On April 12, 2012, an administrative law judge in New York’s Division of Tax Appeals issued a determination that completely re-writes the “accrual rule” as it applies to the sale of real estate by an individual who changes his or her residence to or from New York.1
The accrual rule applies where an individual changes residence, either becoming a New York resident, or ceasing to be a New York resident. Under the rule,2 as of the date of the change of residence, for New York State income tax purposes, the individual applies the federal income tax accrual method of accounting to accrue all items of income, gain, loss or deduction to the resident period or to the nonresident period, as the case may be. The Division of Taxation enacted a regulation in 1992 with examples to explain how the rule is to be applied to such items as salary, bonus and sales of real estate.3
Concerning the sale of real estate, in the example in the regulation, the taxpayer contracts to sell a New York property on September 1, subject to the purchaser investigating title and obtaining a mortgage. On September 10, the taxpayer moves out of New York and ceases to be a New York resident. On October 20, the closing on the property takes place. The regulation concludes that the gain from the sale of the property was not accruable for the portion of the year when the individual was a resident of New York “because of the conditions stated in the contract of sale.” Although not fully articulated, the example suggests a rule based on whether there are contingencies in the contract of sale: if no contingencies exist, the gain is picked up on the date of the contract; if there are contingencies, the gain is to be accrued in the period in which the contingencies cease or on the date of sale.
In this case, the taxpayer was a Connecticut resident. On September 14, 2004, she entered into a contract to sell her Connecticut home for $14 million. The buyer paid 10 percent down and the taxpayer executed a mortgage deed granting the premises to the purchaser, which was held in escrow. The contract set a closing date of November 8, which could be extended for up to three weeks without either party being in default. On November 5, the taxpayer signed the deed and the related closing documents, and authorized her attorney to attend the closing on her behalf. On November 9, the taxpayer closed on the purchase of a condominium in New York City and began residing there, and stopped living in Connecticut. On November 29, the taxpayer closed on the sale of her Connecticut home.
The taxpayer’s 2004 New York State income tax return was audited. The Division of Taxation determined that she became a New York resident on November 10, and that the contract for the sale of her Connecticut home contained contingencies, so that the gain from the sale of the Connecticut residence was not accrued before that date, and accordingly was subject to New York income tax. Because the capital gain was over $11 million, this was not an insignificant amount of tax.4
The taxpayer contested the proposed assessment in the Division of Tax Appeals. As far as the taxpayer and the Division of Taxation were concerned, the only issue was whether there were contingencies in the Connecticut contract, and this was the only issue presented at hearing.
But the administrative law judge saw the case very differently. The determination holds that the example in the regulation did not follow the federal income tax accrual rules. These rules would accrue the sale only upon a transfer of title or the passage of the benefits and burdens of ownership, whichever occurs first. It further held that the contingencies analysis is in the example but not the language of the regulation, and to the extent that the regulation is not consistent with the federal income tax accrual rule, “it is rejected and will not be considered for or relied upon for guidance herein.” The determination held that because the sale of the Connecticut home did not take place until after she became a New York resident, the gain was subject to New York State (and City) income tax. The determination abated penalties because reliance on the regulation was found to be reasonable.
The determination, although not precedent, is troubling. Tax law is complex. Taxpayers should be able to rely on regulations, and the examples in the regulations, in understanding the law and making decisions. The regulation was enacted 20 years ago, in 1992; one wonders how many transactions were structured by relying on the now discredited contingency rule set out in the regulation. One also wonders what other parts of this regulation may be subject to challenge.
In a more perfect world, regulations could not be invalidated to the taxpayer’s detriment. If this taxpayer had lost because the Division of Taxation could prove that that there were contingencies in the contract that were not resolved until she became a resident of New York, that result would be unexceptional. But for the taxpayer to lose because the regulation was thrown out and a new rule applied is disturbing.
It remains to be seen whether the result of this determination will be changed through appeal or otherwise. Taxpayers and their representatives will need to re-evaluate the validity of the remaining portions of the regulation and the examples in applying the accrual rule on a change of residence.
1 Matter of Glenna Michaels, DTA No. 823370. Determinations of administrative law judges finally decide the matter in controversy unless they are appealed to the Tax Appeals Tribunal. ALJ determinations are not considered precedent, and are not given any force or effect in other proceedings in the Division of Tax Appeals. New York Tax Regulation (20 NYCRR) section 3000.15(e)(2).
2 New York Tax Law section 639.
3 New York Tax Regulation section 154.10.
4 The Division of Taxation asserted tax of $811,735, interest of $206,005.10, and penalty of $144,343.54, for a total of $1,162,083.64. The computations apparently take into account a credit for Connecticut tax paid on the gain.