New York's Cooperative and Condominium Community

Habitat Magazine Insider Guide



The Consequences of Conversation

The following is a redacted version of a memorandum attorney Joel E. Miller prepared for a New York City client considering conversion from a cooperative to a condominium. “As you will see,” he said in a note to Habitat, “it deals with only the simplest situation. For example, there are no stores or other non-residential spaces.” Nonetheless, we found it informative for those considering a switch. (Note: the “xxx” in the text indicates copy that has been removed for reasons of confidentiality.)


The essential facts, I have been advised (but have not personally verified), are as follows. The corporation is a New York corporation that is a “cooperative housing corporation” as defined in Section 216(b)(1) of the Internal Revenue Code (hereinafter, respectively, a “qualified housing cooperative” and “the code”). The corporation owns the land and building at xxx (hereinafter, “the premises”). The building is an apartment house that contains xxx residential apartments, one of which has no shares allocated to it and is occupied by the superintendent. The other xxx apartments are held cooperatively (meaning that each has a certain number of the corporation’s shares allocated to it and is the subject of a proprietary lease from the corporation to the shareholder). Of the xxx cooperatively held apartments, xxx are occupied by their owners as their “principal residences” as that term is used in Section 121 of the code (hereinafter, “Section 121 principal residence”), the meaning of which is discussed below.

In addition to the xxx apartments, the premises contain various amenities – a swimming pool, for example – but contain no space that is neither an apartment nor auxiliary to residential use. The premises are subject to a mortgage held by Gracious Lender, the remaining principal balance of which is approximately xxx.

I have been asked to (1) describe briefly the steps that would normally be taken to convert the premises from the cooperative form of co-ownership to the condominium form of co-ownership and (2) outline the most likely federal income taxation of such a conversion.

What is a condominium? Before addressing those matters, I believe it will be helpful to review the legal nature of the condominium form of co-ownership of real property (which, it should be noted, is vastly different from the legal nature of the cooperative form of co-ownership of real property).

In a normal residential condominium, which is the type that is being considered, each apartment owner directly owns a piece of real estate known as a “condominium unit,” which consists of a physical apartment. For property law and real estate tax purposes, each condominium unit is treated the same as a one-family house. As an important example, each unit-owner receives his own real estate tax bill and has no responsibility for his neighbors’ real estate taxes. Also, in a condominium (unlike in a cooperative) there is no building-wide mortgage; rather, each unit-owner is entitled to mortgage his unit for as little or as much as he wishes.

Each unit has associated with it a fixed percentage – technically known as its “common interest” but hereinafter referred to as that unit’s “ownership percentage” – that, generally speaking, corresponds to that unit’s percentage of ownership in the entire property. Naturally, the sum of all of the units’ ownership percentages must be 100 percent. In the case of the premises, each unit’s ownership percentage would be derived from the number of the corporation’s shares allocated to the apartment.

In a normal condominium, all of the property not included in one of the units – typically, this would include the land, the lobby, the roof, the outer walls, the staircases and elevators, any areas like a laundry room, a swimming pool, a superintendent’s apartment, the boiler room, and the heating plant – is known as “the common elements.” Legally, each unit-owner automatically owns his ownership percentage of the common elements and is entitled to the use of the common elements so long as his use does not interfere with the use thereof by the other unit-owners.

A condominium comes into existence when the owner of the property – in this case, the corporation – signs and records in the appropriate public office a document called a “declaration.” Among other things, the condominium declaration must describe each unit and give it a designation. It also must state that unit’s ownership percentage. The declaration must have attached to it a set of bylaws for the governance of the condominium. At the time the declaration is recorded, there must be filed in the same office a set of “as built” plans for the building.

Although in a condominium, unlike in a cooperative, there is no corporation that owns the property, there is an unincorporated association made up of all of the unit-owners. This association is controlled by a group known as the condominium’s “board of managers.” The board functions in a manner similar to that of the board of directors of a corporation.

Still, as indicated above, in many ways it has less power than the board of directors of a cooperative corporation. The managers are elected by the unit-owners, voting by their ownership percentages. In a manner similar to what occurs in a cooperative corporation – but obviously covering much less – the board of managers adopts a budget, and each unit-owner must pay his share each month, which share is normally determined by the units’ relative ownership percentages.

The board of managers also has power to assess the unit-owners for additional amounts if needed. The board of managers can, and usually does, hire a professional managing agent to operate the property, as well as a lawyer, an accountant, and possibly other professionals.

The condominium’s bylaws deal with, for example, the procedures for calling meetings of the unit-owners and the board of managers, the procedures to be used in nominating and electing managers, the specific powers of the board of managers and any limitations thereon, and any restrictions on the use, renting out, or transfer of units. There can be great variation from condominium to condominium as to such matters. Commonly, the board of managers has a right to purchase, on behalf of all of the unit-owners, any unit that is being offered for sale. This is known as the condominium’s “right of first refusal.”

The conversion procedure. The following is a brief description of the procedure that the corporation would most likely use to effect a conversion of the ownership of the premises to the condominium form of ownership. There might be some small variations, but in broad outline the procedure would be as follows:

As a first step, an outline would be drawn up and presented to the corporation’s board of directors. If the board decided to proceed, the outline would be submitted to the shareholders, and, if enough shareholders approved, drafts of the necessary documents would be prepared. In particular, a declaration and bylaws would be drafted by an attorney. An application would then be made to the state attorney general for a so-called “no action letter.” If such a letter were not issued by the attorney general, it would be necessary to prepare and process a complete offering plan. Only after the no-action letter had been issued or the plan had been declared effective, as the case may be, would an application be made to the city surveyor to assign a separate tax lot number to each of the proposed xxx condominium units. Once that was done, the condominium could be established by recording the declaration and bylaws and filing “as built” plans.

As described above, the premises would at that point in time be conceptually divided into xxx units and the common elements. However, there would not yet be any change in ownership, inasmuch as all of the units (and, of course, all of the interests in the common elements) would still be owned by the corporation.

Then the following five steps would occur, conceptually all at the same time:

(1) The corporation would pay off the mortgage (the necessary funds to be obtained as described below).

(2) Each shareholder with a loan secured by his apartment would pay it off and receive back from his lender his stock certificate and his copy of the proprietary lease for his apartment (again, the necessary funds to be obtained as described below).

(3) Each shareholder would turn in his stock certificate and his copy of the proprietary lease for his apartment, after which the shares would no longer be outstanding and the appurtenant leasehold would cease to exist.

(4) The corporation would deed the appropriate condominium unit to each former shareholder.

(5) Each former shareholder, now a unit-owner in the condominium, would obtain a mortgage loan on his unit and use the proceeds (a) in part to pay to the corporation his share of the funds needed by it to pay off the mortgage on the premises, as described in Step 1, to pay other necessary expenses and to pay the income tax that would result from the conversion, and (b) if necessary, in part to pay off any individual loan secured by his cooperative apartment, as described in Step 2. He might possibly take out a large enough loan so as to have funds left over for use for other purposes.

Later on, the corporation would pay (or set aside funds to pay) its remaining liabilities and transfer any personal property and unneeded funds to the condominium association.

This assumes that all shareholders would be taking part in the conversion. However, if there were any who wished to remain as cooperative apartment owners, they could be accommodated. The corporation could remain in existence and continue to operate as before. The difference would be that it would no longer own the entire premises but would instead own only the condominium units containing the apartments that were the subject of those shareholders’ proprietary leases (and as such would be a member of the condominium association). It would also be possible for some or all of those shareholders to convert at one or more later times if agreed to by the corporation.

Income tax consequences. The balance of this memorandum will outline the probable income tax effects for the corporation and for each shareholder taking part. There will be separate discussions of the corporate-level situation and the shareholder-level situation. It will be essential to bear in mind the following three points that are both (a) of great importance and (b) unfortunately, somewhat technical in nature:

(1) Notwithstanding that we are talking generally about a building-wide conversion, what would really be happening would be that the corporation would be entering into a separate transaction with each participating shareholder. As indicated above, there may be as many as xxx of such transactions, in each of which the shareholder would surrender his shares to the corporation and receive from the corporation a condominium unit in exchange.

(2) As to each of those separate corporation-shareholder transactions, the income tax results for the corporation and the income tax results for the shareholder might be dramatically different from one another.

(3) The income tax results of any particular corporation-shareholder transaction – for the corporation and/or for the shareholder – might be very different from the results of other such transactions.

In short, every corporation-shareholder transaction must be separately analyzed to determine both (a) the likely income tax results for the corporation and (b) the likely income tax results for the shareholder involved.

The corporate level. As to the likely corporate-level income tax results of each transaction, the general rule is easy enough to state. When a corporation transfers property to a shareholder in redemption of his shares, the corporation is, unless a special rule applies, taxed as though it had sold that property for its then fair market value. In our situation, the property transferred by the corporation would be a condominium unit with both a high market value and a very low tax basis. It would follow that, if no special rule saved the situation, the corporation would have agreat deal of taxable income as a result of each redemption, which income would be taxed at a rate not far below 50 percent.

As to some of the redemptions in our situation, there is a special rule that would in fact relieve the corporation of having to pay the tax that would otherwise be incurred (regardless of the value of the condominium units). The special rule is this: there is no corporate-level income tax on a particular redemption by a qualified housing cooperative if the subject apartment was at the time of the redemption the shareholder’s Section 121 principal residence.

Based on the assumptions stated at the beginning of this memorandum, it would appear that the corporation would incur no income tax on the vast majority of the redemptions. On the other hand, some of the redemptions clearly would not come within the special rule. No redemption would qualify where the apartment, even though owned by an individual, was not his Section 121 principal residence at the time of the redemption. In summary, it appears likely that the corporation would become liable for some appreciable amount of income tax, but not nearly the prohibitive amount that would become due if the special rule did not apply.

Before we look at the shareholder-level situation, two important points should be noted. First, relief from corporate-level taxation under the special rule does not depend on whether or not the shareholder qualifies for relief from taxation; in other words, the corporation might be excused from tax on account of a particular redemption even if, from the shareholder’s standpoint, the transaction is fully taxable. Second, the special rule can apply to a particular redemption even if, for some reason, the shareholder involved does not qualify as a “tenant-stockholder” as defined in Section 216(b)(2) of the code.

The shareholder level. From each participating shareholder’s point of view, he would be treated for income tax purposes as having exchanged his cooperative apartment for a condominium apartment of the same value. We must begin with the basic income tax rule that applies generally whenever a person exchanges property for other property. The rule: he is treated for this purpose as if he had sold his property for its fair market value and then used the proceeds to purchase the other property. Thus, depending on his tax basis, he may have a taxable gain.

(It is worth noting that his tax basis in the new property would be its fair market value at the time of the exchange, so that, unless it thereafter increased in value, he would have no further taxable gain in a sale of the new property.)

As in the corporate-level situation, there are some special rules that might exempt a shareholder in this situation for some or all of his otherwise taxable gain. There is a special rule that might apply to a shareholder holding his apartment for an income-seeking purpose – as, for example, renting it out – and a different special rule that might apply to a shareholder holding his apartment for purely personal purposes. The income tax situation of each type of shareholder is discussed below.

Income-seeking-use shareholders. Such a shareholder might be able to look to Code Section 1031 for relief. That section provides: “No gain ... shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.” But there are real issues. Among other things, the section itself says that it is not applicable to exchanges of “stocks.”

Nevertheless, notwithstanding that there is no binding authority on the point, it appears that the Internal Revenue Service will consider a New York cooperative apartment “real property” for this purpose and therefore exchangeable for a New York condominium unit, which is undoubtedly realty. Accordingly, it is likely that such shareholders would not have any reportable gain.

Personal-use shareholders. Under Code Section 121, a shareholder, if a “tenant-stockholder” as defined in Code Section 216(b)(2), can elect to exclude up to $250,000 of gain ($500,000 in the case of a couple filing a joint return) if the conditions of that section are satisfied. There are three separate two-year requirements:

(1) During the five years preceding the transaction, the taxpayer and/or the taxpayer’s spouse must have owned the apartment as such as a “tenant-stockholder” for periods aggregating at least two years.

(2) During the five years preceding the sale, the taxpayer and/or the taxpayer’s spouse must have used the apartment as the principal residence for periods aggregating at least two years.

(3) The taxpayer must not have utilized Section 121 in respect of any sale within two years prior to the subject transaction.

As used in Section 121, whether or not an apartment is at any point in time the principal residence is a factual inquiry. In general, the test is whether or not that is where the person actually resides. If he has no other residence, there can be no real issue about this.

As it might be important to some of the corporation’s shareholders, it should be noted that the two years of ownership need not coincide with the two years of principal residence use.

Possibly of even more significance for a shareholder who moved out in the not-too-distant past but kept ownership of the apartment, there is no requirement that the apartment be the Section 121 principal residence at the time of the transaction. (As noted above, such a requirement does exist as to the special rule applicable to the corporation.)

It should also be borne in mind that Section 121 contains a number of special rules that apply in certain circumstances – as, for example, where completion of a required two-year period is prevented by unforeseen matters outside of the taxpayer’s control.

As noted above, Section 121 can shield gain of up to $250,000 per person ($500,000 in the case of a married couple filing a joint return). If the gain were larger, the shareholder might have to pay income tax.

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