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As highlighted in our previous article, it is just a matter of time before the impact of the COVID-19 pandemic on the commercial real estate market will lead to a considerable increase in foreclosures, deeds-in-lieu of foreclosures, and assignments-in-lieu of foreclosures under mortgage and mezzanine loans. Potentially overlooked in mortgage foreclosures and deeds-in-lieu of foreclosure, or in the case of mezzanine loan financings, foreclosures under the Uniform Commercial Code and assignments-in-lieu of foreclosure, are the applicable real property transfer taxes incurred under New York law. In particular, the calculation of “consideration”, upon which applicable transfer taxes are assessed, is certainly not straightforward, and the amount of transfer taxes can be substantial.

Our previous article in this series focused on the calculation of real property transfer taxes in connection with a mortgage foreclosure and a deed-in-lieu of foreclosure. In this article, we now turn our attention to the calculation of real property transfer taxes in connection with a UCC foreclosure of a mezzanine loan and an assignment-in-lieu of foreclosure.

Summary of the Applicable Laws

Article 31 of the New York State Tax Law imposes a real estate transfer tax (the “State Transfer Tax”) on each conveyance of real property or interest in real property if the consideration exceeds $500, with the tax being computed at the rate of $2 for each $500 of consideration (or a fractional part thereof) (N.Y. Tax Law §1402(a)). Similarly, Title 11, Chapter 21 of the City’s Administrative Code (§11-2102(a)(9)(ii)) imposes a real property transfer tax (the “City Transfer Tax”) on each conveyance of real property or interest in real property if the consideration exceeds $25,000, with the tax rate for commercial property being 1.425% where the consideration is $500,000 or less and 2.625% where the consideration is above $500,000.

For purposes of both the State Transfer Tax and the City Transfer Tax, a “conveyance” includes the transfer or acquisition of a “controlling interest” in a partnership, corporation or other entity owning an interest in real property. As a mezzanine loan is typically secured by a pledge of all of the equity ownership (directly or indirectly) in the property owner, the UCC foreclosure or assignment-in-lieu of foreclosure of the pledge will invariably constitute a transfer of a “controlling interest” in the entity owning the real property.

[NOTE: Under the applicable rules and regulations, “controlling interest” means (i) in the case of a corporation, either 50% or more of the total combined voting power of all classes of stock of the corporation, or 50% or more of the capital, profits or beneficial interests in the stock of the corporation, and (ii) in the case of a partnership, limited liability company, or other entity, 50% or more of the capital, profits or beneficial interest in the partnership, association, trust or other entity (N.Y. Tax Law §1401(b); N.Y.C. Admin. Code §11-2101(8)).

The State Transfer Tax and the City Transfer Tax are not imposed when the foreclosure or assignment-in-lieu of foreclosure is consummated under a Chapter 11 plan pursuant to the federal bankruptcy code. Given how real estate loan transactions have been structured (e.g., with single purpose borrowers, bankruptcy remote protections, springing guarantees for bankruptcy filings), the ability of a borrower to be voluntarily or involuntary placed in bankruptcy and have a foreclosure (or assignment-in-lieu of foreclosure) consummated under a Chapter 11 plan is limited to specific and atypical circumstances.]

Calculation of “Consideration” for the Purposes of Calculating Transfer Taxes

In a foreclosure of a mezzanine loan under the Uniform Commercial Code or an assignment-in-lieu of foreclosure, the calculation of the “consideration” under the applicable rules and regulations, upon which the applicable tax rate will be applied in order to calculate the State Transfer Tax and the City Transfer Tax, is neither simple nor logical; and the amount of transfer tax exposure could have a material impact on the parties’ decision on how to best structure the transfer of a property from a borrower to its lender or to pursue a foreclosure.

Set forth below is a summary of the calculation of consideration upon which the State Transfer Tax and, if applicable, the City Transfer Tax will be assessed for a mezzanine loan foreclosure under the Uniform Commercial Code or an assignment-in-lieu of foreclosure:

UCC Foreclosure of Mezzanine Loan Pledge:

State Transfer Tax

If the grantee is the secured party (or its agent, nominee, or an entity wholly owned by such secured party), consideration is the lesser of:

• The fair market value of the real property as of the date of the conveyance, or
• The sum of the following:
  • The unpaid balance of the debt secured by the pledged ownership interest,
  • Any liens, security interests or other obligations remaining on the pledged ownership interest after the conveyance, whether the underlying indebtedness is assumed or taken subject to,
  • The amount of any liens or encumbrances remaining on the real property
  • The amount of any other debt or obligation of the property owning entity, and
  • Any other amount paid by the grantee for the conveyance (not including state or local transfer taxes paid by the grantee in connection with the conveyance, unless the grantee contractually assumed the liability for the payment of such taxes or released its right to seek recovery of the payment from the grantor) (20 NYCRR §575.11(a)(16)).

[NOTE: The express language of NYCRR § 575.11(a)(16) provides that the list of items to be included in consideration (set forth under clause (b) above) is not exclusive. However, in practice, the list has been treated as a complete list of all amounts to include in consideration. The calculation made pursuant to these rules assumes that one hundred percent (100%) of the equity in the property-owning entity, directly or indirectly, has been pledged as collateral for the loan. If the percentage is less than one hundred percent (100%), then the rules provide that the items set forth at clauses (a) and (b) are limited to the percentage interest that the entity in which the interest being foreclosed has an interest, directly or indirectly, in the real property.]

EXAMPLE 1: G owns 100% of the corporate stock in E. E’s assets consist of real property located in New York and other tangible assets. The fair market value of the real property is $2,400,000. The real property is encumbered by a mortgage having a current unpaid balance of $900,000. E has other debts totaling $400,000. G pledged all of its stock in E to X, as security for a $600,000 mezzanine loan, which has an unpaid balance of $700,000, including interest and costs. X is enforcing its security interest in such stock owned by G, which results in a transfer and acquisition of a controlling interest with its winning bid at foreclosure of $600,000.

Consideration is the lesser of:

• $2,400,000 (i.e., the fair market value), or
• The sum of:
  • $700,000 unpaid balance of the mezzanine debt, plus
  • Outstanding mortgage lien on the property of $900,000, plus
  • Additional debts of E in the amount of $400,000.

$700,000 + $900,000 + $400,000 = $2,000,000.

[NOTE: If the property-owning entity owns assets in addition to the real property, then the fair market value of the assets must be apportioned when calculating the consideration. In Example 1, if E also owned other assets valued at $400,000, then consideration would be $1,714,285.71 (i.e., ($700,000 + $900,000 + $400,000) x $2,400,000/ ($2,400,000 + $400,000).]

The New York State regulations do not specifically address the purchase by a successful third-party bidder (i.e., unrelated to the secured party) in the context of a mezzanine loan foreclosure. However, the consideration is believed to be the sum of:

• The amount of the successful bid,
• The amount of any surviving liens, security interests or other obligations on the pledged ownership interest, including the unpaid balance of any senior mezzanine loans,
• The amount of any liens or encumbrances remaining on the real property, and
• The amount of any other debt or obligation of the property owning entity (John M. Zizzo, Bonnie A. Neuman & Michael J. Berey, Transfer Taxes on the Enforcement of Mezzanine Loans, 2009 N.Y. Law Journal).

[NOTE: Unlike in connection with the calculation of State Transfer Taxes applicable to a mortgage foreclosure, in a foreclosure of a mezzanine loan, whether the unpaid debt is recourse or non-recourse to the borrower is irrelevant for purposes of calculating consideration.]

City Transfer Tax:

Consideration is the sum of:

• The amount of the successful bid,
• The amount of any other surviving liens on the pledged interest, including the unpaid balance of any senior mezzanine loans,
• The unpaid balance of any outstanding mortgage on the real property,
• The amount of any other debt (secured or unsecured) of the property-owning entity, and
• The costs of the foreclosure paid by the transferee (19 RCNY §23-03(d)(2); John M. Zizzo, Bonnie A. Neuman & Michael J. Berey, Transfer Taxes on the Enforcement of Mezzanine Loans, 2009 N.Y. Law Journal).

EXAMPLE 2: Same facts as Example 1 above, and the property is located in New York City.

Consideration is the sum of:

• The $600,000 successful bid at foreclosure of the mezzanine loan, plus
• Outstanding mortgage lien on the property of $900,000, plus
• Additional debts of E in the amount of $400,000.

$600,000 + $900,000 + $400,000 = $1,900,000.

Assignment-in-Lieu of Foreclosure of Mezzanine Loan Pledge:

Consideration for the purposes of the State Transfer Tax and the City Transfer Tax in the event of an assignment-in-lieu of foreclosure of a mezzanine loan pledge is calculated in the same manner as that of a UCC foreclosure of a mezzanine loan pledge; except that, with respect to the City Transfer Tax, consideration includes the unpaid balance of the mezzanine debt (in lieu of the bid amount).

In addition, for both the State Transfer Tax and the City Transfer Tax calculations, when the transferee of the mezzanine interest pays the transfer taxes due on an assignment-in-lieu, the amount of taxable consideration is increased by the amount of tax paid, and the tax is actually assessed on this “grossed-up” amount of consideration (20 NYCRR §575.11(a)(2)(i); 19 RCNY § 23-02).

Conclusion

It is imperative that lenders and borrowers have a clear understanding of how transfer taxes are calculated when assessing the possibility of a mortgage foreclosure or deed-in-lieu of foreclosures of a property (or a UCC foreclosure, or assignment-in-lieu of foreclosures, in the case of a mezzanine loan relating to a property) located in New York State, as the costs, particularly in New York City, can be material.

For more information on the topic discussed, contact:

• Robert E. Helpern  |  helpern@thsh.com  |  212-508-6720
• Eric S. Schoenfeld  |  schoenfeld@thsh.com  |  212-508-6713
• Ari Davis  |  adavis@thsh.com  |  212-508-6796