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How can a co-op avoid paying high taxes on rental income from a high-market-value commercial space?
The primary section of the United States Internal Revenue Code concerning cooperatives is Section 216. Among other things, it allows the tenant-shareholders of a qualified cooperative to take a personal tax deduction each year for real estate taxes and mortgage interest paid by the corporation. It also specifies the rules for a corporation to qualify as a cooperative. The so-called "80/20" rule is among the requirements of Section 216 and, until it was changed in 2007, essentially provided that a corporation would not qualify as a cooperative under Section 216 unless at least 80 percent of its income was derived from its tenant-shareholders. Under this rule, income from commercial tenants paying rent to the corporation under leases was considered "bad income," in other words it could not be included in the 80 percent part of the 80/20 equation because the commercial tenants were not tenant-shareholders.
This created a problem for those corporations lucky enough to have commercial space valuable enough to generate more than 20 percent of the corporation's income each year. They wanted to collect all that rent to defray the costs of operation of the building and keep maintenance charges low, but they also wanted to qualify as a cooperative so their tenant-shareholders could receive their annual tax deduction and other benefits.
It would seem that they could either continue to qualify as a cooperative by setting the rents for the commercial space below the 20 percent threshold or collect the full market rents and lose qualification as a cooperative, but not both.
This is where creative lawyering came in. Law firms representing cooperatives created a variety of techniques to try to solve the problem, thereby allowing the tenant-shareholders to keep the benefits of both the high rents and the annual tax deduction; with various degrees of confidence that these structures would survive scrutiny by the Internal Revenue Service (IRS). It is no doubt fortunate that most of these structures were never examined by the IRS.
The affected cooperatives and their lawyers therefore heaved a collective sigh of relief when the 2007 amendment added two, new, alternative tests to the original 80/20 rule. Under these new tests, substantially all of the affected cooperatives were able to both collect the full market rents from their commercial space and qualify as a cooperative under Section 216. The obvious advice for cooperatives that had experienced this problem was to abandon the structures intended to sidestep the rule and start collecting the full market rents from the tenants. Although this sounds like the end of the story, simply collecting the higher rents was not a complete solution for one building that consulted us. In fact, had they chosen to do so they would have ended up losing much of the benefit in higher taxes. Sometimes, the obvious answer is not the right one.
In the case of this particular building, the commercial space made up only about 11 percent of the building. But it was so valuable that market rents for the space could easily cover all of the expenses of operating the entire building and still throw off a profit. In other words, the maintenance charges for the entire building could be eliminated and the building could not only live off the commercial rents quite comfortably, the shareholders could actually get a distribution of excess income each year.
As wonderful as that scenario sounds, there is a problem with all that income. For income tax purposes, only expenses related to the commercial space can be deducted from the co-ops rental income. Any income that is not offset by those deductions is taxable to the corporation. Since most of the building's expenses such as heating the apartments, most of the real estate taxes and debt service, repairs in the residential portion of the building, light and heat in the hallways have nothing to do with earning income from the stores, they cannot be used to offset the income. If the corporation collected all that income it would be subject to taxation at the corporate level. Then, when the excess was distributed to the shareholders, it would be income to them and subject to taxation a second time as a dividend. When you add the corporate tax rate to the personal tax rate on these funds, the double taxation would eat up the lion's share of the benefit.
We consulted with the board and its accountant about how to get around this problem and brought in special tax counsel to assist us in designing a solution. We helped evaluate the various solutions proposed and guided the board to what ultimately turned out to be the right solution for them: assigning shares to the commercial space and making it part of the cooperative. By doing this, the income from the stores was converted from commercial income that could be offset only by commercial expenses to member income that could be offset by all expenses.
The corporation was then in a position either to sell the newly assigned shares in the open market and deposit the proceeds of sale to the corporate accounts tax free, or to distribute to the shareholders ownership interests in an entity created to be the proprietary lessee of the space.
To accomplish this result, we needed to get various technical opinions concerning the space and its permitted uses, obtain a no-action letter from the Attorney General permitting the assignment of shares to the space, revise the proprietary lease to address issues posed by commercial use of a space by a shareholder and get a super-majority vote of the shareholders to approve the changes. This turned out to be a major win for the shareholders. Aside from the financial benefits, by carefully drawing the proprietary lease amendments we were able to put restrictions on the use of the stores to protect the apartments from being unduly disturbed by the commercial use.
From the desk of HS:
Something I do in my spare time.
Period spent renegotiating the terms of an offering plan to eliminate sponsor’s control of management.