Originally published on Forbes.com.
When I spoke with Ken Weissenberg about GKK 2 LLC’s appeal of its Real Estate Transfer Tax, his best comment was that ]taxes, like ogres are like onions.
Ken is Partner-in-Charge of the Real Estate Services Group of EisnerAmper. He seemed to be the right guy to ask about this decision being both a lawyer and a CPA. He also indicated that he has been around long enough to not be overspecialized, which may be the lesson in this case, because taxes are like, you know, onions.
Three Million In Transfer Taxes
The stakes were pretty high. GKK was looking for a refund of over $3 million (including interest). That struck me as quite a bit for real property transfer taxes, but this was the Big Apple where the real property transfer tax can get as high as 2.5%. And there was an iconic building involved- 2 Herald Square (also known as 1328 Broadway and the Marbridge building). That is the very Herald Square that George M. Cohan wished to be remembered to.
A Creative 1031 Deal
The LLC was a disregarded entity owned by Gramercy Capital Corp.(GCC is now known as Gramercy Property Trust, Inc.)GKK acquired a 45% interest in the building in 2007. The other 55% was acquired by SL Green Realty] Corp, which had acquired 100% of a leasehold interest. The arrangement referred to in this story as a joint venture was not considered a partnership between the two entities. The co-ownership structure (sometimes referred to as a tenancy in common) was probably dictated by the interest being a 1031 (like-kind exchange) target as noted in this release.
Andrew Mathias, Chief Investment Officer of Gramercy Capital Corp. and SL Green, stated: “Our success in Manhattan is due to our extensive network in the real estate community, and our proven ability to creatively structure value-add situations for buyers, sellers and co-investors. In this acquisition, we connected with Sitt Asset Management, a savvy New York City real estate investor with which SL Green has transacted on several occasions, and devised and executed a transaction in which the joint venture and Sitt were able to accommodate tax-free 1031 exchanges. We believe this acquisition in particular will deliver secure debt-like returns with the potential for equity upside.”
I have to tell you that the transaction strikes me as just a bit dubious. The co-owner has a 100% leasehold interest in the underlying property, so the 45% interest appears to behave a lot more like debt than equity , but that is not what the case is about.
Substance And Form
In 2010 SL Green bought out Gramercy’s interest in 2 Herald Square as part of a larger deal. Well, that’s the way the real estate press puts it, but to the tax geeks here is what really happened. On December 22, 2010, GKK2 LLC contributed its 45% interest to the newly formed 2 Herald Owner LLC. SLG 2 LLC did the same thing with its 55% interest. Assuming that 2 Herald Owner LLC did not elect to be taxed as a corporation (something exceedingly improbable in these circumstances), there is now a partnership. That is a probably a decent enough interval from the acquisition to not cast doubt on the exchange back in 2007.
As it turns out, the new partnership (for income tax purposes) was extremely short lived. Also on December 22, 2010, GKK2 LLC sold its 45% membership interest in 2 Heald Owner LLC to SLG2 LLC. In order to have a partnership you have to have partners (plural), so 2 Herald Owner LLC was transformed, most likely, to a disregarded entity. What gives me a serious headache is wondering whether 2 Herald Owner LLC needed to file a Form 1065 for its mayfly existence as a partnership. In my experience, none of the deal meisters who designed this whole thing would have thought about that. There is a serious gap between people who design structures and people who actually do returnsI used to think that it must be done better when it came to nine-figure deals, but my brief term with a national firm makes me suspect otherwise.
No Step Transaction Doctrine For Transfer Taxes
Believe it or not, but those extra steps do not seem to have any income tax significance. By converting what was for income tax purposes an interest in real property into a partnership interest, Gramercy was precluded from doing a like exchange. The extra steps were for transfer tax purposes. If it had made a difference for federal income tax purposes, the IRS would have been able to collapse the transaction into a sale, just as the real estate press reported it. Different story for transfer taxes, though. Follow along.
The first step was the transfer of the co-tenancy interest to 2 Herald Owner LLC. There is no argument there.
The Division concedes that petitioner’s contribution of its 45% tenant-in-common interest to Owner LLC in exchange for a 45% interest in Owner LLC, and SLG’s contribution of its 55% tenant-in-common interest to Owner LLC in exchange for a 55% interest in Owner LLC, standing alone, are exempt from the RETT as a mere change in form of ownership. Indeed, the Division’s own regulations provide that the RETT does not apply to “he conveyance by tenants-in-common of their interest in real property to a partnership or a corporation, the partnership or corporation interests being in the same pro rata shares as the tenants-in-common held prior to the conveyance. Such conveyance is not taxable as there is no change in beneficial ownership”
What New York wanted to do as apply something like the step-transaction doctrine.
The Division attempts to “aggregate” three nontaxable transactions, namely (1) the transaction between SLG and Owner LLC, which effectuated a mere change in form of ownership, (2) the transaction between petitioner and Owner LLC, which effectuated a mere change in form of ownership, and (3) the transaction whereby petitioner transferred its 45% interest in Owner LLC to SLG, in order to impose tax under the RETT on the transfer of a minority interest. However, the third transaction does not meet the definition of a transfer of a “controlling interest” because petitioner did not own more than 50% of Owner LLC. As such, that transaction, by definition, cannot be considered a transfer or acquisition of a controlling interest in an entity with an interest in real property.
The court was not buying it. Their message to the Division of Taxation was a lengthier version of Reilly First Law of Tax Planning – It is what it is. Deal with it.
The issue in the present case does not involve an understanding of the physical or social sciences, obscure regulatory practices, complex markets or industries, expert analysis of voluminous factual data, or subtle policy determinations outside the competence of ordinary persons. Indeed, the issues are so purely legal in nature that the parties stipulated the facts and submitted the case without a hearing. The Division’s interpretation herein is inconsistent with the plain language of the statute, regulations, and its own publication and as such is not entitled to deference.
LLC Is Not Always The Right Answer
Ken Weissenberg told me that this is an illustration of exactly what he has been saying over the years about holding co-tenancy interests through LLCs. But don’t forget the onions. He also told me about a couple who were denied favorable real estate tax rates on their cooperative apartment because they held it through an LLC. I recently wrote about a school in New Jersey that lost its property tax exemption.
The people who designed these transactions were pretty slick and I have to take my hats off to them. 2.5% might not sound that large. But you have to remember that it is on the whole value of the real estate interest including the portion that is leveraged. That would have pulled a pretty big chunk out of the “debt-like” return the 1031 acquisition was designed to achieve. The planner’s ability to drill down below the federal income tax issues and have their position sustained shows some really good work. An illustration of Reilly’s Fifth Law of Tax Planning – “A tax plan that ignores AMT of SALT is not much of a tax plan. ” SALT stands for State and Local Tax, a specialty that is quite underappreciated.
If somebody told me that the planners figured out in advance whether a one-day return was required for 2 Herald LLC, I’d be really impressed because almost no planners follow the Ninth Law – Tell the preparer what the plan is.”