Saving Taxes on Air Rights?

When I joined my co-op board a few years ago, I did so with the naive expectation of being able to end our building’s “spending problem.” I quickly learned there was little we could do to cut spending short of rationing hot water. What our building has is a revenue problem. We need more money to cover our costs. Unfortunately, increasing shareholders’ maintenance fees seems to be our only way for raising revenue and doing so, of course, would not endear us board members to our fellow shareholders.

Some of our more fortunate neighbors have found another way to fix their revenue problems – by turning their buildings’ air rights into fortunes. Air rights, with few exceptions, are transferrable only to neighboring buildings. This makes a building’s air rights valuable to the extent the building itself – or surrounding buildings – need the air rights for constructing up. If your neighbor is a deep-pocketed real estate developer, you have a potential fortune on your hands.

With that potential fortune come brokers and real estate and land-use attorneys who can help make the deal happen. There are also people like me, tax attorneys, who ordinarily work behind the scenes to help a building keep what it earns.

A poorly structured air-rights sale can result in tax at rates north of 60 percent. A building that thought it was netting $10 million can end up netting less than $4 million. The reason this happens is because cooperative apartments are structured as “C” corporations, which are probably the costliest way of doing business.

As you may know, businesses today tend to be organized as limited liability companies, or “S” corporations. Owners of such businesses have significant advantages relative to owners of C corporations. First, the former are taxed once on their capital gains whereas the latter are taxed twice (once at the corporate level, then again at the shareholder level). Second, the former enjoy a discounted capital gains tax rate of 20 percent, while the latter do not.

The reason co-ops continue to be organized as C corporations is because the rules and procedures for cooperative corporations developed during the early 20th century, before the advent of more tax-efficient means for structuring businesses. Because cooperative apartments are not organized for making money, the costliness of operating as a C corporation ordinarily is not apparent. This becomes apparent only when the building has an opportunity for making money, as it may have with an air rights sale. This is where tax planning can create meaningful savings.

There are three common ways to save on taxes when structuring an air-rights sale, each with its pros and cons:

The cash sale. This may be the most common technique for transferring air rights. With this approach, the building sells the air rights for a single cash payment and pays tax at the entity level at a rate of approximately 50 percent. This rate results from the sum of real-estate transfer taxes, as well as the corporate taxes on the gain. The advantage to be gained here is that the corporation retains the net sale proceeds, thereby avoiding the second layer of taxes that shareholders would have to pay if they received a dividend.

The promissory note. This offers a few advantages over the cash sale. First, the corporate taxes on the gain are due only when principal payments are made to the co-op. Second, when principal payments are eventually made, they might be made in relatively small increments, thereby permitting more of the gain to be taxed at lower brackets. Third, promissory notes feature interest payments, which can provide the building with an added source of revenue.

The like-kind exchange. This offers perhaps the greatest tax savings. With this approach, the building reinvests its sale proceeds in investment property – for example, nearby commercial real estate – and potentially does not incur any city, state, or federal corporate taxes on the gain. The challenge with this approach is making sure the building continues to qualify for the few tax benefits available. These include permitting the shareholders to deduct real estate taxes paid by the cooperative corporation. A building that acquires too much investment real estate risks forfeiting such benefits.

The tax rules for cooperative corporations are complicated; the tax rates on their earnings are confiscatory. My hope is that co-ops presented with this type of opportunity will be proactive on managing their related tax costs. Otherwise, the government will end up earning the most money on an air-rights deal.

Jason Kleinman is a partner in the law firm of Herrick Feinstein.