Transfer Tax Implications on Real Property Leases

In many states, a real property transfer tax is imposed when one party conveys by written instrument an interest in real property to another. The amount due is typically a percentage of the consideration for such transfer or the fair market value of the real property conveyed.

The traditional transfer subject to the tax is a conveyance of a fee simple interest in real property, but many states have expanded transfer tax laws to apply to the creation, assignment and/or surrender of certain leasehold interests as well. The formula to determine which types of lease transactions trigger transfer tax liability varies from state to state, and it is vitally important to be well-versed in those rules prior to a transaction to ensure that all possible steps are taken to lawfully structure the deal so that it is not subject to the transfer tax.

When undertaking a review of transfer tax rules, the examination must go deeper than a cursory reading of the general statute. The true impact of the rules often lies in the detailed regulations and case law that define the parameters of the statute, and those details can easily be overlooked. As such, the key to anticipating how the transfer tax will apply to any given deal is developing a comprehensive understanding of the relevant rules, an example of which is as follows.

The Case Study: New York State

In New York State, a tax is imposed on each conveyance of real property, or any interest therein, when the consideration therefor exceeds $500.

What Constitutes an Interest in Real Property?

Under New York State law, an “interest in the real property” includes title and fee, a leasehold interest, a beneficial interest, an encumbrance, development rights, air space and air rights, or any other interest with the right to use or occupy real property or the right to receive rents, profits or other income derived from real property. Under the foregoing definition, transfer tax would apply to all leasehold interests in real property; however, as explained below, the applicability of the transfer tax to leasehold interests is limited by the definition of “conveyance” under the statute.

In addition, the transfer tax statute defines an “interest in the real property” to include an option or contract to purchase real property, but not a right of first refusal to do so. Therefore, any lease that contains an option to purchase the real property will be subject to the transfer tax, regardless of whether the conveyance criteria discussed below are met; however, if a lease simply contains a right of first refusal to purchase the property, there is no such automatic trigger of the transfer tax.

Even though transfer tax may be due on a given lease under the law, the traditional exemptions to the transfer tax still apply, including, but not limited to, a conveyance that consists of a mere change of identity or form of ownership or organization. As such, notwithstanding the discussion below, if a transfer of direct or indirect interests in real property does not change the beneficial ownership of the property, the conveyance will be exempt from the transfer tax.

What Constitutes a Conveyance?

The statute defines a “conveyance” as including a lease or sublease where: 1) the sum of the term of the lease or sublease and any options for renewal exceeds 49 years; 2) substantial capital improvements are or may be made by or for the benefit of the lessee or sublessee; and 3) the lease or sublease is for substantially all of the premises constituting the real property. State tax regulations have defined “substantially all” to mean 90% or more of the total rentable space of the premises, exclusive of common areas.

For purposes of determining whether a lease or sublease is for “substantially all” of the premises constituting the real property, premises include, but are not be limited to, the following: 1) an individual building, except for space which constitutes an individual condominium or cooperative unit; 2) an individual condominium or cooperative unit; or 3) where a lease or sublease is of vacant land only, any portion of such vacant land. Each type of transaction presents its own unique considerations relating to this determination.

For example, the New York State Commissioner of Taxation and Finance has issued advisory opinions concluding that, in determining what constitutes “substantially all” of the premises constituting the real property in the context of a shopping center, it is appropriate to compare the total area leased under a store lease with the total rentable area within the existing shopping center, exclusive of common areas. This conclusion stems from the unique nature of shopping centers, which are operated by the landlord and tenants as “closely integrated retail enterprises,” with the landlord retaining strong legal and economic control of the operation.

In addition, a “conveyance” under the statute includes the transfer or acquisition of a controlling interest in any entity with an interest in real property, including a leasehold interest. A controlling interest is at least 50% of the stock of a corporation or at least 50% of the capital, profits or beneficial interests in a partnership or association. This rule includes a three-year look-back provision; namely, separate transfers of less than a controlling interest are aggregated together when the separate transfers occur within a three-year period; and if the total transfers equal a controlling interest, then transfer tax will be due. A transfer of an interest in an entity will not be aggregated with an earlier or later transfer if the two transfers occurred or occur more than three years apart unless the timing of the transfers was part of a plan to avoid real property transfer tax.

Finally, the term “conveyance” also includes an assignment or surrender of a lease, meaning that if a lease is assigned to a third party and the consideration for such transfer is more than $500, then transfer tax will be due, regardless of the term of the lease.

What Constitutes Consideration?

“Consideration” means the price actually paid or required to be paid for the real property or interest therein, including payment for an option to purchase real property, whether paid or required to be paid by money, property or any other thing of value. This definition includes the cancellation or discharge of any indebtedness, as well as the amount of any mortgage, lien or other encumbrance, whether or not the indebtedness is assumed or the property is taken subject thereto. In a controlling interest transfer or acquisition, “consideration” means the fair market value of the real property or interest therein, apportioned based on the percentage of the ownership interest transferred or acquired in the entity that owns or holds an interest in the real property.

When calculating the price “required to be paid” under a taxable lease, that amount is equal to the present value of the right to receive net rental payments or other payments attributable to the use and occupancy of the real property, including the present value of rental or other payments attributable to any renewal term. In the case of a taxable sublease, the value of the remaining prime lease rental payments must be subtracted from the present value as calculated above. The discount rate used in calculating such present value is equal to 110% of the federal long-term rate, compounded semi-annually.

The Takeaway

Each state has its own unique rules to determine which leases of real property are subject to transfer tax. Early in the process of negotiating a lease, the parties should undertake a comprehensive review of the applicable rules and, based on their business needs and any other relevant factors, determine which of the variables can be modified to minimize transfer tax exposure without compromising the essential interests of the parties.

Joseph P. Heins, a member of this newsletter's Board of Editors, is an attorney in the Buffalo, NY, office of Phillips Lytle LLP. He concentrates his practice in the area of commercial real estate, including leasing, sales and acquisitions, project development and title matters. Mr. Heins can be reached at 716-847-5490 or [email protected].

When selling or acquiring a parcel of real property, sophisticated parties will always take into account the cost of the real property transfer tax when evaluating the economics of a particular deal. However, many parties may not realize that a similar transfer tax could apply to a lease of real property as well. A failure to anticipate tax liability can have a significant impact on the viability and economic benefits of a deal. But the real property transfer tax does not apply to all leases, and understanding the tax rules of the applicable jurisdiction can allow parties to plan ahead to structure a lease that avoids unnecessary tax liability.

The real property transfer tax laws vary from state to state (and even between municipalities within a state), and a comprehensive review of all 50 states is not practical here. Instead, this article provides a general overview of basic transfer tax law and its potential implications on real property leases ' then presents a case study analyzing the transfer tax rules in New York State, which will provide an example of the various nuances and strategies that can come into play when negotiating a lease.

The Basics

In many states, a real property transfer tax is imposed when one party conveys by written instrument an interest in real property to another. The amount due is typically a percentage of the consideration for such transfer or the fair market value of the real property conveyed.

The traditional transfer subject to the tax is a conveyance of a fee simple interest in real property, but many states have expanded transfer tax laws to apply to the creation, assignment and/or surrender of certain leasehold interests as well. The formula to determine which types of lease transactions trigger transfer tax liability varies from state to state, and it is vitally important to be well-versed in those rules prior to a transaction to ensure that all possible steps are taken to lawfully structure the deal so that it is not subject to the transfer tax.

When undertaking a review of transfer tax rules, the examination must go deeper than a cursory reading of the general statute. The true impact of the rules often lies in the detailed regulations and case law that define the parameters of the statute, and those details can easily be overlooked. As such, the key to anticipating how the transfer tax will apply to any given deal is developing a comprehensive understanding of the relevant rules, an example of which is as follows.

The Case Study: New York State

In New York State, a tax is imposed on each conveyance of real property, or any interest therein, when the consideration therefor exceeds $500.

What Constitutes an Interest in Real Property?

Under New York State law, an “interest in the real property” includes title and fee, a leasehold interest, a beneficial interest, an encumbrance, development rights, air space and air rights, or any other interest with the right to use or occupy real property or the right to receive rents, profits or other income derived from real property. Under the foregoing definition, transfer tax would apply to all leasehold interests in real property; however, as explained below, the applicability of the transfer tax to leasehold interests is limited by the definition of “conveyance” under the statute.

In addition, the transfer tax statute defines an “interest in the real property” to include an option or contract to purchase real property, but not a right of first refusal to do so. Therefore, any lease that contains an option to purchase the real property will be subject to the transfer tax, regardless of whether the conveyance criteria discussed below are met; however, if a lease simply contains a right of first refusal to purchase the property, there is no such automatic trigger of the transfer tax.

Even though transfer tax may be due on a given lease under the law, the traditional exemptions to the transfer tax still apply, including, but not limited to, a conveyance that consists of a mere change of identity or form of ownership or organization. As such, notwithstanding the discussion below, if a transfer of direct or indirect interests in real property does not change the beneficial ownership of the property, the conveyance will be exempt from the transfer tax.

What Constitutes a Conveyance?

The statute defines a “conveyance” as including a lease or sublease where: 1) the sum of the term of the lease or sublease and any options for renewal exceeds 49 years; 2) substantial capital improvements are or may be made by or for the benefit of the lessee or sublessee; and 3) the lease or sublease is for substantially all of the premises constituting the real property. State tax regulations have defined “substantially all” to mean 90% or more of the total rentable space of the premises, exclusive of common areas.

For purposes of determining whether a lease or sublease is for “substantially all” of the premises constituting the real property, premises include, but are not be limited to, the following: 1) an individual building, except for space which constitutes an individual condominium or cooperative unit; 2) an individual condominium or cooperative unit; or 3) where a lease or sublease is of vacant land only, any portion of such vacant land. Each type of transaction presents its own unique considerations relating to this determination.

For example, the New York State Commissioner of Taxation and Finance has issued advisory opinions concluding that, in determining what constitutes “substantially all” of the premises constituting the real property in the context of a shopping center, it is appropriate to compare the total area leased under a store lease with the total rentable area within the existing shopping center, exclusive of common areas. This conclusion stems from the unique nature of shopping centers, which are operated by the landlord and tenants as “closely integrated retail enterprises,” with the landlord retaining strong legal and economic control of the operation.

In addition, a “conveyance” under the statute includes the transfer or acquisition of a controlling interest in any entity with an interest in real property, including a leasehold interest. A controlling interest is at least 50% of the stock of a corporation or at least 50% of the capital, profits or beneficial interests in a partnership or association. This rule includes a three-year look-back provision; namely, separate transfers of less than a controlling interest are aggregated together when the separate transfers occur within a three-year period; and if the total transfers equal a controlling interest, then transfer tax will be due. A transfer of an interest in an entity will not be aggregated with an earlier or later transfer if the two transfers occurred or occur more than three years apart unless the timing of the transfers was part of a plan to avoid real property transfer tax.

Finally, the term “conveyance” also includes an assignment or surrender of a lease, meaning that if a lease is assigned to a third party and the consideration for such transfer is more than $500, then transfer tax will be due, regardless of the term of the lease.

What Constitutes Consideration?

“Consideration” means the price actually paid or required to be paid for the real property or interest therein, including payment for an option to purchase real property, whether paid or required to be paid by money, property or any other thing of value. This definition includes the cancellation or discharge of any indebtedness, as well as the amount of any mortgage, lien or other encumbrance, whether or not the indebtedness is assumed or the property is taken subject thereto. In a controlling interest transfer or acquisition, “consideration” means the fair market value of the real property or interest therein, apportioned based on the percentage of the ownership interest transferred or acquired in the entity that owns or holds an interest in the real property.

When calculating the price “required to be paid” under a taxable lease, that amount is equal to the present value of the right to receive net rental payments or other payments attributable to the use and occupancy of the real property, including the present value of rental or other payments attributable to any renewal term. In the case of a taxable sublease, the value of the remaining prime lease rental payments must be subtracted from the present value as calculated above. The discount rate used in calculating such present value is equal to 110% of the federal long-term rate, compounded semi-annually.

The Takeaway

Each state has its own unique rules to determine which leases of real property are subject to transfer tax. Early in the process of negotiating a lease, the parties should undertake a comprehensive review of the applicable rules and, based on their business needs and any other relevant factors, determine which of the variables can be modified to minimize transfer tax exposure without compromising the essential interests of the parties.

Joseph P. Heins, a member of this newsletter's Board of Editors, is an attorney in the Buffalo, NY, office of Phillips Lytle LLP. He concentrates his practice in the area of commercial real estate, including leasing, sales and acquisitions, project development and title matters. Mr. Heins can be reached at 716-847-5490 or [email protected].