Monday, February 29, 2016

Legal Line Question: Ground Leases

Q: I am a licensed real estate salesperson and I am representing a purchaser who is considering a co-op apartment in a building that has a Ground Lease. Can you please clarify exactly what a Ground Lease is? Also, are there any particular considerations that should be made before purchasing a co-op apartment in a building that has a Ground Lease?
A: If a co-op building has a Ground Lease (also known as a Land Lease) it means that the co-op corporation does not own the land under the building.  Rather, the co-op corporation leases the land from the owner of the land. About 100 buildings in Manhattan have Ground Leases, many of which are co-ops. Generally the terms of Ground Leases are quite long, varying from terms of 50 to 99 years.
Several important considerations should be made before purchasing a co-op apartment in a building with a Ground Lease:
  1. Can the rent payable by the co-op corporation increase during the term of the Ground Lease? 
     
  2. If the rent can increase during the term of the Ground Lease, how is the increase calculated?  Is the increase in rent a set amount or is it based on a formula that requires a determination in the future (for example, the rent increase could be tied to the fair market value of the property).
     
  3. If the rent increases in the future, how does the increase affect the maintenance paid by the co-op shareholders?
     
  4. Does the Ground Lease restrict the co-op corporation in making structural changes to the building?
     
  5. What are the "events of default" under the Ground Lease and does the Ground lease provide for the co-op corporation to cure such defaults.
     
  6. What is the term of the Ground Lease and when does it expire?
     
  7. If the Ground Lease expires, does the co-op corporation have the right to renew the Ground Lease?
     
  8. How does the Ground Lease affect the ability of prospective purchasers to obtain loans in the co-op? For example, if the Ground Lease expires in 30 years or less (the term of a 30 year mortgage), most lenders are not going to make a loan in the co-op.
     
  9. What are the tax implications of purchasing a co-op unit in a building with a Ground Lease?  More specifically, do shareholders have a lower maintenance deductibility percentage (than co-op corporations that do not have Ground Leases) because the shareholders are prevented from deducting the portion of maintenance charges used to pay the rent under the Ground Lease?
     
  10. Does the co-op have a history of strong re-sales or does it appear that the Ground Lease creates an impediment to the ability to re-sell the co-op?

Important Tip:  This is not an exhaustive list and each situation may vary. Accordingly, it is recommended that anyone seeking to buy a co-op apartment in a building with a Ground Lease should consult with an attorney beforehand

The Legal Line Question by:
Neil B. Garfinkel
REBNY Broker Counsel

Legal Line Question: The Mansion Tax

Q: I am a licensed New York state real estate broker and I am representing a purchaser who is considering buying an apartment for $999,999.00. My purchaser is worried that she will be required to pay the Mansion Tax on the sale. Can you please tell me what the Mansion Tax is and whether she will have to pay the Mansion Tax if the apartment closes at $999,999? 
A: The Mansion Tax is a fee paid by the purchaser of residential real property in New York State, when the total consideration is One Million ($1,000,000.00) Dollars or more. Residential real property is defined as "any premises that is or may be used in whole or in part as a personal residence at the time of conveyance, and includes a one-, two-, or three-family house, an individual condominium, or a cooperative apartment unit." The Mansion Tax is equal to 1% of the total "consideration." New York State Tax Law defines "consideration" as the price actually paid or required to be paid for the real property. This amount corresponds with the "amount of consideration for conveyance" listed on Schedule B, Part II, Line 1 of the New York State Real Property Transfer Tax Form TP-584 ("the TP584"). See the illustration below for the relevant portion of the TP-584.
TP584
If the total consideration for the property (as it appears on the TP-584) is for anything less than $1,000,000.00, the purchaser will not have to pay the Mansion Tax. Thus, if the total consideration for the apartment is $999,999.00 the purchaser does not have to pay the Mansion Tax on the sale.
Nonetheless, determining whether the Mansion Tax applies to a particular transaction is not as simple as ascertaining the purchase price for the property. If the purchase price of residential property is less than $1,000,000.00, a purchaser may still have to pay the Mansion Tax because of what is known as "grossed up consideration." In New York, the consideration in a real estate transaction is "grossed up" (increased) if a purchaser agrees to pay the seller’s transfer taxes on the transaction. In this scenario, the transfer taxes that the purchaser has agreed to pay are added to the purchase price as part of the total consideration.
Accordingly, real estate brokers should be aware of the transfer tax implications when the purchase price approaches $1,000,000.00 and the purchaser agrees to pay the seller’s transfer taxes. In such a scenario, the grossed up consideration could increase the total consideration to exceed $1,000,000.00, thereby implicating the Mansion Tax.
In New York City, real estate transactions are subject to both New York State and New York City transfer taxes. The New York State transfer tax is .4% of the total consideration. The New York City transfer tax is 1% of the total consideration if the sale is for $500,000.00 or less and 1.425% of the total consideration for sales greater than $500,000.00.
For example, if the purchase price of an apartment is $999,999.00 and the purchaser agrees to pay the seller’s transfer taxes, then the purchaser will be responsible for $3,999.99 in New York State transfer taxes and $14,249.99 in New York City transfer taxes. The combined $18,249.98 of transfer taxes is added to the purchase price and the total grossed up consideration amount is $1,018,248.98. Thus, the purchaser would have to pay the Mansion Tax on this transaction because the total consideration exceeds the $1,000,000.00 threshold.
Furthermore, if the purchaser agrees to pay the seller’s transfer taxes, the transfer taxes will be re-calculated using the "grossed up" consideration amount, rather than the original purchase price. Thus, in the example above, the transfer taxes would be recalculated using the grossed up amount of $1,018,248.98. This equates to $18,583.04 in combined New York State and New York City transfer taxes.
Important Tip: Please note that because these calculations are complex, you should always consult with an attorney and an accountant when commencing a transaction in which the Mansion Tax may be implicated.

The Legal Line Question by:
Neil B. Garfinkel
REBNY Broker Counsel

Monday, February 15, 2016

Legal Line Question: 1031 Exchanges

Legal Line Question: 1031 Exchanges

Q: I am a licensed real estate salesperson and I am representing a seller who is selling a three family investment property. She is interested in reinvesting the proceeds from the sale in a 1031 Exchange. What is a 1031 Exchange? Will the seller be able to avoid paying capital gains tax by participating in a 1031 Exchange?
A: The term "1031 Exchange" refers to Section 1031 of the Internal Revenue Code (the "Code"). A 1031 Exchange affords the seller of an investment property (the "Original Property") the opportunity to defer paying capital gains on the Original Property if the seller reinvests the proceeds of the sale in the purchase of a "Like Kind" replacement property (the "Replacement Property").
It is important to note that the seller does not avoid paying capital gains on the sale of the Original Property. Rather the capital gains taxes on the sale of the Original Property are deferred until such time as the seller is unable to complete a 1031 Exchange, at which time the capital gains will be payable.

To assist REBNY members in further understanding 1031 Exchanges, we have provided answers to the following frequently asked questions:
Q1.         Are there any significant time frames that a seller must keep in mind when participating in a 1031 Exchange?
A1.         Yes, there are two significant time frames that a seller must comply with when executing a 1031 Exchange. First, the seller must identify the Replacement Property within 45 days of the closing date of the Original Property. This 45 day window is known as the "Identification Period." Second, the seller must generally complete the acquisition of the Replacement Property within 180 days from the closing date of the Original Property.  This is known as the "Exchange Period." The Identification Period and the Exchange Period begin on the same day and run concurrently.
Q2.         What is "Like Kind" Property?
A2.         Like Kind Property is defined broadly under the Code. Any real property held either as an investment or for use in trade or business is considered to be of "Like Kind" with any other real property which is also held as an investment or for use in trade or business. For example, a condominium unit would be considered "Like Kind" with a house provided both properties are used as an investment or for use in trade or business. Real property held primarily for personal use does not qualify as "Like Kind" property. Also, property in the United States is not considered "Like Kind" with property outside of the United States.
Q3.         Is it possible to execute a partial deferment of capital gains taxes rather than a full deferment of capital gains taxes?
A3:         Yes, a seller is not required to invest the full sales proceeds from the Original Property in the Replacement Property. Rather, the portion of the proceeds from the sale of the Original Property that is not reinvested in the Replacement Property will not qualify for the deferment of capital gains taxes and will be taxed at the normal tax rate. 
Q4:         Is it possible to purchase more than one Replacement Property?
A4:         Yes, a seller may exchange the Original Property into (or out of) as many Replacement Properties as possible within the 180 day Exchange Period. However, the maximum possible deferment of capital gains taxes is capped at the amount of the sale proceeds of the Original Property.
Q5:         What is a Qualified Intermediary ("QI") and what role does a QI serve in the 1031 Exchange process?
A5:         A QI, sometimes known as a "facilitator," is a third party hired by the seller to hold the proceeds from the sale of the Original Property so that the seller never takes actual or constructive possession of the proceeds. A QI is necessary because, as a requirement for receiving a deferment of capital gains, the Code forbids the seller from ever taking possession of the proceeds from the sale of the Original Property.  Once the seller has identified the Replacement Property, the QI will use the proceeds of the sale being held by the QI in order to complete the purchase of the Replacement Property on behalf of the seller.
Important Tip: Because the seller must comply with very specific rules in order to utilize a 1031 Exchange, an accountant or attorney should always be consulted in connection with such transaction.

Thursday, February 4, 2016

New York Property Capital Gains Tax (and other taxes)

Here is a summary of the major tax categories when buying property in New York.  Besides capital gains, there is also monthly property tax, income tax and estate (inheritance) tax.  


Property Tax
Property tax is provided as a monthly amount with each property but paid quarterly.   A rough guide is $1 per sqft per month but it varies with the apartment and building.  For example, a 1000 sqft apartment may have monthly property tax of $1000.  This is the second largest carrying cost after common charges each month (excluding mortgage). 

Newer buildings usually have a tax abatement, which means a decreased property tax amount lower than the $1 per sqft per month example, during the first 10 years of the property's life.  This is commonly known as a 421-A tax abatement.  During the first 10 years, taxes typically increase every two years linearly and by year 10, it would be what taxes should be without the abatement.  


Income Tax
This depends on the owner's income level but assuming the owner only has income from one property in the US, it should be around 20 percent of taxable income.  It's important to note that the US allows annual depreciation of investment property.  This depreciation is a phantom expense which would wipe out taxable income especially in the early years of ownership.  


Estate (Inheritance) Tax
While US residents have estate tax exemptions, the exemption for foreign property owners is minimal.  Hence inheritance tax is the biggest exposure for foreign buyers because it can be up to 50 percent of property value.  

It is extremely important to get sound advice from a foreign buyer expert when structuring the purchase.   There are simple ways or more complex ways, both of which would protect the owner's estate from estate/inheritance taxes.  


Capital Gains Tax
Capital gains tax is the taxes levied on the profit arising from sale of the property.  Assuming the owner has owned the property for more than 1 year, capital gains tax ranges from 22 percent (if property is held individually) to 40 percent (if property is held through an entity or company).   Another area to get advice from an experienced tax attorney.  

For primary residence owners, there is a capital gains tax exemption of $250,000 for individuals and $500,000 for married couples.  To qualify, the owner must have lived in the property for at least 2 out of the previous 5 years.  


For the tax matters above, we will refer clients to an experienced tax attorney who specializes in foreign buyers of Manhattan property.

Real Estate Purchase Overview for Foreign Buyers

1 Why New York
Manhattan is the most expensive, most stable and most recognized market in the US.  The recent Knight Frank Wealth Report 2015 ranks Manhattan as the top real estate market in the world based on factors including economic environment, political climate, knowledge and quality of life.  Globally, Manhattan is a bargain when compared to cities like London, Paris and Hong Kong.  

2 Can foreigners buy property in Manhattan, New York?
Yes. Our foreign clients buy property in Manhattan because of brand value and appreciation potential. They often purchase as a pied-a-terre (vacation home), or as an investment property.



3  What type of properties are popular among foreign / international buyers?
There are two categories of apartments - condominiums and cooperatives. We recommend condos because of the higher appreciation and investment values. Co-op buildings often restrict ability to rent and perform renovations.  This reduces their attractiveness as an investment property. The process of buying a co-op is subject to board approval which prolongs the buying process.   Further, a co-op board may even reject a buyer.

The value of a condo, on a per-square-foot basis, is about 30 to 50 percent higher than that of a co-op. However, the appreciation potential and demand for condos are higher as well.  

Besides apartments, our clients also purchase commercial mixed use and multifamily buildings.  Apartments are more popular because they are easier to manage and simple to understand. 

4  What are expenses associated with owning a property in Manhattan?
For apartments, the main monthly expenses are: 
(i) property taxes
(ii) common charges
(iii) insurance
(iv) if financing is used, mortgage principal and interest.

New development apartment buildings often have a tax abatement which reduces the monthly tax bill. Without abatement, annual taxes are between 0.5 to 1 percent of property value.  Common charges average $1 per square foot per month and goes up or down depending on number of units and amenities.  Insurance is about $500 per year.

Expenses for mixed use or multifamily buildings are higher and include taxes, insurance, maintenance, repairs, property management and others.  

5  Financing for foreign / international buyers
Mortgage loan financing is available and can be obtained either through a U.S. or non-U.S. bank.  Since the credit crisis, lenders have tightened credit criteria and will require about 40 percent as down payment from a foreign buyer.   

Financing allows the ability to leverage funds, thereby magnifying returns.  For example, if  an investor buys one condo at $1 million in cash, he gets the appreciation benefit of  only one  apartment.  But if the investor obtains mortgage financing and only puts 50% down payment, he can actually buy two apartments, effectively benefiting from the appreciation of two properties with the same (theoretical) equity investment. 

The two ways of arranging financing are:
(i) Financing from U.S. lender:  This option is easily arranged through a bank in the U.S.   The requirement is usually a 40 percent down payment (60% Loan-to-Value).  Also, the buyer needs to show liquid assets that is usually based on a multiple of the monthly payments.  Since financing is in the U.S., the buyer would have to pay about 2% mortgage tax.

(ii) Financing from home country:  This refers to getting an international mortgage from the home country of the investor.   Hence from the U.S.'s perspective, a cash transaction.  The main difference is saving on the mortgage tax and various bank fees.  But of course, there may be other fees associated with the financing bank.  

We would refer our foreign clients to contacts for both options.  Ultimately, the international investor needs to do a cost benefit analysis.  It's a matter of comparing loan terms, amortization period, interest rate, costs etc.

6  Cash buyers 
Foreign investors purchasing in cash save on the New York mortgage tax, about 2% of the loan amount.  In addition, the cash buyer saves various bank related fees.  



7  Transaction costs
For the buyer,  transaction costs are about 5-6 percent of the loan amount.  This estimate includes mansion tax, mortgage tax, title insurance,  attorney fees, recording taxes and other administrative expenses.  With an all-cash closing, the transaction costs are about 1.5 to 2 percent of property price.  The broker's commission is paid from the seller's proceeds.

For the seller, transaction costs are about 8% of the selling price and this is driven by the broker commission and transfer taxes.

8 Taxes, taxes, taxes
The categories of taxes are: 

(i) Property tax
These are reflected as a monthly expense with each condo and paid quarterly.  If there is a mortgage, the bank could escrow the tax amount.  This means collecting and paying on behalf of the owner.  For properties without a tax abatement, this tax is roughly 1 percent of price per year.    

(ii) Capital Gains Tax - depends on how ownership is held.  

(iii) Annual Operating Tax
This refers to annual taxes on profits assuming the property is rented out.  The U.S. government allows depreciation of property every year.  In Manhattan, 40 percent down payment is typically required for rental income to offset carrying costs including financing.  Hence, assuming break even cash flow, the depreciation allowance would create a NEGATIVE taxable income.  This means no operating taxes for the owner.  However, depreciation would have to be recaptured at time of sale.

(iv) Estate tax:
The largest tax exposure to a foreign property owner (compared to a U.S. owner) is the estate tax.  U.S. law is such that if a foreign owner passes, estate taxes could be as high as 50 percent.  The good news is that there are tax structures that can be set up to remove this risk.   

We have tax attorneys and accountants in our network that are qualified to advise our clients on all the above tax matters.  

9  How does the agent fee work when buying or selling?
In New York, agent fees are paid by the seller. When the seller’s agent agrees to list a property for sale, a certain percentage is agreed upon as commission.  If the buyer is represented by an agent, this pre-negotiated commission would be split with the buyer’s agent.  If the buyer does not have an agent, then the seller’s agent keeps the entire pre-negotiated commission.  Hence, it is in the best interest of the buyer to have agent representation to help identify the right property, negotiate the best price and coordinate the entire purchase process.

Access to inventory:  The property inventory in New York is openly accessible to all.  For example, if there are 5,000 listings for sale at a given point in time, all brokers and consumers have access to this inventory.  There is no restricted or exclusive access given to certain brokers.  Brokers usually access the inventory through the broker system while consumers can access them through websites like Streeteasy.com and Trulia.com.  Any broker can bring a buyer client to view any property.  As such, the value of a buyer's broker is in identifying and negotiating the good buys.  The value is not in getting access to properties.   

The fiduciary responsibility of the buyer's agent is to the buyer while the fiduciary responsibility of the seller's agent is to the seller - regardless of the fact that the commissions for both is coming from the seller's side.   This is just the way the brokerage trade agreement works in New York.  

Buying Process For Foreign / Overseas Investors

Below is the process for buying a condo in Manhattan, New York.  The process is similar for those buying the condo as an investment property or as a vacation home.  Main difference is that for investment property buyers, down payment required by the lender is higher.  

Estimated Time to closing after identifying property:
With Financing:  10 to 12 weeks
All Cash:  2 to 3 weeks

1.  Obtain pre-approval from lender (1-5 days)
Lender can be a U.S. bank or overseas bank at buyer's home country with an international mortgage program.  

2.  Identify Property (2 days - several months)
Property viewing can be a pleasurable or tiring experience.  Our value is in filtering properties based on the client's objective to maximize productivity of the client's time.  

3.  Make offer and negotiate price (1 week)
Negotiation skills are critical.   Experienced negotiators could obtain many favorable financial and non-financial terms for the buyer.

4.  Execute contract (1-2 weeks)
The agreed upon terms are provided to both parties' attorneys who will prepare the contract.  The buyer's attorney will perform due diligence on the property prior to actual contract execution.  Once all is agreed upon, the contract is executed.  At this time, a 10% deposit will be required from the buyer to be held in escrow by the attorney.

5.  Apply For Mortgage and Obtain Commitment Letter (6-9 weeks)
The buyer formally applies for a mortgage after which the lender will perform due diligence, including appraisals etc.  Consequently, the lender will issue a commitment letter.  

6.  Submit condo package to condo board for approval (1 to 4 weeks)
This occurs concurrently with Step 5 above.

7.  Schedule Closing
At closing, all parties - buyer, seller, bank, attorneys, brokers, will come together at a table.  A lot of paperwork is signed and funds will be provided to the seller in exchange for the buyer getting legal title to the property.  The deal will be completed at the table and usually no future follow-ups are necessary.