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Congress Cooperates with Co-Ops

Congress Cooperates with Co-Ops On December 20, 2007, President Bush signed into law the Mortgage Forgiveness Debt Relief Act of 2007 (the “Act”). In addition to the forgiveness of debt provisions suggested by the title of the Act, the Act contains an important new rule that is extremely favorable to cooperative housing corporations (“co-ops”). The new legislation is effective for taxable years ending after December 20, 2007, which means that the new rules apply for 2007 calendar year taxpayers. In general, Section 216(a) of the Internal Revenue Code (the “Code”) provides that a tenant-stockholder of a co-op is entitled to deduct amounts paid or accrued to the co-op to the extent those amounts represent the tenant-stockholder’s share of the real estate taxes and interest on indebtedness paid by the co-op with respect to the property owned by the co-op. For example, if Luxury Towers, a co-op, pays real estate tax and interest on the mortgage on its property, and the maintenance charges paid by Abby, a tenant-stockholder, include $5,000 for her share of the real estate taxes and $4,000 for her share of the interest, then Abby can deduct such amounts on her personal federal income tax return. Both before and after the Act’s amendment, Section 216 of the Code requires that four criteria be met in order to qualify as a co-op. A co-op corporation must have only one class of stock outstanding. Each of the stockholders of the co-op must be entitled, solely by reason of ownership of the co-op stock, to occupy for dwelling purposes a house or an apartment in a building owned or leased by the co-op. No stockholder can be entitled to receive any distribution from the co-op not out of its earnings and profits, except on a complete or partial liquidation of the co-op. Fourth, as previously in effect prior the Act, the co-op was required to derive at least 80 percent of its gross income for each taxable year from tenant-stockholders. As amended by the Act, the Code requires that the co-op either meet the fourth requirement or one of two alternative tests. Under the first alternative test, a co-op can qualify if, at all times during the taxable year, at least 80 percent 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. Under the second alternative test, a co-op can qualify if at least 90 percent of the expenditures of the co-op during the taxable year are paid or incurred for the acquisition, construction, management, maintenance, or care of the co-op’s property for the benefit of the tenant-stockholders. Prior to amendment by the Act, co-ops typically met the first three requirements without difficulty. However, many co-ops—particularly those located in New York City—struggled not to run afoul of the requirement that at least 80 percent of the co-op’s income be derived from tenant-stockholders (the so-called “80/20 test”). Many New York City co-ops rent space on the lower floors to commercial tenants or lease garage space to parking operators and receive “bad” 80/20 gross revenues potentially exceeding 20 percent of the co-op’s gross income from all sources. In order to ensure compliance with the 80/20 test, co-ops often engaged in economically inefficient practices. The simplest approach to limit bad 80/20 income was to charge below-market rent to commercial tenants, such as by writing leases with a “safety cap” whereby rents would be capped at less than 20 percent of the co-op’s gross income for the year. In addition, to comply with the 80/20 test, many co-ops restructured their operations. For example, if a co-op rented space to an independent contractor to operate a parking garage on premises for the tenant-stockholder residents, the rent from the operator would be bad income for purposes of the 80/20 test. As a result, many co-ops provided these kinds of services to their tenant-stockholders directly, even though they had no desire to be engaged in such a business (e.g., operating a parking garage). Another common technique used to meet the 80/20 test involved allocating co-op stock to the commercial space in order to make the commercial tenant a tenant-stockholder of the co-op. As discussed above, one of the Code Section 216 requirements to qualify as a co-op is that each of the tenant-stockholders be entitled solely by reason of ownership of the co-op stock to occupy for dwelling purposes a house or an apartment in a building. An issue that arose with the strategy of having the commercial tenant as a tenant-stockholder of the co-op was whether the commercial tenant would be entitled to occupy the commercial unit for dwelling purposes. The IRS position on this issue has been that the strategy would not jeopardize the co-op’s status so long as the co-op could demonstrate that the tenant-stockholder would have a right as against the co-op corporation to use the unit for residential use if the unit was converted into a dwelling unit, and that conversion to residential use was physically feasible and permitted under local zoning laws. A further alternative structuring solution to the 80/20 problem was the creation of the so called “cond-op.” In this structure, the co-op’s property was separated into two condominium units: one containing the commercial units and one containing the residential tenant-stockholder units. The residential tenant-stockholder units would be retained by the co-op and would qualify as a co-op. The commercial units would be sold to a third party or transferred to a limited liability company or partnership owned by the tenant-stockholders. By bifurcating the commercial units from the residential units, the income from the commercial units would flow to the tenant-stockholders, but never to the co-op itself, thus eliminating the 80/20 problem. However, creating a cond-op structure often involved substantial tax costs as well as significant operational complexity. In order to separate the commercial units from the residential units, the co-op needed to distribute the commercial units to its tenant-stockholders. This distribution would ordinarily result in taxable income both at the co-op entity level and at the tenant-stockholder level. The common 80/20 problem also affected the investment of a co-op’s reserves. A co-op typically will invest its capital reserves to generate a return before such funds are needed for building maintenance or capital improvements. Most investment returns are treated as bad 80/20 income; however, tax-exempt income is excluded from gross income for purposes of the 80/20 test. Therefore, if a co-op generated bad 80/20 income from investing in non-tax-exempt instruments, the amount of other nonqualifying income, such as rent, that the co-op can receive from its commercial tenants would be reduced. For example, if a co-op received 5 percent of its gross income from investments, it could receive no more than 15 percent of its income from commercial tenants in order to qualify as a co-op. Consequently, the tax rules of Section 216 of the Code led to distortion in economic behavior as many co-ops eschewed higher returns and balanced portfolios in favor of investing in tax-exempt instruments generating lower returns. Congress’s stated intent in loosening the 80/20 test was to allow co-ops to rent space to commercial tenants at market rates. Congress had become aware that, in order to meet the 80 percent income requirement, some co-ops were renting to commercial tenants at below market rates in order to keep such rental income below 20 percent of the co-ops gross income. Congress believed that the tax law should not create an incentive to charge below-market rate rents and acted to ameliorate this unintentional effect of the 80 percent gross income requirement. For non-co-op buildings wishing to become co-ops, it will be much simpler and more efficient to structure operations to comply with the requirements of Section 216 of the Code than under previous law. With respect to currently operating co-ops, almost all will satisfy at least one of the new tests. Those co-ops with below-market or safety cap commercial leases will, upon renewing existing leases or entering into new ones, negotiate for market-rate rent. Co-ops that have specifically structured their operations so as to satisfy the 80/20 test should reassess whether such structures continue to be desirable in the event the co-op can qualify under one of the new alternative tests.