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Andrew Brucker on IRC Sec. 216
AUTHORAndrew Brucker, Montgomery McCracken Walker & Rhoads
PAGE #pp. 56-57
It is vital for boards to protect a co-op’s designation as a cooperative housing corporation under Section 216 of the Internal Revenue Code.
You might ask: what do taxes have to do with co-ops? The answer is: everything. Co-ops exist today because of the tax code.
If Section 216 applies and you are a cooperative housing corporation, which is defined in the tax code, then you get certain benefits. For example, shareholders can deduct their pro-rata portion of the interest paid on the underlying mortgage. They can also deduct their pro-rata portion of the real estate taxes. Another benefit, by the way, is that when you sell your apartment, you can get certain tax benefits on capital gains. You get an exemption up to a certain point.
So there’s a great benefit to being a cooperative corporation under Section 216. Probably 99 percent of all co-ops are created under the Business Corporation Law, but guess what? The law never uses the term “cooperative corporation.” That’s a creation of the tax law. This started in 1942, and it’s been amended since then, but this is part of being a co-op.
Now the reason I’m bringing up Section 216 is because many co-ops do things without thinking about the tax ramifications. Keep in mind, if you lose your status as a 216 cooperative corporation, you would lose all those benefits I just discussed. So keeping your status as a 216 cooperative corporation is very important.
I’ll give you some examples. We had a co-op that came to us, and one of the shareholders had expanded his unit substantially. In normal situations, you would just charge the owner some money to buy some additional shares. The problem is that the taxes are going to go up substantially. So if he’s just paying his pro-rata portion of those taxes because there’s additional shares, it’s not fair because everybody else is paying a great portion of those increased taxes. If you look carefully at Section 216, there’s an exception to the normal rule that will let you make a special allocation for taxes instead of regular maintenance. So that’s what we did. We said the shareholder alone pays the increase in taxes caused by the increase in his square footage. Because of that, the cooperative saved itself a lot of money. The shareholder is paying what is fair and equitable, and everybody goes home happy.
The other issue is space. Sometimes a shareholder wants to take on additional space, so the co-op assigns shares for use of a hallway or the roof. But you can’t just come up with any kind of number. Under Section 216, there has got to be a reasonable relationship between the assigned shares and all the shares in the building. In other words, you can’t do anybody a favor. It’s got to be fair and equitable for everybody. Some boards forget this, and they’ll just assign a certain number of shares. That’s not the way to do it.
The way to do it is to get an appraiser or real estate professional to say, “Yes, that extra 20 square feet in the hallway that he’s taking should be four shares.” If you get that letter and put it in the file, the Internal Revenue Service can never come and try to take away your classification as a 216 co-op.
Another problem is that co-op boards are giving out leases to commercial enterprises that are paying a lot of money. In the old days there was the 80/20 rule, which said that at least 80 percent of a co-op’s income had to come from shareholders, while no more than 20 percent could come from other sources, such as commercial rents, or the co-op loses its 216 status. Then the rules changed, leading many people to believe that the 80/20 rule is dead. It’s not dead. There’s the 80/20 square footage rule, which says you can ignore the income if your commercial space occupies less than 20 percent of your total square footage. There’s also the 90-percent-of-expenses rule. If a co-op is expending 90 percent or more on shareholder items – and not expenses having to do with that commercial space – you’re safe, too.
So if people tell you 80/20 is dead, don’t believe them. You have to be aware of how the rules have changed, because if you lose that 216 status, you will lose your deductions we discussed earlier. The moral is whenever you do anything in a co-op, consider Section 216. If you have any questions, speak to your accountant or your lawyer, and make sure that you’re not jeopardizing your status as a 216 cooperative housing corporation.
Andrew Brucker is a partner at Montgomery McCracken Walker & Rhoads.