Gains tax update; Stanhope decision reversed.

Those in the real estate industry had hoped that a way to avoid being subject to the New York State Real Property Transfer Gains Tax ("gains tax") was to transfer property in bankruptcy under a plan of reorganization. However, in a recent court decision, it was ruled that the gains tax imposed on the transfer of property was not a "stamp tax or similar tax" within the bankruptcy law and that the debtor is subject to the tax on the transfer of property. This decision reversed a prior court ruling which specified that the sale of property under a plan of reorganization was exempt under bankruptcy law from all transfer taxes, including the gains tax.

The debtor, 995 Fifth Avenue Associates, L.P., operated the Stanhope Hotel. In February 1988, it filed a bankruptcy petition under Chapter 11 of the Bankruptcy Code and thereafter continued to operate the hotel as a debtor in possession. In accordance with its plan of reorganization, the Bankruptcy Court authorized the sale of the hotel for $76 million. The court's order also specified that the sale was exempt from all transfer taxes. However, in order to transfer a deed in New York, a tentative assessment and return must be filed and any tax due must be paid prior to the closing of the transaction. Therefore, the debtor, in accordance with the pre-transfer audit procedures required by the State, filed a return requesting an exemption from the tax. In turn, the State denied the exemption and issued a tentative assessment for approximately $2.6 million.

Since the tax due must be paid prior to closing of title, the debtor paid the tax.

Subsequently, the debtor brought an action in Bankruptcy Court against the State, seeking a refund of the gains tax paid. The Bankruptcy Court found that the debtor's sale was exempt from the gains tax. The decision was also affirmed at the Federal district court level. The State appealed, and on April 13, 1992, the United States Court of Appeals reversed the order of the district court. In so doing, it ruled that although the gains tax bears some resemblance to a stamp tax, it is not a "stamp tax or similar tax" within the Bankruptcy Code.

In reaching its decision, the court reviewed the different stamp taxes and found that they share five common elements: (1) All are imposed at the time of transfer (2) The amount due is based on the value of the item being transferred (3) The tax rate is relatively low - about one percent or less of the consideration (4) The tax is imposed irrespective of gain or loss on the transaction (5) The tax must be paid prior to recording the deed

The court then compared these common elements of transfer taxes to the gains tax. Although the gains tax is due at the time of transfer and payment is due prior to recording, the court found that the similarities end there. First, the gains tax rate of 10 percent is substantially greater than the tax rate used in any stamp tax. Second, the tax due is based on the profitability of the transaction as calculated for gains tax. It the transaction yields no gain, there is no tax due, unlike a stamp tax.

Unless there are subsequent developments in this area, the parties to a workout situation must proceed under the assumption that any gains tax due on the transfer of property must be paid in order to transfer title to the property.

Larry Weiser, a partner in Friedman Alpren & Green, specializes in the tax and accounting aspects of residential real estate ownership, development and conversion. He is significantly involved with all aspects of the New York State Real Property Transfer Gains Tax.

Friedman Alpren & Green has responded to inquiries regarding previous articles and is pleased to discuss these and other tax questions posed by the readers of Real Estate Weekly. Any such questions should be directed to their office at 1700 Broadway, New York, New York.