On December 20, 2007, many co-ops were relieved from making the difficult decision of giving up thousands of dollars of rental income or risking the loss of their vitally important status as a housing cooperative under the federal tax laws. As a result of hard work by Congressman Charles Rangel and Senator Charles Schumer, on that date, the so-called “80/20” test defining co-ops was significantly modified – if not effectively killed – when a bill sponsored by the two legislators was signed into law by President George W. Bush.
The background: in order for co-op shareholders to (1) take income tax deductions for their share of a building’s real estate taxes, (2) deduct interest on the building mortgage on the loans secured by the shareholders’ stock and proprietary lease, and (3) shelter from taxes profits from the sale of apartments up to $250,000 for a single taxpayer or $500,000 for a married couple, the co-op had to meet the strict Internal Revenue Service (IRS) code definition of a “housing cooperative.”
One of the requirements of Section 216 of the code was that “80 percent or more of the gross income [of the corporation be] derived from tenant-shareholders.” Buildings with income from leasing stores, selling air rights or easements, or have income from any other non-shareholder source faced the loss of all tax benefits if that income were to exceed 20 percent of the co-op’s gross income. The provision has been described as a potentially dangerous fiscal precipice. If the co-op missed the ratio by even a single dollar, the co-op could fall off the metaphorical cliff and shareholders would lose all tax benefits.
The New Law
The new law added two tests to the IRS code for a corporation to qualify as a “housing cooperative.” A corporation may now qualify under any one of three criteria, including the original “80 percent of income” test.
The first additional test requires that “80 percent or more of the total square footage of the corporation’s property is used or available for use by the tenant-stockholders for residential purposes or purposes ancillary to such residential use.” This test would appear to help a five-story co-op with a major portion of the first floor leased to a store to qualify as a co-op no matter how much rental income it received from its tenant. The reference to “ancillary” space means that a garage, basement storage area, laundry room, or gym used or available for use by tenant-shareholders would count as “good” space under the formula.
The second new test allows a corporation to qualify as a co-op if “90 percent or more of the expenditures of the corporation…are paid or incurred for the acquisition, construction, management, maintenance, or care of the corporation’s property for the benefit of the stockholders.”
It is too early to know with certainty how co-op expenditures may be allocated under this paragraph. Some operating costs such as the real estate taxes, heating costs, and capital repairs will have to be allocated to any part leased to a commercial tenant. Other expenses, such as labor costs for services provided only to residential tenants, elevator costs if the commercial tenant does not use the elevator, heating and lighting of residential common areas, and any other expenditures that do not serve the commercial tenant may not have to be allocated at all. Future commercial leases will be structured to provide that, to the maximum extent possible, the commercial tenants will pay directly for costs attributable to their leased space. These would include separately metered electrical, gas and water charges, separate insurance coverage, and the like.
As with any tax law, there will always be subtleties of interpretation that may be critical, and these new provisions have not yet been subject to any IRS interpretations. Board members should not reach any conclusion about the effect of the new provisions without consulting their lawyer or accountant.
Qualifications Still Needed
Even though only one of the three tests must now be met, there still may be corporations that face issues in qualifying as a cooperative (check with your attorney, but some danger areas may be brownstones with first-floor commercial space or co-ops in which all the shareholders do not qualify under Section 216 for various reasons). Those co-ops may wish to explore the various methods used by buildings over the years when faced with the problem of having non-shareholder income that exceeds 20 percent of the building’s gross income.
Such tactics include: (1) working with a “friendly” unaffiliated entity to lease the commercial space from the co-op at a rental level assuring less than 20 percent of the co-op’s income; (2) selling shares to the commercial unit and qualifying that unit as a “co-op” unit; (3) seeking to increase the “good income” and decrease the “bad income” so that the bad becomes a smaller percentage of the total income; and (4) bunching all of the bad into a single payment to the co-op and thereby creating a short tax year in which the corporation would not be a qualified co-op for a limited time.
Each of the historical solutions has advantages and disadvantages. Some co-ops have created limited liability companies (LLCs) to lease their commercial spaces. They have offered their existing shareholders the opportunity to purchase interests in the LLCs but do not necessarily require it. The LLCs could operate at a profit because the rental income it would receive from a subtenant – the actual occupant of the space – would exceed the rent it pays to the co-op. However, there could be no guarantee of a profit, since at any time a tenant could move on. The LLCs would be required to pay rent whether or not they had tenants. Any profits realized by the LLCs would be distributed to their owners and would usually represent taxable income. Losses would have to be funded by those owners. There have been concerns that the interests of the LLCs may eventually differ from those of the co-ops (the use by the subtenant being one of the primary disagreements, for example), and there has been concern that if the LLCs simply become a mirror of the co-ops, the IRS could describe the entire arrangement as a sham.
Qualifying a commercial space as a co-op apartment, to which shares may be allocated and sold, requires strict adherence to rules laid down by the IRS. These relate to a different requirement of the code: that each shareholder of a co-op must “be entitled … to occupy [the unit] for dwelling purposes ….” If local zoning laws at a building’s location do not permit ground floor space or basement space to be used for residential purposes, it is difficult to properly issue shares to a first-floor or basement store in that building. However, if the zoning permits both commercial and residential use, and existing commercial space can, in the opinion of a licensed architect, be converted to meet building department requirements for residential occupancy at a cost of not more than 25 percent of the value of the unit, shares may be issued for the unit, sold to an owner, and the income from the sale and the maintenance received from those shares would be counted as good under 80/20.
Other co-ops with 80/20 problems have solved them by increasing their good and minimizing their bad income. Some have met the test creatively: through bulk purchases of electricity, internet access services, and cable TV for all apartments; via purchases of homeowners’ insurance for all shareholders; and by designing lease provisions requiring commercial tenants to be responsible for payment of many operating costs applicable to their units.
Finally, there are buildings that have solved their 80/20 dilemmas by carefully timing the receipt of a substantial amount of money to coincide with the creation of a short accounting year, during which the corporation is not, for that brief period, a qualified co-op under Section 216. For example, the corporation could require its commercial tenant to pay what would, in essence, be a prepayment of rent: a one-shot payment on a specific date, with rental payments for the remaining lease term to be a level of less than 20 percent of the co-op’s total income. The co-op could file tax returns in which it elects a one-time, short tax year. In that period, the co-op would record the receipt of the large rental income, and not qualify as a co-op for federal tax purposes. Its shareholders would not be eligible to deduct interest or real estate payments from their income taxes or shelter any profits from sales. Such an election must be made after careful consultation with the building’s accountants and attorneys, as well as with all shareholders to enable them to schedule projected sales of units around the short tax year.
That said, I expect that the new legislation will make the 80/20 problems easier to deal with for the majority of co-ops that have had to face these issues. For this circumstance, the co-op community owes a debt of gratitude to the efforts of our two “Charlies” – Rangel and Schumer – as well as to Mary Ann Rothman, executive director of the Council of New York Cooperatives & Condominiums. They have spent many years of hard work in solving this vexing situation.