In Matter of Ronald K. and Maxine H. Linde, DTA No. 823300 (N.Y.S. Tax App. Trib., May 24, 2012), the New York State Tax Appeals Tribunal substantially affirmed the decision of an Administrative Law Judge that income earned by a nonresident partnership from the sale of New York real property should be allocated entirely to New York.
The two individual petitioners were residents of Arizona, and were partners in Strategic Hotel Capital, LLC (“Strategic”), which was headquartered in and managed from Chicago, Illinois. Strategic purchased, renovated and managed hotel properties, aiming to sell the properties at a gain. It acquired two hotels in New York City in 1998 and 1999 and renovated them. The cost of maintaining the hotels plus the depreciation deductions available were included in Strategic’s operating income, and Strategic used the three-factor formula in its New York State partnership return to allocate to New York its operating income from all of its hotels.
During 2005, Strategic sold its two New York hotels, as well as hotels in other states. Strategic apportioned the resulting gains to New York on its New York State partnership return using a business allocation percentage of approximately 16%, and the Lindes allocated the same portion of the gains on their New York nonresident personal income tax return. The Department of Taxation and Finance conducted an audit, and took the position that the entire gains on the New York hotels should have been allocated to New York as the situs of the properties.
The Lindes argued that, under Section 132.15 of the Department’s regulations, Strategic properly used a three-factor formula, set forth in Section 132.15(c), to allocate all its business income. While recognizing that Section 132.16 provides that income from the rental of real property, and gain or loss from real property, must be allocated to the property’s situs, the Lindes argued that applying Section 132.16 in that way would effectively remove all real property from the property percentage, and that Section 132.16 should be limited to rental properties.
The ALJ rejected the Lindes’ argument. He found that the Department’s regulation interpreting the statute was neither irrational nor unreasonable, was consistent with Tax Law §§ 631 and 632, and was therefore entitled to deference. He noted that Section 132.15(d) specifically provided that real property that produces the income or gain that is allocated pursuant to Section 132.16 is disregarded in computing the property percentage, and that under Section 132.16 gains from the sale or exchange of real property—as well as income from property rental—are treated as entirely derived from the situs of the property.
The Tax Appeal Tribunal affirmed the ALJ’s decision, holding that the Department correctly interpreted Section 132.16 as requiring that gains from the sale or exchange of real property “are to be considered as entirely derived from or connected with the situs of such real property.” The Tribunal, as had the ALJ, rejected the Lindes’ attempt to rely on previous decisions, finding that those decisions did not concern real estate sales gains.
The Tribunal also generally rejected the Lindes’ arguments that the application of Section 132.16 to allocate all the gain to New York was a violation of the Commerce Clause or the Privileges and Immunities Clause as discrimination against nonresidents. The Tribunal found the Department applied the regulation in an “‘evenhanded’” manner, exactly the same to resident and nonresident individual partners. However, the Tribunal did recognize that a potential detriment to nonresidents arose from the Department’s method of computing accumulated depreciation, since nonresidents are required to take into account all of the accumulated depreciation on the property, but receive deductions only for an allocated portion of the depreciation, while resident individual partners are able to fully utilize the depreciation deductions that make up the accumulated depreciation component of the gain calculation. Therefore, the Tribunal required the Department to adjust the Lindes’ basis in the property the partnership sold, to take into account only the depreciation for which they previously received a benefit. This adjustment, according to the Tribunal, remedied any potential discrimination .
Additional Insights. In dealing with the issue of alleged discrimination, the Tribunal resolved one problem that had not been addressed by the ALJ. As noted in the September issue of New York Tax Insights reporting on the ALJ decision, in earlier years the partnership was required to use a threefactor apportionment formula to allocate to New York only a portion of the costs and depreciation deductions attributable to the properties, but when the properties were sold was being required to allocate to New York the entire amount of depreciation recapture, which clearly seemed to result in a mismatch between the treatment of costs and deductions in the earlier years and the treatment of gain in later years. The Tribunal’s decision eliminates this mismatch which would otherwise have resulted in a detriment to nonresidents.