In Matter of Ronald K. and Maxine H. Linde, DTA No. 823300 (N.Y.S. Tax App. Trib., July 21, 2011), a New York State Administrative Law Judge held that income earned by a nonresident partnership from the sale of New York property should be allocated solely to New York.

The two petitioners were partners in Strategic Hotel Capital, LLC (“Strategic”) which was headquartered in and managed from Chicago, Illinois. Strategic was engaged in the purchase, renovation and management of hotel properties, aiming to sell those properties at a gain. It acquired 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 threefactor business allocation percentage to allocate to New York its operating income from all of its hotels.

During 2005, Strategic sold its New York hotels, as well as hotels in other states. Strategic apportioned the gains using a 16% business allocation percentage on its New York State partnership return, and the Lindes allocated the same portion of the gains on their personal income tax return. Strategic was completely liquidated in 2009. The Department of Taxation and Finance conducted an audit, and took the position that the entire gains should have been allocated to New York as the situs of the properties.

The Lindes argued that, under Section 132.15 of the State’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 or 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 repeated the well-known rule that the Department’s interpretation of the statute is entitled to deference as long as it is not irrational, unreasonable or inconsistent with the statute, and he found the Department’s interpretation wholly consistent with Tax Law §§ 631 and 632. He noted that Section 132.15(d) specifically addressed the issue, and provided that real property that produces 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 ALJ also rejected the Lindes’ attempts to rely on other cases in which various items had been found to be apportionable rather than allocable. He concluded that none of those cases applied when the gain was from the sale of real estate, rather than from, for example, development and managements fees, as in Matter of Domber v. Tax Appeals Tribunal, 210 A.D.2d 529, 531-32 (3d Dep’t 1994), lv. denied, 85 N.Y.2d 810 (1995), or allocation of ordinary business income as in Matter of Ausbrooks v. Chu, 66 N.Y.2d 281 (1985).

The ALJ also rejected the Lindes’ argument that interest should be abated due to the Department’s intentional delay, finding that they had neither alleged nor established any unreasonable errors or delays.

Additional Insights. The regulation relied upon by the ALJ, Section 132.16, certainly provides that gain or loss from the sale of real property, as well as income and deductions from the rental of real property, is treated as entirely derived from the situs of the property. However, the ALJ does not seem to resolve the taxpayers’ argument that such a rule effectively excludes from the property percentage of Section 132.15 any property that generates income or loss, whether from rental or sale. Under the ALJ’s interpretation, it appears that virtually all real property might be found to be allocable rather than apportionable. Presumably, the only property that would be included in the property factor is property that is used by the partnership but does not generate any income, loss or deductions. If a partnership rents space in New York State, and then sublets a portion of that space, thereby earning rental income, should the property (measured at eight times the gross rent) be included in or excluded from the apportionment factor? Also, the facts as recited seem to suggest that, in earlier years, the partnership used the three-factor apportionment formula to allocate to New York only a portion of the costs and depreciation deductions attributable to the properties. If that is correct, then there seems to be a mismatch between the treatment of costs and deductions in the earlier years (which were apportioned) and the treatment of gain in later years.