Leases and transfer taxes in New York City and State.

Particularly in light of the recent rise in real estate values, the real property transfer taxes in New York State ($2 per $500 of consideration) and New York City (1% to 2.625% of consideration) have become significant costs for parties to transactions involving New York real estate.

This article will focus specifically on the transfer tax issues implicated by leases of real property located within the State and City. The term "lease" when used in this article includes subleases, the treatment of which is substantially the same under both transfer taxes.

Both transfer taxes apply to fee conveyances; transfers of controlling interests in entities; assignments of leases; granting of most purchase options coupled with a right of possession; and some other transactions. The State transfer tax applies to the grant of a lease that meets a three-part test described below.

However, the City transfer tax does not apply to the grant of a lease provided that the consideration constitutes rent for purposes of the City commercial rent tax (CROT). The State and City transfer tax exemptions relevant to leasing transactions include instruments used to secure a debt or other obligation; conveyances without consideration; and conveyances to the extent that there is no change in beneficial ownership.

The grant of a lease coupled with a purchase option is taxable regardless of the lease term. For State transfer tax purposes, the consideration is the option premium paid, if any, pins the present value of the lease payments through the latest day on which the purchase option may be exercised.

For City transfer tax purposes, the consideration includes only the option premium paid unless the rental payments under the lease do not qualify as rent for commercial rent tax purposes. A right of first refusal is not treated as a purchase option.

The three requirements for the grant of a lease without a purchase option to be a "conveyance" subject to State transfer tax are:

The sum of the term of the lease and any options for renewal exceeds fortynine years;

Substantial capital improvements are or may be made by or for the benefit of the lessee; and

The lease is for substantially all of the premises constituting the real property.

If a lease satisfies each of the three requirements, the taxable consideration equals the present value of the net rental payments throughout the lease term, computed with a discount rate equal to 110% of the applicable federal long-term rate in effect 30 days prior to commencement of the lease term. To compute net rents,the lessor may deduct-certain actual or estimated operating costs and, in the case of a sublease, any rental payments dueunder the prime lease-during the sublease term. If net rents are tied to unknown factors, areasonable estimate must be made as of the lease commencement date. Similarly, the likelihood of payments being made based on the circumstances in effect as of the lease commencement date is also relevant.

An issue that sometimes arises under the first requirement is the effect of a subsequent agreement to extend the term of the lease. In that ease, the term is measured by adding the extension term and any renewal terms to the remaining portion of the original lease term. If that sum exceeds forty-nine years, the first requirement will be satisfied.

For example, if the parties enter into a 20-year lease, and in year 5 enter into an amendment of the lease providing two consecutive renewal terms of 20 years each after the expiration of the original 20 year term, then the first requirement is satisfied because the remaining term (15 years) plus the renewal terms (20 years each) exceeds 49 years. The consideration would equal the present value of the net rents payable for the remaining 15 years of the original term and both renewal terms.

A lease may provide for an "interim term" during which the tenant may enter the premises for certain limited purposes, such as obtaining permits and performing tests. In 1999, the State advised that in that case, the lease term does not commence for purposes of the first requirement until the tenant begins to occupy the premises for construction or business purposes. In September 2005, the State advised that an interim term is excluded from the term of the lease even if the tenant must make a nominal payment to the landlord before entering the premises during the interim term.

The regulations provide that "substantially all" of the premises means 90% or more of the total rentable space of the premises, exclusive of common areas. For purposes of determining whether the 90% or more requirement is met, premises include, but are not limited to: (i) an individual building; (ii) an individual condo or co-op unit; and (iii) any portion of a parcel of vacant land.

In September 2005, the State also clarified the application of the "substantially all" requirement to the shopping center context. A shopping center is operated by the landlord and tenants as a closely integrated retail enterprise. Accordingly, the State advised that for a shopping center lease, the "premises" must include all of the real property constituting the shopping center exclusive of common areas. Therefore, a lease for a single store or a single building in an integrated shopping center would not constitute a lease of substantially all of the "premises". In NYC Finance Letter Ruling No. 96-4666, February 24, 1997, the City ruled that PILOT payments made by a tenant pursuant to a separate agreement for which the landlord has no legal obligation do not qualify as rent for CROT purposes. However, the PILOT payments were not subject to transfer tax because they were not part of the consideration for the lease. Payments attributable to capital improvements made to a part of the landlord's building other than the leased premises do not qualify as rent for CROT purposes because they are not payment for use or occupancy of the premises. Those payments would be included in taxable consideration for the lease.

A "synthetic" lease arrangement is a financing device treated as ownership of the premises by the lessee for federal income tax purposes but an operating lease of the premises to the lessee for financial accounting purposes. In a 2002 ruling, the City concluded that such an arrangement is in substance a financing arrangement (i.e. a conveyance to secure a debt or other obligation) and not a lease. Therefore, it was not subject to either the transfer tax or the commercial rent tax.

Consideration paid by an assignee or lessor in exchange for an assignment or surrender of a lease, excluding the remaining rental payments due under the lease, is subject to State and City transfer tax. If there is a taxable transfer of a controlling interest in an entity that is a party to one or more leases, transfer tax will be due to the extent that one or more real property interests, including leases, owned by the entity have a fair market value (e.g. a tenant's interest in a lease that provides for below-market rents). Transfer tax applies to an amount equal to the fair market value of the real property interests owned by the entity times the percentage ownership interest transferred.

Two taxpayers have argued unsuccessfully that they should be permitted to offset the positive value of one or more real property interests held by an entity with the "negative equity" with respect to one or more unfavorable leases to which the entity was a party. The leases conceptually had a negative fair market value to the taxpayer because their terms were less favorable than those prevailing in the market at that time for similar premises. The State and City concluded that the consideration for each property interest held by an entity is computed separately, so the negative value of the leases could not offset the value of an entity's other real property interests for purposes of computing the value of real property interests held by the entity.

The application of the State and City transfer taxes to transactions involving leases has become more complicated over the past decade and is likely to continue doing so for the foreseeable future. Accordingly, taxpayers and counsel involved with the purchase, lease or disposition of real estate and entities that own real estate should familiarize themselves with the transfer tax implications of leasing transactions.

(1) 20 NYCRR 575.1(e); 19 RCNY 2303(d).

(2) NYC Finance Letter Ruling No. 964666, February 24, 1997. The author has been informally advised by the City that in determining whether a payment is within the exception for payments that fall within the CROT definition of rents, it does not consider the location of the property (e.g. outside Manhattan) or the nature of its use (e.g. residential) in determining whether the rent payable under the lease would be subject to the commercial rent tax.

(3) In the Matter of Iron Ford Associates, Tax Appeals Tribunal, May 26, 1994, DTA No. 810849, 1994 NY Tax LEXIS 294 (applying the rule to the now-repealed Transfer Gains Tax).

(4) Resnick Water St. Development Co., TSB93(2)R, January 12, 1993.

(5) ICY Tax Law 1401(e); 20 NYCRR 575.7(a).

(6) 20 NYCRR 575. 7(b).

(7) In the Matter of Fort Tyron Apartments, Tax Appeals Tribunal, August 10, 1995, DTA No. 810198, 1995 NY Tax Lexis 418. Subsequent events could not be considered to retroactively reduce the taxable consideration.

(8) Advisory Opinion, June 14, 1994, TSBA-94(8)R (applying the rule to the now-repealed Transfer Gains Tax).

(9) Advisory Opinion, March 1, 1999, TSB-A-99(1)R, 1999 Tax LEXIS 68.

(10) Advisory Opinion, September 27, 2005, TSB-A-05(1)R. The opinion indicates that payments of $100 and $5,000 would be nominal

(11) Advisory Opinion No. TSB-A-OS(I)R, September 27, 2005. A taxpayer may establish that a different discount rate is appropriate.

(12) NYC Finance Letter Ruling No. 01-4789, February 5, 2002. See also NYC Finance Letter Ruling No. 00-4773, April 19, 2001 (transfer of condominium unit to trust and a synthetic lease of the unit back to the transferor, coupled with a purchase option, were all in substance a financing arrangement and a right to redeem collateral, which is not subject to transfer tax).

(13) Approximately seven taxing jurisdictions across the country tax transfers of controlling interests in entities that own real property in their jurisdiction.

(14) In the Matter of the Petition of Tanus Corporation, DTA No. 819623, January 13, 2005.

(15) In the Matter of the Petition of The Chase Manhattan Corporation (f/k/a Chemical Banking Corporation) and Shareholders of the Chase Manhattan Corporation, TAT(H) 99-99(RP) and TAT(I-I) 99-100(RP), February 4, 2005.

By Timothy W. Lewis

T.W. Lewis & Co., LLC