NYC Real Estate on the Ropes
In March of this year, the Department of Homeland Security classified real estate as an “essential business.”[i] I imagine that the person in Washington who suggested that real estate be added to the list of enterprises that were deemed critical to the public’s security and well-being must have been thinking of New York City (“NYC”).
The real estate market is a major force in the life of the City, and any downturn in that industry is likely to have negative repercussions throughout NYC’s economy. This relationship has been borne out by the pandemic,[ii] which has had a significantly adverse impact upon the ownership and disposition of commercial real estate in the City, and upon the revenues of City government.[iii]
According to the Real Estate Board of New York, in the first half of 2020, total investment sales for commercial and multifamily rental properties experienced a 32 percent decline in the volume of transactions, and a 54 percent decline in total consideration, compared to the first half of 2019. The total tax revenue for the City and NY State generated from investment sales in the first half of 2020 was down 49 percent from the previous 6 months and 58 percent from the previous 12 months.[iv]
Perhaps more disconcerting, because of its potentially longer-term effects to the City’s real estate market, is the realization among many employers that their businesses may be operated remotely, without the heretofore significant cost of maintaining a physical presence in the City.[v]
At the same time, many of NYC’s more affluent denizens are preparing – some more publicly than others – to leave the City for jurisdictions with friendlier tax environments and more inviting climates.[vi]
Don’t Count NYC Out
Of course, this isn’t the first time many folks have counted the City out.
Many of us remember the extremely weak economy of the 1970s – often described as one in “freefall” – the oil embargo, the recession, and the City’s brush with bankruptcy.[vii] Over 600 hundred thousand jobs were lost – one-sixth of the City’s employment base – almost one million households were on welfare, graffiti was everywhere, arson was common, whole blocks were abandoned, crime was rampant, prostitutes crowded the streets around the then-under-construction Javits Center and, by the end of the decade, almost a million people had left the City.[viii]
The City bounced back.
More recently, many predicted that the September 11 attacks would lead to the demise of the City’s office market.
The City bounced back.
Bill de Blasio became Mayor in January of 2014.[ix] His term ends in December of 2021 – after years of watching all major crime indices increase.
The City will bounce back.
It would be wise to keep this history, and this potential, in mind as we consider the City’s future.
A recent article in Forbes, “The Case for Betting Long on New York City Real Estate,”[x] delivers a positive message both succinctly and pretty convincingly:
“The upshot is this: New York real estate has boosted the metropolitan economy for a decade with exceptional growth that can withstand even major adversity, like the current slowdown. The long-term trend is still upward.”[xi]
Be Smart – Don’t Forget Taxes[xii]
For those closely held investors who are already committed to holding NYC real properties, and for those who are thinking about making such a long-term commitment – perhaps to take advantage of the softer market – it is imperative that they understand the Federal, state and local income tax consequences arising from the acquisition, operation and disposition of their property.
It would be folly to ignore taxes – or, more appropriately, their economic impact on one’s investment – or to defer[xiii] planning for them, especially in the current environment: a softer real estate market with thinner margins, the near certainty of not insignificant income tax and other tax increases, the possible limitation on the use of the like kind exchange, and the possible elimination of the basis step-up at death.[xiv]
A recent decision by the NYC Tax Appeals Tribunal (the “Tribunal”)[xv] addressed what appear to have been the unanticipated NYC income tax consequences realized by a foreign corporation (from a state on the other side of the Hudson River[xvi]) on the indirect sale (the “Sale”) of its equity interest in a partnership that owned and operated real property in NYC.
The Joint Venture
Corp was a NY corporation that teamed up with Partner to form a joint venture (“JV”) to act as a construction contractor doing business primarily in the NY Metro area. Corp owned a 50 percent interest in JV.
At some point, JV ceased construction operations and, instead, acquired investment interests in three limited partnerships (the “LPs”) which engaged solely in the “holding, leasing, and managing” of their respective real properties located in NYC.
JV owned a limited partnership interest in each of the LPs.[xvii] None of the general partners of the LPs was related to either JV or Corp.
For all periods preceding JV’s sale of its interest in one of the limited partnerships (“LP-1”), Corp reported and paid NYC General Corporation Tax (“GCT”) on its share of the income, gain, and losses of the LPs.
Prior to the Sale, Corp “reorganized” itself as a New Jersey (“NJ”) corporation. Specifically, Taxpayer was newly incorporated under the laws of NJ in order to effectuate this reorganization; Taxpayer then elected to be treated as an S corporation for tax purposes; shortly thereafter, Corp was merged with and into Taxpayer in an “F” reorganization[xviii] – a “mere change in place of organization”[xix] – in which Taxpayer was the surviving corporation and successor to Corp.
As the successor to Corp, Taxpayer held the 50 percent ownership interest in JV.
The Sale, the Gain, the Exam
JV sold its limited partnership interest in LP-1 to an unrelated third party. It reported its gain from the Sale on its Federal,[xx] NY State, and City tax returns.
Taxpayer was allocated its 50 percent share of the gain realized on the Sale by JV (the “Capital Gain”), which it reported on its Federal corporate income tax return.[xxi] In turn, as an S corporation, Taxpayer must have issued Schedules K-1 to its shareholders, allocating the Capital Gain among them in proportion to their stock holdings.[xxii]
Taxpayer also reported the Capital Gain on its City GCT return,[xxiii] but excluded the gain from its entire net income (“ENI”) by deducting an amount equal to the Capital Gain from its Federal taxable income – the starting point for determining ENI – with a notation explaining that Taxpayer’s deduction was based upon its treatment of the gain as “Gain on the sale of partnership interest – not used in trade or business in NY.”
The NYC Department of Finance (the “Dept.”) examined Taxpayer’s GCT return for the year at issue, following which it issued a Notice of Determination[xxiv] to Taxpayer asserting a GCT deficiency for that year. The Notice explained that “Adjustment is made to include [the Capital Gain] from the sale of partnership interest” in Taxpayer’s ENI.[xxv]
Taxpayer disagreed with the Dept.’s conclusion, and filed a petition with the Tribunal to contest the asserted deficiency.
The Parties’ Positions
The issue before the Tribunal was whether, for GCT purposes, the Federal conformity provisions of the City’s Administrative Code (the “Admin. Code”) required the exclusion by a foreign taxpayer[xxvi] of the gain realized by such taxpayer from the sale of an interest in a limited partnership that did business in the City.
The parties agreed on the following basic facts:
- During the year at issue, JV’s sole contacts with NYC were its investment interests in the LPs (including LP-1), which in turn owned interests in NYC real properties;
- Neither JV nor Corp/Taxpayer directly or indirectly engaged in operating or managing any portion of business activities of the LPs, or engaged in a unitary business with any of the LPs;
- JV did not independently conduct a trade or business in NYC, and had no property, payroll, or receipts in NYC; and
- Corp/Taxpayer maintained its only office in NJ, and had no place of business in NYC.
Notwithstanding these agreed-upon facts, the Dept. argued that Taxpayer engaged in business within NYC by virtue of its ownership interest (through JV) in LP-1, which owned, leased, and managed property within NYC.[xxvii] The Dept. stated that because the GCT is imposed upon the privilege of doing business in NYC, and because Taxpayer was doing business in NYC – by virtue of (i) LP-1’s doing business in NYC, and (ii) JV’s derivatively doing business through its interest in LP-1, and (iii) Taxpayer’s interest in JV – the Capital Gain was properly included in Taxpayer’s ENI for GCT purposes.
Taxpayer argued that the proposed adjustment ran afoul of the Federal “conformity” doctrine.[xxviii] It submitted that as Federal income is the starting point for ENI,[xxix] Federal conformity required that NYC treat the Capital Gain as it would be treated under the Code; specifically, “In the case of a sale or exchange of an interest in a partnership, gain or loss shall be recognized to the transferor partner. Such gain or loss shall be considered as gain or loss from the sale or exchange of a capital asset…”[xxx]
Prior to the Tax Cuts and Jobs Act of 2017,[xxxi] Taxpayer continued, the “entity approach” to partnership taxation could apply to the disposition of a partnership interest.[xxxii] Under this approach, it noted, a partner is treated as though it owns a partnership interest, an intangible asset, as opposed to a proportionate, undivided share of the partnership’s underlying assets.[xxxiii] Taxpayer argued that the gain from the sale of the LP-1 partnership interest – an intangible not used in a trade or business – should be sourced to Taxpayer’s domicile outside NYC and, therefore, excluded from Taxpayer’s ENI.
The Dept. countered by stating that nothing in either NYC or NY State law barred the use of the “aggregate approach” toward the disposition of a partnership interest, meaning that a partner’s sale of a partnership interest could be treated as the sale by the partner of its separate, undivided interest in each asset owned by the partnership. In any case, it argued, the Federal conformity doctrine did not apply to the present case because, while the Code addresses the tax treatment of the disposition of a partnership interest, the GCT imposes a tax on the privilege of doing business in NYC.
The Tribunal’s Opinion
The Tribunal explained that the GCT is imposed on every corporation doing business, owning or leasing property, or engaging in various other activities in the City.[xxxiv] The tax, it stated, is computed as the sum of (1) the greatest amount of tax calculated under four alternative methods (including on the basis of the corporation’s ENI allocated to the City); plus (2) an amount of tax calculated on subsidiary capital.[xxxv]
The Tribunal also noted the Rules of the City provide that: “a corporation shall be deemed to be doing business in the City if it owns a limited partnership interest in a partnership that is doing business, employing capital, owning or leasing property, or maintaining an office in the City.”[xxxvi]
According to the Tribunal, interpreting “doing business” to include ownership in a limited partnership that does business in the City has been upheld by the NY courts on multiple occasions. “These decisions,” it stated, “bind this Tribunal and are determinative in this matter.”[xxxvii]
LP-1 conducted business within NYC because it leased, held, and managed real property in the City. Taxpayer, through JV, owned an interest in LP-1. Through its ownership in LP-1, Taxpayer was doing business in NYC.[xxxviii] Therefore, the Capital Gain, which flowed to Taxpayer from JV’s sale of its interest in LP-1, was properly included in Taxpayer’s ENI for the tax year at issue.
In reaching this conclusion, the Tribunal also rejected Taxpayer’s argument based upon Federal conformity. “This doctrine,” the Tribunal stated, “has its limits.” It explained that
“arguments in favor of applying the doctrine are particularly strong and persuasive where the State act and regulations were modeled upon the federal law and regulations and both statutes and regulations closely resemble each other. However, where state tax law diverges from federal law, there is no requirement that a court strain to read the federal and state provisions as identical.”
The Tribunal observed that Taxpayer did not establish any statutory authority or legislative history that would bind the City’s GCT calculations to the Federal tax treatment of the sale of a partnership interest. As a result, the differences between the two taxes “militated against the importing of federal treatment of the sale of partnership interests into the GCT’s ENI basis.”
Further, the Tribunal noted that “[T]he aggregate approach has been and continues to be applied for a variety of purposes under the GCT,” including the computation of ENI, and the character of items of income as coming from subsidiary or investment capital.[xxxix]
Therefore, Federal conformity did not require the exclusion of the Capital Gain from Taxpayer’s ENI for the tax year at issue.
The inclusion in Taxpayer’s ENI of its share of the Capital Gain subjected Taxpayer to NYC’s GCT at a rate of 8.85 percent. That’s an expensive tax, but it was one that should have been anticipated and accounted for in negotiating the terms of the sale.
Is it possible that Taxpayer’s shareholders confused the sourcing rule, applicable to nonresident individuals, which generally sources the gain from the sale of an intangible asset – for example, shares of stock of a corporation that does business in NYC – to the domicile of the nonresident? Is that why they “moved” Taxpayer (a pass-through entity) from NY to NJ?
But even that reasoning is unsatisfactory when one considers NY’s treatment of entities that own real property located in the State. For example, NY source income includes income attributable to the ownership of any interest in real property, including the gain from the sale or exchange of an interest in certain entities that own real property in NY.
Indeed, since 2009, items of gain derived from or connected with NY sources have included 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 that equals or exceeds 50 percent of all the assets of the entity on the date of the sale or exchange of the taxpayer’s interest in the entity.[xl] An interest in such an entity is treated as an interest in real property located in NY.
The bottom line: as we ride out what promises to be an undeniably rough time for the NYC real estate industry, it will behoove the long-term investor to familiarize themselves with, and to take advantage of, whatever tax benefits the law affords them – both during the operation and upon the disposition of their property – and to thoroughly consider, and plan for, the tax consequences of any transaction involving the property. Of course, much may depend upon the outcome of the November elections.
The economic rewards of such “tax diligence” may be the difference between a successful and a not-so-successful investment.
[i] https://www.wsj.com/articles/real-estate-now-an-essential-business-new-york-state-says-11585869087 . https://chicagoagentmagazine.com/2020/03/31/during-coronavirus-shutdown-real-estate-is-deemed-an-essential-business/ In the Department’s report, “residential and commercial real estate services, including settlement services” are considered essential, as are “workers responsible for the leasing of residential properties to provide individuals and families with ready access to available housing.”
[ii] Look at what has happened to all of the restaurants and retail spaces – not to mention mass transit – that serviced the City’s “business districts” when office workers started to work remotely.
[iii] For example, in 2018, real estate related taxes (real property, commercial rent, hotel occupancy, mortgage recording, and transfer taxes) accounted for 52% of all New York City taxes collected. https://www.rebny.com/content/rebny/en/research/real_estate_policy_reports/2018-Economic-Impact-of-New-York-Citys-Real-Estate-Industry.html
[iv] Citywide, investment sales transactions declined 32%, consideration declined 54% and the average price declined 32% year-over-year.
Multifamily rental, elevator transactions declined 7%, consideration declined 56% and the average price declined 53% year-over-year.
Multifamily rental, non-elevator transactions declined 32%, consideration declined 42% and the average price declined 13% year-over-year.
Office transactions declined 27%, consideration declined 47% and the average price declined 27% year-over-year.
Industrial transactions declined 37%, consideration declined 60% and the average price declined 37% year-over-year.
Hotel transactions declined 70%, consideration declined 81% and the average price declined 37% year-over-year.
Retail transactions declined 27%, consideration declined 27% and the average price remained flat year-over-year.
Commercial condo transactions declined 68%, consideration declined 98% and the average price declined 93% year-over-year.
[v] Manhattan Faces a Reckoning if Working From Home Becomes the Norm, https://www.nytimes.com/2020/05/12/nyregion/coronavirus-work-from-home.html . “[A]s the pandemic eases its grip, companies are considering not just how to safely bring back employees, but whether all of them need to come back at all. They were forced by the crisis to figure out how to function productively with workers operating from home — and realized unexpectedly that it was not all bad. If that’s the case, they are now wondering whether it’s worth continuing to spend as much money on Manhattan’s exorbitant commercial rents. They are also mindful that public health considerations might make the packed workplaces of the recent past less viable.”
[vi] The prospect of a Democrat in the White House, along with what most believe will be the attendant federal tax increases, only exacerbates the matter. https://www.taxlawforchb.com/2020/08/bidens-tax-proposals-for-capital-gain-like-kind-exchanges-basis-step-up-the-estate-tax-tough-times-ahead/ ; https://www.taxlawforchb.com/2019/07/escape-from-new-york-it-will-cost-you/
[vii] “Economic and Demographic Change,” Samuel M/ Ehrenhalt, Monthly Labor Review, February 1993. https://www.millersamuel.com/change-is-constant-100-years-of-new-york-real-estate/
[ix] The views expressed are mine alone, and should not be attributed to Farrell Fritz.
[xi] In case you have forgotten, Amazon spent $1.15 billion to acquire the old Lord & Taylor Building in March of this year, as closures were being announced throughout the State.
[xii] By now, you’ve probably been wondering when, if ever, taxes would make it into the discussion.
[xiii] Like the pun?
[xv] Mars Holdings, Inc., NYC TAT ALJ Division, TAT (H) 16-14 (GC).
[xvi] I am often tempted to say something, anything, about our western neighbor. Check out this NYU publication: “Across The River, A World Away: Why We Trash New Jersey.” https://nyulocal.com/across-the-river-a-world-away-why-we-trash-new-jersey-d10dd1aa00b?gi=74f0e8c00b5c
[xvii] LP-1’s only significant source of income was from the holding, leasing, or managing of real property consisting of rental apartments within NYC.
JV held a 25 percent limited partnership interest in LP-2, which was formed to own and operate a rental housing project in the City.
Finally, JV owned a 0.01% limited partnership interest in LP-3.
[xviii] IRC Sec. 368(a)(1)(F).
[xix] Reg. Sec. 1.368-2(m). Basically a non-event for tax purposes. See https://www.taxlawforchb.com/2015/10/sometimes-an-f-is-a-good-result/
[xx] IRS Form 1065, U.S. Return of Partnership Income.
[xxi] IRS Form 1120S, U.S. Income Tax Return for an S Corporation.
[xxii] IRC Sec. 1366.
[xxiii] Form NYC-3L, General Corporation Tax Return. https://www.taxlawforchb.com/2020/07/an-s-corporation-in-new-york-city-eschew-obfuscation-or-not/
[xxiv] The counterpart to a Federal notice of deficiency.
[xxv] Administrative Code Section 11-602(8). This is equal to total net income from all sources; it is presumably the same as the entire taxable income (i) which the taxpayer is required to report to the IRS, or (ii) which the taxpayer would have been required to report to the IRS if it had not made an S corporation election.
[xxvi] Foreign = New Jersey.
[xxvii] Similarly, see IRC Sec. 875(1), which provides that “a nonresident alien individual or foreign corporation shall be considered as being engaged in a trade or business within the United States if the partnership of which such individual or corporation is a member is so engaged.”
Mind you, I am not suggesting that NJ is not part of the U.S., nor am I intimating that the Constitution be amended to provide for the removal of a state. Secession, on the other hand? The Constitution makes no mention of it, though it does address the partition of a state and the “junction” of existing states. Article IV, Section 3, Clause 1.
Remember the Harford Convention of 1814?
California and Texas have each seen active secessionist movements in recent years. (CA, most recently, in response to the election of Mr. Trump in 2016.)
In a 1993 referendum, more than 65% of Staten Island voted to secede from NYC, but was thwarted by Albany. The borough is making noise again this year.
Canadian law provides for legal secession.
[xxviii] In brief, the incorporation of Federal tax provisions into state tax law. For a general discussion of conformity, please see https://www.taxlawforchb.com/2020/06/conformity-the-lockdown-and-new-yorks-audit-of-like-kind-exchanges/#_edn1.
[xxix] Admin. Code § 11-602.8.
[xxx] IRC Sec. 741.
[xxxi] P.L. 115-97.
[xxxii] Grecian Magnesite, 149 T.C. No. 3 (July 2017), aff’d by 926 F3d 819 (DC Cir 2019). https://www.taxlawforchb.com/2017/07/foreigners-sale-of-partnership-interest-not-taxable/
The holding was effectively overturned by IRC Sec. 864(c)(8).
[xxxiii] Under the so-called “aggregate theory,” a partner’s sale of a partnership interest would be treated as the sale by the partner of its separate, undivided interest in each asset owned by the partnership.
The Code generally applies the “entity theory” to sales and liquidating distributions of partnership interests – it treats the sale of a partnership interest as the sale of “a capital asset” – i.e., one asset (a partnership interest) – rather than as the sale of an interest in the multiple underlying assets of the partnership.
That said, the Code carves out certain exceptions to this general rule that, when applicable, require that one look through the partnership to the underlying assets and deem the sale of the partnership interest as the sale of separate interests in each asset owned by the partnership; for example, where the partnership holds “hot assets,” or where it holds substantial interests in U.S. real property, in which case an aggregate approach is employed in determining the tax consequences of a sale.
[xxxiv] Admin. Code Sec. 11-603.1
[xxxv] Admin. Code Sec. 11-604.1.E
[xxxvi] 19 RCNY Sec. 11-06 [a]. This provision is subject to certain limitations which were not relevant here. See 19 RCNY § 11-06 [b] with respect to an interest in a publicly traded partnership or in a “portfolio partnership.”
[xxxvii] City Charter Sec. 170 [d]. “The tribunal shall follow as precedent the prior precedential decisions of the tribunal (but not of its small claims presiding officers), the New York State Tax Appeals Tribunal or of any federal or New York state court or the U.S. Supreme Court insofar as those decisions pertain to any substantive legal issues currently before the tribunal.”
[xxxviii] 19 RCNY Sec. 11-06 [a].
[xxxix] The Tribunal remarked that the same was true under the comparable NY State Corporate Franchise Tax. Both the State and City use the aggregate approach for purposes of determining whether a corporation is doing business in the jurisdiction.
[xl] NY Tax Law 631(b)(1)(A)(1). See also TSB-M-09(5)I. The portion of the total gain allocated to NY is determined by a fraction, the numerator of which is the FMV of the entity’s NY real property, and the denominator of which is the FMV of all of the entity’s assets.