor of the petitioner. The May 26, 2016 determination dismissed the State’s attempt to aggregate the two separate nontaxable real estate transfers to achieve a taxable event. The judge ruled that the tax regulations do not authorize adding the mere change of identity exemption together with the controlling interest exemption in order to create a transfer subject to the RETT.
While the petitioner was successful with respect to the RETT, the New York City Tax Appeals Tribunal sustained the RPTT assessment. In its decision, the Tribunal applied the step transaction doctrine to treat the two conveyances as part of an integrated plan, whereby the petitioner’s contribution of its tenant-in-common interest of the property and sale of its Owner LLC interest were steps in a single transaction not exempt from the RPTT, either as a mere change of identity or as a transfer of a non-controlling interest in real estate. The step transaction doctrine is comprised of two tests, either of which if met would satisfy the doctrine. The first test is an “end results test,” under which purportedly separate transactions will be aggregated when it appears that they are really component parts of a single transaction intended from the outset to achieve a particular result. The second test consists of an “interdependence test” whereby activities are aggregated when it is clear that no single step would have been taken except as part of the overall transaction. The Tribunal deemed the facts at hand to satisfy both tests of the step transaction doctrine. First, the end result of the two transfers resulted in the petitioner’s ultimate intention, namely the sale of the tenant-in-common real estate interest to SLG. Second, nothing was offered by the petitioner suggesting that any of the conveyances would have been taken independent of the other. In fact, all steps were completed on the same day. Once the two transfers were recharacterized as a single conveyance of a 45% tenant-in-common interest in real estate, the exemption from RPTT was no longer applicable.
While the New York City ruling is likely not the end of the petitioner’s appeal of this tax assessment, the case reminds us of the risks involved, here over $3,000,000, in tax planning. Taxpayers certainly can structure business transactions to minimize tax exposure; however, each aspect of the plan must have substance that can be demonstrated in addition to tax consequences. Friedman LLP has extensive experience advising parties involved in real estate transactions with compliance and regulatory requirements. If you have questions regarding New York State Real Estate Transfer and New York City Real Property Transfer taxes, please contact Alan Goldenberg, Senior Manager of State and Local Taxation and Tax Controversy, at firstname.lastname@example.org or 212-897-6421, or your Friedman LLP tax professional.