We frequently hear about the many wealthy foreigners who acquire investment interests in New York real property, and the complex tax considerations relating to such investments. Yet, we sometimes forget that there are many US persons outside of NY (New Jersey is still part of the US, right? Oh well) who are drawn to an investment in NY real property for the very same reasons.
Every now and then, however, NY’s Department of Taxation (the “Tax Department”) reminds us that the tax rules applicable to such an investment by a US person who is not a NY resident can be just as daunting.
A recent advisory opinion illustrated the application of these tax rules. Taxpayer owned stock in an S corporation operating in NY. The S corporation owned NY real estate, and derived 69% of its income from an active parking operation and 31% from real estate rentals. The company had been in business for over twenty years and had no plans to liquidate. In 2012, Taxpayer, who had been a resident of another State (not NJ) and had never been active in the business, sold her entire 33% interest in the S corporation back to the corporation pursuant to a stock redemption plan and received an interest-bearing installment note from the corporation as part of the purchase price for the stock sale.
Taxpayer asked the Tax Department whether the gain from the stock redemption and the interest income on the installment note payments were subject to NY personal income tax.
Disposing of Intangible Property: An Interest in NY Real Property
NY source income is defined as the sum of income, gain, loss, and deduction derived from or connected with NY sources. For example, where a non-NY resident sells real property or tangible personal property located in NY, the gain from the sale is taxable in NY.
Under NY tax law (the “Tax Law”), income derived from intangible personal property, including interest and gains from the disposition of such property, constitute income derived from NY sources only to the extent that the property is employed in a business, trade, profession, or occupation carried on in NY.
From 1992 until 2009, this analysis also applied to the gain from the disposition of interests in entities that owned NY real property.
However, in 2009, the Taw Law was amended to provide that items of gain derived from or connected with NY sources include items attributable to the ownership of any interest in NY real property.
For purposes of this rule, the term “real property located in” NY was defined to include an interest in a partnership, LLC, S corporation, or non-publicly traded C corporation with one hundred or fewer shareholders that owns real property located in NY and has a fair market value (“FMV”) that equals or exceeds 50% of all the assets of the entity on the date of the sale of the taxpayer’s interest in the entity.
Only those assets that the entity owned for at least two years before the date of the sale of the taxpayer’s interest in the entity are used in determining the FMV of all the assets of the entity on the sale date.
The gain or loss derived from NY sources from a nonresident’s sale of an interest in an entity that is subject to this rule is the total gain or loss for federal income tax purposes from that sale multiplied by a fraction, the numerator of which is the fair market value of the real property located in NY on the date of the sale and the denominator of which is the FMV of all the assets of the entity on such date.
For most non-NY residents, the rule before the 2009 amendment would have yielded the preferred tax result. Nonresidents who owned interests in partnerships, for example, and that had gains on the sale thereof could, in many cases, sell their partnership interests without triggering NY income tax.
The Department’s Opinion
The Tax Department determined that, if the valuation conditions in the Tax Law were satisfied, a portion of the gain on the redemption of Taxpayer’s stock in the S corporation, reflected in the principal payments on the installment note, would be NY source income subject to NY personal income tax. The portion of the gain that constituted NY source income would be determined by multiplying the amount of the gain by a fraction, the numerator of which was the FMV of the NY real property on the date of the redemption sale and the denominator of which was the FMV of all of the corporation’s assets (owned for at least two years) on the date of the redemption sale. To the extent that this gain was payable to Taxpayer under an installment payment agreement (the note), a portion of each installment payment would be taxed as NY source income when it was received (thereby deferring the tax liability). As to the interest paid on the note, the Tax Department concluded that the note, and not the corporation’s real property, was the income-producing property. Because the note was intangible personal property, and the interest received by Taxpayer was not income attributable to property employed in a business or trade carried on in NY, the interest was not subject to NY personal income tax.
What’s A Nonresident Seller To Do?
As in any sale transaction, a price must be established for a taxpayer’s interest in an entity. This may entail negotiations between the buyer and seller. In each case, it will behoove the seller to understand and to try to quantify the costs (including taxes) of the sale in advance of any discussions. This will enable the seller to settle on the appropriate sales price: one that will yield the desired after-tax economic result.
In the case of a non-NY resident with an interest in an entity that owns at least some NY real property, the taxpayer will need to determine whether the entity meets the 50% threshold described above. In some cases, depending upon the entity’s business or investment purpose, not to mention the level of authority possessed by the non-NY resident, it may be possible to periodically adjust the entity’s investment holdings – being mindful of the two-year “anti-stuffing rule” – so as to fall short of the threshold. Of course, any such adjustments must make sense from a business or investment perspective.
Where the nonresident has little control over the entity, it may be possible to “time” the sale of his or her interest, taking advantage of a drop in real estate values or of an increase in the value of other assets held by the entity (for example, securities). However, this option may be impractical in cases where, for example, a shareholders or operating agreement restricts the sale of interests in the entity.
The important point is to recognize at the inception of one’s investment in an entity that there may be an issue on a subsequent disposition of the investment, to try to account for the ultimate tax cost when pricing the acquisition of the investment and/or its later sale, and to try to secure the periodic valuation of the entity’s underlying assets so as to facilitate any decision as to a disposition, and to support one’s reporting position in the event of a sale.