Transfer taxes apply to cash poor too.

This is the last in a series of articles summarizing certain of the federal, New York State and New York City tax consequences of real estate foreclosures, bankruptcies and workouts. The articles will serve as text for a seminar on the tax consequences of these transactions to be co-sponsored by the law firm of Ziegler, Sagal & Winters and Real Estate Weekly on June 25 at the Grand Hyatt from 8:30 a.m. to 11:00 a.m.

This article discusses the New York State Real Property Gains Tax (the "Gains Tax"), the New York State Real Estate Transfer Tax (the "New York State Transfer Tax"), and the New York City Real Property Transfer Tax (the "New York City Transfer Tax") consequences of surrendering property in settlement of a mortgage liability.

These taxes often present the greatest obstacle to negotiating the surrender of property to a creditor because they require an immediate outlay of cash by the owner at a time when the owner is typically cash poor. Tax liability can result even though the owner suffers an economic loss on his investment and realized no cash proceeds. Furthermore, the taxing authorities -- the New York State Department of Taxation and Finance (the "New York State Department") and the City of New York Deparment of Finance "New York City Deparment") -- have adopted interpretations of these that often have harsh consequences. Many of these interpretations by the taxing authorities have been or will be challenged by taxpayers.

This area is very complex, and the real estate owner in financial difficulty should seek tax advice as early as possible to insure that settlements are structured to minimize tax. In addition, tax liability can result even though the owner suffers an economic loss on his investment and realizes no cash proceeds.

General Tax Structure

The general structure of these taxes can be summarized as follows:

1. The Gains Tax equal 10 percent of the gain realized from the sale of real property located in New York State. The gain is the difference between the consideration received by the seller, and the property's original purchase price ("OPP"). The OPP generally equals the undepreciated cost incurred to buy the property, plus the cost of capital improvements made to the property.

2. The New York State Transfer Tax is equal to .4 percent of the consideration received for the transfer of property.

3. The New York City Transfer Tax is equal to 1 percent, 1.425 percent or 2.625 percent (depending upon the type of property) of the consideration for the transfer of property.

Consideration

The primary issue in determining the amount of tax incurred as a result of surrendering a property to a creditor is the amount of consideration that the owner receives as a result of the surrender.

The New York State Department's position regarding the measurement of consideration for purposes of the Gains Tax and the New York State Transfer Tax, although not entirely clear, appears to be as follows:

1. When an owner surrenders a property by foreclosure and the creditor is the successful bidder, the owner is deemed to receive consideration equal to the greater amount of the bid by the amount of liabilities encumbering the property will be the measure of consideration in this situation.

2. In a surrender to a creditor by deed in lieu of foreclosure, the consideration will include the entire amount of the liabilities encumbering the property.

The New York State Department says that all liabilities encumbering a property are included in consideration, regardless of whether the owner is completely relieved from such liability. However, it can be reasonably argued that the consideration should not include liabilities for which the owner remains liable after the surrender.

The New York State Department also says that the entire amount of liabilities encumbering the property are included in consideration, even if the liabilities are in excess of the property's fair market value (FMV). However, it can also be reasonably argued that the consideration should not include liabilities in excess of the property's FMV (at least in the case of recourse liabilities).

To illustrate, let's assume that you own a property with an OPP of $750,000 and an FMV of $1 million which is encumbered by a $1,35 million recourse mortgage held by the bank. You then surrender the property to the bank and by agreement remain liable for the $350,000 shortfall (the amount by which the debt exceeds the FMV). The New York State Department would include the full $1,350,000 in consideration, leaving you with a gain of $600,000 ($1,350,000 consideration less $750,000 OPP), resulting in a $60,000 tax (10 percent of $600,000 gain).

It can be argued, however, that the consideration should be only $1 million. Under this position, the Gains Tax would be reduced from $60,000 to $25,000.

If in a foreclosure, the successful bidder is a third party purchaser, the NYS Department will apparently treat the consideration as equal to the amount bid (even if it is less than the foreclosed mortgage), plus the amount of liabilities assumed by the purchaser.

Let's look at another example. You own property encumbered by a first mortgage of $400,000 and a second mortgage of $300,000. In a foreclosure auction for the second mortgage, an unrelated third party bids $200,000 to acquire the property subject to only the first mortgage. In this case, the consideration is equal to $600,000 (cash of $200,000 plus first mortgage of $400,000). This is the case even though the total liabilities encumbering the property were $700,000.

In the case of the New York City Transfer Tax, the consideration in a foreclosure is the amount bid for the property, senior liens not canceled by the sale, plus advertising expenses, taxes and other costs paid by the purchaser. In transfers to creditors by deed in lieu of foreclosure, the New York City Department says that the full amount of the liabilities encumbering the property (including accrued interest) should be included in consideration.

Payment of Gains Tax

When Gains Tax is applicable, it is the liability of the owner. If the creditor agrees to pay the tax for the owner, the amount of tax is added to consideration. In some cases, the tax may be paid in three equal annual installments, with the first installment paid at the time of the transfer. Interest at market rates is charged on tax deferred under this election.

Bankruptcy

It is unclear to what extent the foregoing taxes will apply to bankruptcy transfers made pursuant to a confirmed plan of reorganization under the federal Bankruptcy Act.

Although there had been a split in the lower courts regarding whether the Gains Tax would be applicable to transfers in bankruptcy, a recent decision by the U.S. Court of Appeals held that the Gains Tax does apply to such transfers. This decision may be appealed by the taxpayer.

Prior to the Court of Appeals decision, it had been uniformly held that neither the New York State Transfer Tax nor the New York City Transfer Tax applied to these bankruptcy transfers. This recent decision, could be read to suggest that the New York City Transfer Tax is applicable to these bankruptcy transfers, though it most likely will not apply.

In summary, the owner/debtor facing a workout, foreclosures and a possible bankruptcy or reorganization proceeding, must deal with complex tax rules which, in many cases, impede sensible transactions, and in some cases, permit transactions only at a significant tax cost.

The only sound basis for developing a strategy for these transactions is for the taxpayer and his tax counsel, accountant and counsel for the creditor proceedings to work as a team in attempting to project the business and tax consequences of all viable strategies. These projections should be made early so the best overall strategy can be adopted, and then should be updated from time to time as the events unfold.

Stephen S. Ziegler is a member of Ziegler, Sagal and Winters, P.C., a New York City Law firm exclusively for the practice of business and personal tax planning, tax controversy work and estate planning.