Tax Department Advisory Opinion on Development Technique
After a brief down period during the years 2008 and 2009, the real estate market in New York City has bounced back making development parcels in Manhattan, Brooklyn and Queens extremely attractive. An interesting structural problem that arises from time to time involves a property owner that uses property in his business, for example a store or restaurant, where the underlying land would permit the construction of a much larger building. While in most cases, the simplest solution would be to sell the land to a developer and move the business to a new location, often the property owner has either a sentimental or economically rational preference to maintain the current location for the business. A savvy developer will often see the advantages in accommodating the desires of such an owner.
It is easy to envision the end result the property owner and developer desire, a large building with the property owner's business located on the ground floor and residential or commercial units constructed above it. It has, however, generally been difficult to agree on a transaction structure that would achieve such objectives at a reasonable tax cost.
A recent advisory opinion by the New York State Department of Taxation and Finance sets forth a form of this transaction that may be employed in a variety of situations.1 Although the advisory opinion addresses only the impact of the New York State Real Estate Transfer Tax (RET),2 and does not state or comment upon the income tax consequences, it contains a useful description of the operative arrangements.
The opinion describes a transaction where the owners of a property entered into a tenancy-in-common (TIC) arrangement with a third party developer (Owners and Developer will be referred to collectively as the parties), with a conveyance by the owners to developer of an undivided 87.68 percent TIC interest in the property. The owners retained the remaining undivided 12.32 percent TIC interest. At the closing, the parties paid all of the transfer taxes due on the conveyance of the 87.68 percent interest to New York City and State.
At the time of the conveyance, the parties also entered into a TIC and Retail Unit Construction and Exchange Agreement (TIC Agreement). Under the TIC Agreement, the developer engaged a contractor to construct a building on the property, 12.32 percent of which would be ground floor commercial space, corresponding to the owners' percentage of the TIC. Under the TIC Agreement, each of the parties agreed to pay its pro-rata share of the costs to construct the building, with owners agreeing to pay the hard and soft costs attributable to the commercial space, and developer agreeing to pay the costs of constructing and designing the balance of the building (such portion comprising residential units). The owners controlled construction of the commercial space.
The TIC Agreement also provided that, after construction of the building was completed and the parties paid off all of the construction expenses, the building would be converted to a statutory condominium under Article 9-B of the Real Property Law, with the commercial space comprising one unit and residential units for the upper floors. At that point each of the condominium units would still be owned as tenants in common, with owners owning an undivided 12.32 percent TIC interest and developer owning an undivided 87.68 percent interest. The parties would then swap interests with owners' interest in the residential units conveyed to developer and developer's interest in the commercial space conveyed to owners. Thus, after all of the transfers, owner would own a condominium unit comprising the commercial space, and developer would own the residential condo units.
The owners and developers requested three separate rulings under the RET: (1) whether transfer taxes would be due with respect to the payment by owners to developer of $4.275 million, owner's share of the hard and soft costs of construction of the commercial space; (2) whether RET would be due on the transfer by owner to developer of owner's 12.32 percent TIC interest in the residential units; and (3) whether RET would be due on the transfer by developer to owner of developer's 87.68 percent TIC interest in the commercial space.
In its legal analysis, the advisory opinion focused on three sections of the Tax Law. Section 1402(a) provides that the RET is imposed on each "conveyance" of real property or interest therein. Section 1401(c) defines "conveyance" as a "transfer or transfers of any interest in real property by any method…." Section 1405(b)(6) provides an exemption from RET for conveyances "that effectuate a mere change of identity or form of ownership or organization where there is no change in beneficial ownership."
The advisory opinion concludes that, under the agreement, although each TIC owner owns its percentage interest in each unit, the economic arrangement between the owners and the developer is, from the beginning, that owners own the commercial unit and developer owns the residential units. The opinion explains:
Pursuant to the TIC Agreement, Developer has a nominal undivided interest in the Commercial Space, but Developer has no right to sell, lease, license, use or further encumber the unit. After the conveyances, Owners will have a fee interest in the commercial space equal to the fee interest in the Property that they had prior to the construction of the building. Likewise…all proceeds for the sale or lease of any residential condominium unit can accrue solely to Developer…. The parties were in exactly the same position before and after the conveyances.
On that basis, the advisory opinion concluded that the conveyances by the owners to the developer and from the developer to the owners of their respective interests in the other units were exempt as mere changes in form.