As part of a $275 million corporate acquisition, the buyer took over an office lease with below-market rent (the tenant paid about $42/sq ft while fair market rent was about $75/sq ft) plus roughly $80-105 million in leasehold improvements. For Real Estate Transfer Tax purposes, is the taxable consideration for that lease assignment (a) the present value of the below-market-rent savings PLUS the leasehold improvements' value, and (b) can I reduce that amount for hypothetical leasing commissions or for the 50% share the landlord could have claimed if it had exercised its lease-recapture right instead?

Plain-English summary

A law firm asked the Department, on behalf of a landlord ("Landlord"), how to value the Real Estate Transfer Tax consideration for an assigned office lease. The tenant ("Tenant") held a lease (expiring 2013) for about 370,000 square feet of Class A Manhattan office space at roughly $42/square foot in contract rent. After making substantial leasehold improvements, Tenant's business units -- including the lease -- were sold to a third party ("Buyer") for $275 million in cash (plus assumption of about $15.475 billion in liabilities against roughly $15.75 billion in acquired assets), structured as an assignment of the lease in connection with Buyer's purchase of all membership interests in the entity ("Seller") holding those business units. A broker's contemporaneous analysis estimated fair market rent at about $75/square foot -- meaning the lease was significantly below-market -- with the net present value of that rent-savings differential at roughly $69 million (using a 9% discount rate). Separately, the unamortized book cost of the leasehold improvements allocated to the sold business units was about $80 million, and Buyer ascribed an additional $25 million of fair-market-value premium on top of that, for a total leasehold-improvement value of roughly $105 million.

Because the transaction didn't qualify under the lease's "reorganization" carve-out, Tenant was required to first offer Landlord the chance to "recapture" the lease before assigning it -- and if Landlord had recaptured and later re-let the space at a higher rent, Landlord would have owed Tenant 50% of the increased rent (net of re-letting costs). Tenant didn't offer that recapture option, so the assignment went forward over Landlord's objection.

The valuation method: rent savings plus improvement value, both included. The Department confirmed the assignment of the lease -- and Buyer's acquisition of the leasehold improvements -- both constitute taxable conveyances of real property or an interest therein under Tax Law §1401(e), so the transfer tax applies if the resulting consideration exceeds $500. To value that consideration, the Department held it's reasonable to treat the Leasehold interest's value as the present (discounted) worth of the difference between fair market rental value and actual contract rent, when contract rent is below current market rent -- PLUS, where the tenant has improved the property, the fair market value (not the book/tax cost) of the leasehold improvements. The Department declined to fix the actual dollar consideration here, noting that valuing both the discounted rent savings and the fair market value of improvements are inherently subjective factual determinations beyond the scope of an advisory opinion (which only applies stated law to "a specified set of facts" per Tax Law §171, Twenty-fourth and 20 NYCRR 2376.1).

No discounts allowed. The Department rejected both proposed reductions to that consideration: (1) there is no legal authority to reduce the fair market value of the Leasehold interest for hypothetical or actual leasing commissions or other transaction costs, and (2) there is no legal basis to reduce consideration by the 50% share Landlord could have received had it exercised its recapture right and re-let the space -- that right was never exercised, and its hypothetical value doesn't offset the actual consideration paid for the assignment.

What this means for you

Below-market rent is itself taxable value when a lease changes hands

If you're assigning or acquiring a lease with rent below current market rates, don't assume only the "improvements" or "goodwill" portion of a deal price is subject to transfer tax -- the discounted present value of the below-market-rent advantage itself is taxable consideration, separate from any improvements.

Leasehold improvements are valued at fair market value, not tax book value, for transfer tax purposes

If a tenant's leasehold improvements have appreciated (or depreciated) differently from their book basis, the transfer tax consideration tracks the improvements' actual fair market value at the time of conveyance -- which can produce a materially different number than what shows up on a balance sheet.

You can't discount transfer-tax consideration for deal costs or forgone landlord rights

Hypothetical brokerage commissions, re-letting costs, or a landlord's unexercised right to capture some of the upside (like a lease-recapture clause) don't reduce the taxable consideration -- the Department looks at what was actually paid/transferred, not what a different structure might have yielded to a different party.

An advisory opinion won't do your appraisal for you

Because valuing below-market rent and improvements is inherently a factual, appraisal-driven exercise, don't expect the Department to bless a specific dollar figure in an advisory opinion -- it will confirm the METHOD (rent-savings PV plus improvement FMV) but leave the actual numbers to the parties (and, ultimately, audit).

Common questions

Q: If I assign a lease with rent below current market rates as part of a larger business sale, is the "discount" itself taxable?
A: Yes -- the present value of the difference between fair market rental value and actual contract rent is part of the taxable consideration for the assignment, in addition to any leasehold improvements conveyed.

Q: Are leasehold improvements valued at their depreciated book cost or their current market value for transfer tax purposes?
A: Fair market value at the time of conveyance, not book or tax cost -- which may be higher or lower than what's recorded on the balance sheet.

Q: Can I reduce the taxable consideration for brokerage commissions I'd have to pay to re-lease the space, or for a landlord's forgone recapture rights?
A: No -- the Department found no legal basis for either reduction; consideration is measured by what was actually transferred, not hypothetical costs or unexercised third-party options.

Citations and references

Statutes, guidance, and case law:

• Section 1402 of the Tax Law
• Section 1401(c) of the Tax Law
• Section 1401(d) of the Tax Law
• Section 1401(e) of the Tax Law
• Section 1401(f) of the Tax Law
• Section 171, Twenty-fourth of the Tax Law
• 20 NYCRR 2376.1

Source

• Landing page: https://www.tax.ny.gov/pubs_and_bulls/advisory_opinions/real_estate_tran_ao_2002.htm
• Opinion: https://www.tax.ny.gov/pdf/advisory_opinions/real_estate/a02_5r.pdf

Original ruling text

New York State Department of Taxation and Finance

Office of Tax Policy Analysis
Technical Services Division

TSB-A-02(5)R
Real Estate Transfer Tax
September 18, 2002

STATE OF NEW YORK
COMMISSIONER OF TAXATION AND FINANCE
ADVISORY OPINION

PETITION NO. M020326A

On March 26, 2002, the Department of Taxation and Finance received a Petition for
Advisory Opinion from Paul, Hastings, Janofsky & Walker LLP, 75 East 55th Street, New York, NY
10022.
The issues raised by Petitioner, Paul, Hastings, Janofsky & Walker LLP, are:
1.

Whether for purposes of the Real Estate Transfer Tax (hereinafter the “transfer tax”),
the consideration for an assignment of lease includes both (a) the net present value
(“NPV”) of the difference between the fair market rental value of the leased property
and the actual rent payable under the Lease and (b) the value of the Leasehold
Improvements acquired in the conveyance.

2.

Whether in calculating the NPV of the difference in fair market rental value and
actual rent, such amount may be reduced by the estimated cost of hypothetical
commissions and other costs.

3.

Whether in calculating the NPV of the difference in fair market rental value and
actual rent, such amount may be reduced by subtracting 50% of such difference,
which represents the amount that Landlord could have received if Tenant had
allowed Landlord the opportunity to exercise its recapture rights under the Lease
prior to the assignment.

Petitioner submits the following facts as the basis for this Advisory Opinion.
Petitioner represents the owner (“Landlord”) of an office building located in midtown
Manhattan (the “Building”), which contains Class A office space. Landlord and Tenant entered into
the Lease for certain office space in 1997 (the “Demised Property”). The Lease expires in year
2013.
The Demised Property contains approximately 370,000 square feet and the Lease requires payment
of rent by Tenant of approximately $42 per square foot. After entering into the Lease, Tenant made
a substantial investment in leasehold improvements to the Demised Property (the “Leasehold
Improvements”).
In 2001, Tenant assigned the Lease to a third party (“Buyer”), in connection with Buyer’s
purchase of all of the membership interests in a limited liability company (“Seller”) owning the
assets of certain business units of Tenant. At the time, a licensed real estate broker provided Seller
and Buyer with an analysis estimating the fair market rental value for the Demised Property to be
approximately $75 per square foot and the NPV of the difference between the fair market rental
value and actual rent to be approximately $69 million using a discount rate of 9%.

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At the time of the conveyance, the unamortized cost of Tenant’s investment in the Leasehold
Improvements allocated to the business units being sold was approximately$80 million. In addition,
in entering into the transaction, Buyer ascribed an additional $25 million in value to such Leasehold
Improvements (i.e., totaling $105 million for the Leasehold Improvements), which represented the
difference between the fair market value and the book value of the Leasehold Improvements.
Petitioner states that if the conveyance did not qualify as a “reorganization” under the
pertinent provisions of the Lease, Tenant could not assign the Lease to Buyer unless Tenant first
offered Landlord the opportunity to “recapture” the Lease. If Landlord elected to recapture the
Lease and subsequently leased the Demised Premises for an increased rent to another person during
the term of the Lease, Landlord would have been required to share 50% of the proceeds of such
increased rent with Tenant, after deducting commissions and other costs, if any, incurred by
Landlord in re-letting the Demised Premises. Tenant, however, did not offer Landlord any such
right of recapture and, therefore, the assignment occurred over Landlord’s objection. Buyer took
occupancy of the Demised Property, the Leasehold Improvements were conveyed to the Buyer and
the Buyer is carrying the cost of those Leasehold Improvements on its books and records.
Buyer paid approximately $275 million in cash to Seller at the time of closing. Buyer
acquired approximately $15.75 billion in assets, mostly representing securities, and assumed
corresponding liabilities of approximately $15.475 billion.
Buyer’s agreement with Seller required that at the time of closing the business units being
sold have a net book value of $238 million. The balance sheet that accompanied the conveyance
reflected that the Seller’s assets included approximately $80 million in Leasehold Improvements.
Seller allocated an additional $25 million of the purchase price to the difference between the fair
market value and the book value of such Leasehold Improvements.
In publicly issued statements Seller attributed $12 million of the purchase price to goodwill
and $263 million of the purchase price to the net value of the assets acquired (which included a book
value of $238 million, $80 million of which represented the book value of the Leasehold
Improvements, plus another $25 million in additional value allocated to the Leasehold
Improvements).
Applicable Law and Regulations
Section 1402 of the Tax Law imposes the real estate transfer tax on each conveyance of real
property or interest therein when the consideration exceeds five hundred dollars.
Section 1401(c) of the Tax Law provides:

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September 18, 2002

“Real property” means every estate or right, legal or equitable, present or
future, vested or contingent, in lands, tenements or hereditaments, including
buildings, structures and other improvements thereon, which are located in whole or
in part within the state of New York. It shall not include rights to sepulture.
Section 1401(d) of the Tax Law provides, in part:
“Consideration” means the price actually paid or required to be paid for the
real property or interest therein, including payment for an option or contract to
purchase real property, whether or not expressed in the deed and whether paid or
required to be paid by money, property, or any other thing of value. It shall include
the cancellation or discharge of an indebtedness or obligation. It shall also include
the amount of any mortgage, purchase money mortgage, lien or other encumbrance,
whether or not the underlying indebtedness is assumed or taken subject to.
Section 1401(e) of the Tax Law provides:
“Conveyance” means the transfer or transfers of any interest in real property
by any method, including but not limited to sale, exchange, assignment, surrender,
mortgage foreclosure, transfer in lieu of foreclosure, option, trust indenture, taking
by eminent domain, conveyance upon liquidation or by a receiver, or transfer or
acquisition of a controlling interest in any entity with an interest in real property.
Transfer of an interest in real property shall include the creation of a leasehold or
sublease only where (i) the sum of the term of the lease or sublease and any options
for renewal exceeds forty-nine years, (ii) substantial capital improvements are or
may be made by or for the benefit of the lessee or sublessee, and (iii) the lease
or sublease is for substantially all of the premises constituting the real property.
Notwithstanding the foregoing, conveyance of real property shall not include a
conveyance pursuant to devise, bequest or inheritance; the creation, modification,
extension, spreading, severance, consolidation, assignment, transfer, release or
satisfaction of a mortgage; a mortgage subordination agreement, a mortgage
severance agreement, an instrument given to perfect or correct a recorded mortgage;
or a release of lien of tax pursuant to this chapter or the internal revenue code.
Section 1401(f) of the Tax Law provides, in part:
“Interest in the real property” includes title in 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 occupancy of real property or the right to
receive rents, profits or other income derived from real property. . . .

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Opinion
With respect to issue (1), Tenant’s assignment of the Lease to Buyer constitutes a
conveyance of real property or interest therein, as does Buyer’s purchase of the ownership interest
in the Leasehold Improvements acquired as a part of the assets of certain business units of Tenant.
Accordingly, the transfer tax will be imposed if the consideration attributable to the real property
or interest therein exceeds $500.
For purposes of calculating the transfer tax due on Tenant’s assignment of the Lease to
Buyer, the overall consideration paid by Buyer to Seller is required to be apportioned between the
value of Tenant’s Leasehold interest and the value of Seller’s other assets.
For purposes of determining the fair market value of the Leasehold interest so transferred,
it is reasonable to value the Leasehold interest as the present (discounted) worth of the difference
between the fair market rental value and the actual rent payable under the Lease, when contractual
rent as of the date of conveyance is less than the current market rent. In addition, if the Demised
Property is improved by Tenant, then the value of the Leasehold interest is to be increased by the
fair market value (not the cost) of the Leasehold Improvements.
As an advisory opinion merely sets forth the applicability of pertinent statutory and
regulatory provisions to “a specified set of facts” (Tax Law, section 171. Twenty-fourth; 20 NYCRR
2376.1) and the determination of the discounted worth of the rent savings and the fair market value
of Tenant’s Leasehold Improvements are subjective findings, this Opinion makes no determination
respecting the actual amount of consideration required to be recognized on Tenant’s assignment of
the Lease.
With respect to issues (2) and (3), there is no legal authority for allowing a reduction in
consideration; i.e., the fair market value of the Leasehold interest in this case, based upon
commissions or other costs whether actually incurred or hypothetically forecast. Further, there is
no legal basis to reduce the amount of consideration based on the amounts Landlord would have
received in this case if it had exercised its recapture rights under the Lease.

DATED: September 18, 2002

/s/
Jonathan Pessen
Tax Regulations Specialist IV
Technical Services Division

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NOTE:

The opinions expressed in Advisory Opinions are
limited to the facts set forth therein.