When It Rains
Sometimes you go for weeks without having to consider a particular tax issue in any depth. Then, unexpectedly, that issue comes to the forefront of several projects. That was my experience this past week when it seemed as though almost every other person who came to my office had a question concerning New York transfer taxes.
No, I am not talking about New York’s estate tax.[i] Rather, I am referring to the transfer taxes that are generally imposed by N.Y. State (“NYS”) and by N.Y. City (“NYC”)[ii] upon a taxpayer’s “conveyance” or “deed”[iii] of real property located in NYS or NYC,[iv] or of certain interests in such real property including, for example, the creation of a leasehold interest in such real property.
In fact, it was the granting of a leasehold interest under varying circumstances that several of my colleagues wanted to discuss with me last week. Before delving into NYS’s and NYC’s transfer tax treatment of leases – including what may come as a surprise to some – let’s first consider the basic operation of the two transfer taxes.
The NYS Tax
In general, the NYS Real Estate Transfer Tax (“RETT”) applies to the “conveyance”[v] of real property, or of an interest in real property, when the consideration for the transfer exceeds $500.
Among other things, an interest in real property[vi] includes title in fee, a leasehold interest, and an option to purchase real property. It also includes a controlling interest in an entity that holds real property, meaning 50 percent or more of the total combined voting power of all classes of stock of a corporation or, in the case of a partnership, 50 percent or more of the capital or profits interest in the partnership.
The tax is imposed on the consideration paid, or required to be paid,[vii] for the conveyance. In the case of commercial real property,[viii] if the consideration is under $2 million, the tax is determined at a rate of 0.40 percent;[ix] if the consideration is at least $2 million, the tax is determined at a rate of a rate of 0.65 percent.[x]
In the first instance, the tax is payable by the grantor, failing which it may also be collected from the grantee – it is a joint and several liability.[xi] Payment is due fifteen days after the conveyance, at which time a joint return is also required to be filed.[xii]
Some conveyances are exempted from the tax. These include a conveyance pursuant to a devise, bequest or inheritance, as well as a conveyance to secure a debt.[xiii] Another is the “mere change” exemption, which is one of the most relevant for conveyances by closely held businesses and their owners.[xiv] Under this exemption, the tax does not apply to the extent the conveyance does not change the beneficial ownership of the property. For example, a conveyance by a partner to the partnership as a contribution of partnership assets is subject to tax only to the extent there is a change in beneficial ownership. Similarly, a conveyance to partners upon the liquidation of a partnership is subject to tax only to the extent there is a change in beneficial ownership.
The NYC Tax
The NYC Real Property Transfer Tax (“RPTT”) generally applies to the delivery of a “deed”[xv] by a grantor to a grantee when the consideration for the real property exceeds $25,000.[xvi] This includes any document whereby any real property or interest therein is created or transferred. It also includes any document by which any leasehold interest in real property is granted.
The RPTT also applies to a transaction by which any economic interest in real property is transferred[xvii] where the consideration exceeds $25,000.[xviii] This includes the transfer of a controlling interest in an entity that owns real property. In the case of a corporation, this is defined as 50 percent or more of the total combined voting power of all classes of stock of the corporation, or 50 percent or more of the total fair market value of all classes of stock of such corporation; in the case of a partnership, 50 percent or more of the capital or profits interest in such partnership.
In the case of commercial real property with a value in excess of $500,000, the RPTT is imposed at the rate of 2.625 percent of the consideration.[xix] Payment, along with a joint return,[xx] are due within thirty days after the delivery of the deed by the grantor to the grantee.[xxi] If the grantor does not pay the amount of tax due, the grantee also becomes liable for the tax.
As in the case of the RETT, there are certain transactions that are exempt from the RPTT, including one that effects a mere change of identity, or form of ownership or organization, to the extent the beneficial ownership of the real property or of the economic interest therein remains the same.[xxii]
RETT + RPTT
In a situation in which both the RETT and the RPTT apply – i.e., a taxable transfer of real property, or of an interest in such property, located in NYC – the grantor will be faced with a combined RETT and RPTT rate of up to 3.275 percent in the case of commercial property. This may result in a not insignificant increase in the overall cost of a transaction and, so, has to be considered by the parties in assessing the economics of a deal.
For example, the sale of real property in NYC in exchange for consideration of $20 million generates a RETT of $130,000 (0.65 percent) and a RPTT of $525,000 (2.625 percent), for a total of $655,000 in transfer taxes that must be paid by the seller shortly after closing the sale.
When this amount is added to the income taxes that are to be incurred on the sale,[xxiii] the seller may want to consider other options for “disposing” of their property, including, for example, a lease.
Creation of a Lease and the RETT
A conveyance for purposes of the RETT includes the transfer of an interest in real property located in NYS, which may include the granting of a leasehold in such property.
There are two ways by which the creation of a lease will be subject to the RETT. The first is where:
(1) the sum of (a) the term of the lease, and (b) any options for renewal exceeds 49 years; and
(2) substantial capital improvements are, or may be made, by or for the benefit of the lessee; and
(3) the lease is for substantially all of the premises constituting the real property.
“Substantially all” means at least 90 percent of the total rentable space of the premises, exclusive of common areas. For the purpose of determining whether a lease is for substantially all of the premises constituting the real property, “premises” generally include, but are not limited to, the following:
(i) an individual building;[xxiv] or
(ii) where a lease is of vacant land only, any portion of such vacant land.[xxv]
The second way by which the creation of a lease will be subject to the RETT is where an option to purchase real property is coupled with the granting of the right to use and occupancy of the real property.
Therefore, the creation of a lease coupled with the granting of an option to purchase the real property, regardless of the term of the lease, is a conveyance subject to the transfer tax.[xxvi]
RETT: Consideration for a Lease
In general, where the creation of a lease constitutes a conveyance subject to the RETT, the consideration used to compute the tax is equal the present value of the right to receive rental payments for the term of the lease, the present value of rental payments attributable to any renewal term, plus any amount paid for an option to purchase.
A discount rate equal to 110 percent of the federal long-term rate,[xxvii] compounded semiannually, is generally used in determining the present value of such payments which constitute consideration in the case of the creation of a taxable lease. The lower the rate, the greater the present value of the rental payments, and the greater the consideration on which the RETT is imposed.
In the case of a lease created for a term of less than 49 years, that contains an option to purchase the real property, net rental payments for periods that occur after the option is no longer exercisable, are not included in the calculation of consideration.
RETT Lease Examples
The foregoing concepts are illustrated in the following examples.[xxx]
A, as lessor, creates a lease with B as lessee. The lease is for a term of 60 years and covers an entire office building owned by A. The terms of the lease allow B to make substantial capital improvements to the building. The gross rents to be received by A over the term of the lease total $5 million. Operating costs are estimated to be $2 million. Net rents total $3 million (gross rents of $5 million less operating costs of $2 million paid by A). Assume the present value of the net rents is $550,000.
Since all three of the conditions set forth above are met, the creation of the lease constitutes a conveyance subject to tax. The taxable consideration is $550,000, the present value of the net rents. The total tax due, at the rate of $2 for each $500 of consideration, is $2,200.
Same facts as in Example 1, except that the lease is for a term of 30 years with no option to renew included. Since the lease is for a term of less than 49 years, the creation of the lease is not a conveyance subject to the transfer tax.
Same facts as in Example 1, except that the lease created between A and B has a fixed term of 30 years and B is granted an option to renew the lease at the end of the fixed term for another 30 years. This would be treated as the creation of a 60-year lease and, therefore, would be a taxable conveyance. The consideration used to compute the tax includes the present value of the net rental payments to be received during the fixed term and the renewal term.
Corporation Z owns a ten story building. Corporation Z creates a 60-year lease with corporation Y as tenant, such lease covering five floors of the building (50 percent of the premises). Since the lease covers less than 90 percent of the rentable space of the premises, the creation of the lease is not a conveyance subject to the transfer tax.
In the case of the creation of a lease for less than 49 years, coupled with the granting of an option to purchase, the consideration for purposes of determining the RETT is (a) the present value of the net rental payments under the lease, plus (b) the consideration paid for the granting of the option to purchase. Rental payments for periods that occur after the last date that the property may be purchased, if the option is exercised, are not included in the calculation of the present value of the rental payments.[xxxi]
A, as lessor, creates a lease of a building with B as lessee. The term of the lease is 20 years. The lease contains an option to purchase the building which is exercisable through the tenth year of the lease. If the option is exercised, the lease provides that the property will be transferred to B not later than 6 months after the option is exercised. B paid $10,000 specifically for the granting of the option.
Since this is the granting of an option with use and occupancy, the transaction is subject to the transfer tax. The consideration used to compute the tax would be the present value of the net rental payments to be received from the effective date of the lease through the expiration of the first ten years and six months of the lease, which is the period during which the property may be purchased pursuant to the option, plus the $10,000 paid for the granting of the option.
It should be noted that a grantor who acquired real property by exercising an option to purchase such property will be allowed a credit against the tax due on a subsequent conveyance of the property to the extent tax was paid by the grantor on a prior creation of a leasehold of all or a portion of the same real property or on the granting of an option or contract to purchase all or a portion of the same real property, by such grantor.[xxxii]
RPTT: Creation of, and Consideration for, a Lease
The RPTT is imposed at the time of the delivery of a deed by a grantor to a grantee, which includes a writing whereby a leasehold interest is granted in real property located in NYC.
In general, the RPTT is based upon the price actually paid or required to be paid for the real property or economic interest therein; i.e., the amount paid for the leasehold interest.
However, unlike the RETT, the amount of the consideration subject to the RPTT at the grant of a leasehold interest does not include any amount that is treated as rent for purposes of the commercial rent tax.[xxxiii] Significantly, there does not appear to be a requirement that the tenant be subject to the commercial rent tax. In other words, the consideration subject to the RPTT does not include the amount paid or required to be paid by a tenant for the use or occupancy of the premises anywhere within NY;[xxxiv] rather, it seems to include only the amount paid by the tenant to obtain the lease.
The determinative issue, therefore, is whether a payment made by a grantee to a grantor in connection with the grant of a leasehold interest was rent paid to the grantor in their capacity as a landlord, or whether it was paid in consideration of something else.[xxxv]
Lease Instead of Sale?
Might the application of the RPTT to the grant of a leasehold interest – or, more specifically, the calculation of the consideration paid by the grantee for such leasehold interest – present an opportunity for the owner of NYC real property who wants to develop such property but does not want to sell the property or contribute it to a joint venture, with the attendant tax costs? Should it encourage the owner to consider a lease arrangement with the developer, perhaps in the form of a ground lease?
After all, the RPTT seems to disregard the rental payments for purposes of determining the transfer tax. While the RETT would take the rental payments into account, the NYS tax rate is relatively low, at least when compared to NYC’s rate. The lease will not constitute a sale of the real property, provided the burdens and benefits of ownership remain with the owner; thus, no taxable gain is realized. What’s more, although the owner’s contribution of the real property to a joint venture partnership may not result in the imposition of any income tax,[xxxvi] the owner will likely incur RETT and RPTT to the extent there is a reduction of their beneficial interest in the contributed property.
In light of the foregoing, and assuming the use of a lease is feasible and makes sense from a business perspective, the owner of real property located in NYC may want to consider a lease arrangement as the first step in the development of the property.
[i] New York eliminated its gift tax effective for transfers made after December 31, 1999.
[ii] There are differences between them, some more significant than others. The adviser should not assume that the two sets of rules are identical.
[iii] In general, NYS refers to a conveyance while NYC refers to a deed.
[iv] Of course, both the NYS and NYC taxes may apply to the conveyance/deed of an interest in real property located in NYC. Again, I use the word “may” because a transfer that is taxable by NYS may not be taxable by NYC and vice versa.
[v] NY Tax law Sec. 1401(e). This includes the creation of a leasehold. It also includes the transfer of a controlling interest in an entity with an interest in real property.
[vi] Tax Law Sec. 1401(f).
[vii] There is no installment reporting for the transfer tax.
[viii] Commercial real property is real property that is not residential property. Residential property is any premises that is or may be used in whole or in part as a personal residence; this includes a one-, two- or three-family house, a condominium unit, and a cooperative apartment unit.
[ix] $2 for every $500 of consideration (or fractional part thereof). NY Tax Law Sec. 1402; 20 NYCRR Sec. 575.2.
[x] Effective July 1, 2019 for conveyances in cities having a population of at least one million.
[xi] NY Tax Law Sec. 1404; 20 NYCRR Sec. 575.4.
[xii] NY Tax Law Sec. 1409 and Sec. 1410.
If a conveyance is to be recorded, the return must be filed with the recording officer of the county where the conveyance is recorded. A recording officer cannot record a conveyance unless the transfer tax return has been filed and any tax due has been paid. Recording officers are authorized to collect the tax and accept returns only in those cases where an instrument effecting a conveyance of real property is presented for recording. 20 NYCRR Sec. 575.14(b).
[xiii] Sec. 1401(e). It should be noted that a tax deferred like kind exchange under IRC Sec. 1031 is not exempted, as such, from the RETT or the RPTT.
[xiv] NY Tax Law Sec. 1405(b)(6). A conveyance to effectuate a mere change of identity or form of ownership or organization where there is no change in beneficial ownership.
[xv] NYC Admin. Code Sec. 11-2101.2.
[xvi] NYC Admin. Code Sec. 11-2102(a).
[xvii] NYC Admin. Code Sec. 11-2101.7. Compare this to the definition of a “controlling interest” under the RETT. NYC Admin. Code Sec. 11-2101.8.
[xviii] NYC Admin. Code Sec. 11-2102(b). Thus, one will have paid $100 of RETT before any RPTT is owed: ($25,000/$500) x $2 = $100.
[xix] NYC Admin. Code Sec. 11-2102. Generally speaking, the RETT rate does not depend upon the kind of property being transferred.
[xx] NYC Admin. Code Sec. 11-2105.
[xxi] NYC Admin. Code Sec. 11-2104.
[xxii] NYC Admin. Code Sec. 11-2106(b)(8).
[xxiii] Which, in the case of an individual seller, would include federal capital gain tax at 20%, perhaps unrecaptured depreciation at 28%, perhaps depreciation recapture at 37%, perhaps the net investment income surtax at 3.8%, NYS income tax at 8.82%, and NYC income tax at 3.876%.
[xxiv] Except for space which constitutes an individual condominium or cooperative unit.
[xxv] 20 NYCRR Sec. 575.7(a).
[xxvi] 20 NYCRR Sec. 575.7(c).
[xxvii] Which is determined pursuant to IRC Sec. 1274(d). The federal long-term rate in effect 30 days prior to the date of transfer is used when computing this discount rate.
[xxviii] 20 NYCRR Sec. 575.7(b).
[xxix] Such operating costs include amounts paid for heat and gas, electricity, furnishings, insurance, maintenance, management and real estate taxes. Operating expenses paid directly to third parties by the lessee, for example, under a net lease, are not included in gross rents, nor are they deductible as operating costs. If the lease specifies that the lessor will pay a fixed amount of operating expenses, the lessor may deduct such amount from gross rents in computing net rents. If there is no itemization of the operating costs paid by the lessor and, according to the terms of the lease, the lessor must pay such costs, the lessor may make a reasonable estimate of such costs.
[xxx] From 20 NYCRR Sec. 575.7.
[xxxi] 20 NYCRR Sec. 575.7(c).
[xxxii] NY Tax Law Sec. 1405-A.
[xxxiii] NYC Admin. Code Sec. 11-2102(a)(10)(iii).
NYC requires most tenants to pay the CRT based on the tenant’s base rent (generally at an effective rate of 3.9%) where the annual base rent exceeds $250,000. The CRT is imposed only with respect to “taxable premises.” The term “taxable premises” generally means any premises located south of the center line of 96th Street in Manhattan that are occupied or used for the purpose of carrying on any trade, business, or other commercial activity, including any premises that is used solely for the purpose of renting the same premises in whole or in part to tenants.
The term “base rent” means the amount paid, or required to be paid, by a tenant for the use or occupancy of premises for an annual period, whether received in money or otherwise.
In none of the very few rulings issued by the NYC Department of Finance has the City indicated that this favorable treatment of rent applies only to taxpayers that are, in fact, subject to the commercial rent tax.
[xxxiv] NYC Admin. Code Sec. 11-701.6. Also not included is any payment required to be made by a tenant on behalf of his or her landlord for real estate taxes, water rents or charges, sewer rents or any other expenses (including insurance) normally payable by a landlord who owns the realty other than expenses for the improvement, repair or maintenance of the tenant’s premises.
[xxxv] See In The Matter Of The Petition of RHM-88, LLC TAT(H) 2001-23(RP) January 11, 2006, where the taxpayer argued, unsuccessfully, that the amounts paid were rent and, therefore, exempt from the RPTT.
[xxxvi] IRC Sec. 721.