Limiting the Cuomo tax in workouts.

On behalf of their clients, Andrew Feiner, a tax partner at Zellermayer Gratch & Jacobs, a New York City law firm, and William Korman, a senior tax manager in the New York office of Deloitte & Touche, petitioned the New York State Department of Taxation for an advisory opinion on the so-called Cuomo tax (the 'New York Real Property Transfer Gains Tax, referred to here as the "gains tax"). The ruling asked New York State to approve a structure designed to reduce the amount of gains tax owed in a workout of troubled real estate. The requested ruling was granted on Dec. 28, 1992.

The gains tax has re-emerged as a significant impediment to real estate restructuring because of a recent decision of the federal court of appeals holding that the gains tax is owned even if a workout occurs in a formal bankruptcy proceeding. It was therefore critical to find alternatives to limit tax on "phantom" gains. We recently obtained from New York State a ruling that presents just such an opportunity.

New York State and City impose three separate taxes on transfers of real estate: the State real estate transfer tax, the City real property transfer tax and the State real property transfer gains tax. These transfer taxes are in addition to property taxes, mortgage recording tax and Federal, State and City capital gains taxes. Because the State and City transfer tax rates are .4 percent and 2.625 percent, respectively, of the gross sales price and the State gains tax is 10 percent of the gain on real estate, both taxes amounted to very substantial sums during the days of spiralling real estate values. One might justifiably have expected, however, that at least the gains tax would not be owed if the properties were later sold at a loss. However, due to aggressive interpretations of the law by the New York State Department of Taxation, that has not proved to be the case.

Instead, foreclosures, deeds in lieu of foreclosure, bankruptcies and other restructuring have produced sizable gains tax liabilities. The problem is that gains tax is measured by the difference between the sales price, including liabilities, and the undepreciated purchase price of the real estate. New York State has required that liabilities be included in this measurement at their face value, even if the liabilities exceed the value of the property.

Liabilities secured by a property often will be greater than the purchase price of the property because of unpaid interest accrued on the debt or an increase in the principal amount owed that resulted from refinancing the debt. To the extent that the growing debt or the falling value of the property leaves a liability that exceeds the value of the property, the result is 'phantom" gains tax - in other words, gains tax without any gain.

Phantom gains tax has proved to be a major obstacle to lender takeovers of property. Because of transferee liability, the concern is not only that of the borrower-transferor, but also that of the lender-transferee. This is because of the lender has transferee liability for the gains tax outside of a judicial foreclosure proceeding. Both the lender and the borrower therefore must insure that the tax is paid. If the borrower is insolvent, the burden will fall entirely on the lender.

For a short period of time, federal bankruptcy court appeared to be the best forum for accomplishing a foreclosure without gains tax liability being imposed on either the lender or the borrower. The reason for going to bankruptcy court was that, under federal bankruptcy law, states are prohibited from imposing certain types of transfer taxes on sales of real estate pursuant to a bankruptcy plan. Although New York state took the position that the gains tax was not covered by this bankruptcy exemption, a federal district court ruled against the state on this issue. Unfortunately, however, the state obtained a reversal of the district court opinion on appeal to the federal court of appeals for the second circuit.

This left no suitable means of protecting against phantom gains tax liability and led to our request for a ruling to validate a new approach for limiting the tax to the true economic gain realized in a transfer of property to a lender (usually, zero). Both of us had encountered resistance from other professionals about the approach outlined in our ruling request. We were told that our approach would not be approved by New York State and, in fact, administrators in the Department had informed us that there was an internal division within the Department as to the proper approach to this question. Because we disagreed with the conventional wisdom, we asked for a formal opinion of the State. The favorable response that we received to our request for an advisory opinion provides a road map for a new approach to avoiding "phantom' gains tax liability.

The factual situation presented in our ruling request describes hundreds of troubled real estate partnerships in New York. The facts were simply that a partnership owned both commercial real estate and a very small bank account. The real estate was secured by a mortgage with an outstanding balance that far exceeded the value of the property. The mortgage lender also held a security interest in the bank account and a guaranty of the debt from the partners. In exchange for cancellation of the debt, the partners transferred their interests in the partnership to the lender. New York State ruled that, under the circumstances, the sales price would be limited to the value of the property. The sales price therefore would not include any increase in the debt that resulting from a refinancing or from unpaid accrued interest.

The facts of the ruling were designed with the hope that a favorable ruling would apply to numerous similarly situated lenders and borrowers and would enable them to arrange a restructuring without fear of phantom gains tax liability. Even when the facts do not lend themselves to the approach taken in the ruling, it may be possible to rearrange the structure of ownership of the real estate so that the ruling will be available.

Nevertheless, many questions remain unanswered. We are currently discussing these questions with the Department of Taxation in the hope of avoiding an overly parsimonious interpretation of the ruling and the underlying provisions of law. We are therefore hopeful that the ruling ultimately will be expanded to apply in an even broader range of situations.