Flipping Over Flip Taxes

One of the greatest challenges a co-op board faces is maintaining an operating budget at breakeven or better while managing the longer term issues of the capital budget which covers the repair and replacement of the building's equipment and systems

The economic environment in which co-ops exist has changed dramatically in the last 18 months - insurance costs have skyrocketed since the terrorist attacks of September 11, 2001; property taxes in New York City went up by 18.5 percent; and energy costs hit record highs as winter temperatures went below freezing and stayed there for long stretches. In addition, a new labor agreement is in the offing that will surely to entail some increase in wage costs.

"I don't know of any costs that aren't going up," says Edward Seh, president of a 183-unit co-op at 165 East 72nd Street. "I think the handwriting is on the wall for us. We need to find another way to generate revenue so that we don't get caught off guard when we need to do capital improvements."

It's no wonder, then, that Seh, like many of his counterparts, is engaged in a campaign to pass a flip tax in his building to bring in new revenue to strengthen the building's finances.

"Most co-ops have looked at a flip tax over the last five years," says Allen H. Brill, a partner in the law firm of Brill & Meisel. "We represent over 100 co-ops and at least half of them have a flip tax of one kind or another."

A flip tax is money collected by the co-op when an apartment is sold and the shares are transferred. Over time, it can strengthen the finances of a building. It is not, however, a quick fix for immediate problems.

Because the tax occurs only when an apartment is sold, it reduces the amount of money a seller realizes on a sale. Getting one passed is not easy. "It's like the issue of abortion rights," says Michaele McCarthy, a senior account executive at Charles H. Greenthal Management. "It's one of the most divisive issues you can raise in a building."

Flipping Over Transfers

The term "flip tax" is actually a misnomer. A flip tax is really a transfer fee. They were originally instituted in the 1970s, when numerous recently converted buildings were looking for a way to capture some of the windfall profits speculators were making on the difference between an insider's price and what an apartment could sell for to an outsider. People were buying and flipping units and the co-ops felt entitled to a piece of the action. The name stuck.

Sponsors encouraged fledgling boards to pass flip taxes because the funds collected would increase the co-op's working capital, thereby strengthening the co-op and protecting the value of a sponsor's residual interest in the building and making it easier for them to sell their unsold inventory of apartments. Sponsors were also exempt from paying flip taxes.

Court challenges to the validity of the flip in 1985 resulted in a decision that essentially reversed the taxes charged to selling shareholders. The prospect of having to repay the taxes collected spurred co-ops into action. An emergency lobbying effort led by the Council of New York Cooperatives & Condominiums brought about the passage of Chapter 598 of the Laws of 1986 in New York State. An amendment passed in 1986 to Section 501(c) of the business corporation law, this law enables co-ops to enforce any form of flip tax if it is written into the original offering plan or its subsequent amendments or if it is adopted as an amendment to the proprietary lease.

Flip taxes passed by boards alone are not valid. If a flip tax was not already included in the original documentation, it must be approved by the number of shares required to make changes in the bylaws and the proprietary lease. In most co-ops, changes to the critical governing documents, including the proprietary lease, require approval by at least two-thirds of the shares and in some buildings the critical threshold is 75 percent. Getting to "yes" may not be easy for boards trying to implement a tax.

Proponents of flip taxes couch their arguments in terms relating to maximizing the value of a shareholder's investment in the building. They point out that buyers place higher values on apartments in buildings with strong reserve funds, and low maintenance relative to a peer group of comparable apartments.

At 340 Riverside Drive, a luxury building on the Upper West Side, the flip tax is 10 percent of the net profits that a seller realizes on a sale. The only deductions allowed from the selling price in calculating profit are the costs of buying and selling. The costs of improvements made to the apartment are not allowed as deductions. The tax was written into the offering plan and proprietary lease when the building went co-op. "Our maintenance is 15 percent below comparable buildings," says Brill, who is also a member of the 340 Riverside Drive board.

"The maintenance on a 'classic six' on the tenth floor in our building is currently about $1,400. Even if we have an increase and that goes to $1,800, we will still be on the low end of the market range," he notes. "If a shareholder is able to sell his apartment for 10 percent more because the maintenance is 10 percent to 15 percent lower than the market as a result of the building being able to collect additional revenue from flip taxes, then it seems that everybody comes out ahead."

The financial stability that the income from a flip tax provides a building is cited as another benefit. "Imagine two identical apartments in two identical buildings, both with the same infrastructure in the same good current condition and both with the same maintenance," says Dan Douglas, a broker with the Corcoran Group. "Now, one has a flip tax and one does not. Which one would I put my mother in? It's going to be the one with the flip tax because I don't want to expose her to major assessments down the road. Nobody likes unpleasant surprises. In buildings where the maintenance is high, a flip tax is even more important. Assessments on top of high maintenance can be very difficult for some shareholders."

The income that a flip tax provides to a building can be significant. Brill cites the hypothetical case of an apartment purchased for $250,000 20 years ago and selling for $1 million today.

"How much a building receives will depend on the type of flip tax they have," he says. "Let's say it is a per share charge of $100 per share and the apartment represents 150 shares. The building collects $15,000. If the tax is 10 percent of the profit and closing costs are $100,000, then the building collects $65,000. A percentage of the selling price of three percent would net the building $30,000.

Any one of those numbers is a significant benefit to a co-op. If you assume there is one sale per year and the budget for the building is $1 million, then in this hypothetical example the building would have to collect from 1.5 to 6.5 percent less in maintenance or they can put that money into a reserve fund to cover capital costs when they arise and avoid having to assess the shareholders."

Each type of tax has its own drawbacks. The per-share charge is regressive. In the example above, the person who sold after 20 years would have a gain of $750,000 and pay $15,000 or 2 percent. Someone who bought two years ago for $900,000 and sold this year for $1 million would have a gain of $100,000 and the $15,000 tax would be 15 percent of their gain.

Calculating the tax as a percentage of the profit can lead to disagreements over what is allowed as a deduction. By not allowing improvements to be deducted, Brill's building has simplified the matter greatly. But in buildings where improvements are allowed to be used to increase a seller's costs, there are other issues to consider. What is an improvement and what is acceptable documentation? Do extensive repairs to the walls performed as part of a paint job count as a capital improvement? Does a bathroom installed 15 years ago have any real value as an improvement today?

When the tax is a percentage of sale price, a major question is what happens if the seller sells for less than he paid for the apartment? Also, sellers and buyers are encouraged to find a way to beat the tax. The sale price in the official documentation, using the example above, might be $500,000. Through a side arrangement not disclosed to the co-op the seller might sell "the improvements" to the apartment for another $500,000. The Council of New York Cooperatives & Condominiums recommends that buildings with this kind of flip tax get an affidavit from buyers and sellers that all the consideration in the transaction is reflected in the documentation provided to the co-op.

Just Do It

When asked to explain why the co-op is entitled to take a share of the money a seller receives from a sale, flip tax proponents cite a number of justifications. Many believe that the departing shareholders should reimburse the co-op for their portion of the deterioration of the building's infrastructure that occurred during their time in the building.

"Buildings wear out, elevators need to be replaced, roofs have to be fixed. That work may need to be done after a shareholder leaves but the deterioration took place while they were living there. They should pay for that," says Milton Norman a real estate lawyer and resident of 50 Riverside Drive in Manhattan. "You could have someone live in a building and never get hit with a maintenance increase or an assessment for improvements and then move out," says one managing agent with several client co-ops in older buildings. "It's only fair that they pay something towards the long-term upkeep of the building."

Another argument is that it is a relatively painless way to collect money for the co-op. When a sale is made, there is usually plenty of money changing hands and a flip tax will hardly be noticed. In the case where the apartment is being sold with a gain to the seller, a flip tax is a way to compensate the co-op for its contribution to the value of the apartment. Apartments in buildings with sound finances, in good repair, with strong curb appeal, and clean and attractive lobbies and hallways, command higher prices. Since the seller would probably not be getting the same price for an apartment in a lesser building, they should share the benefit with the co-op.

"It's particularly galling for shareholders who don't sell to see their neighbors take huge profits out of their apartment and sale and walk away," observes Brill. "All that value didn't come from the new kitchen the seller installed. In fact, in higher-end apartments the buyer is likely to rip out all the new construction the seller has done so that they can do it their own way to their own taste."

The Arguments Against

"If I have paid the maintenance, paid any assessments, and done everything else that is required of me as a shareholder, then why is the building entitled to any of my sales proceeds?" asks one former co-op owner who helped to fight off a flip tax in his building for several years before selling. "It's a 'taking' by the quasi-government of the co-op. They see you are getting money and they want some. You can't stop them; it's almost like graft."

If the tax is intended to cover the deterioration in the infrastructure, then shouldn't that be quantified? No matter what form the tax takes, it is arbitrary and not levied in proportion to any costs actually incurred in the building.

The dollars paid for a per-share fee today are much lower in value than those paid ten years ago. Later sellers pay less in real dollars than what the earlier sellers paid for their use of the infrastructure. So different sets of shareholders pay different prices.

With a tax on profit you could have two sellers of similar apartments, who bought and sold at the same time receiving very different prices and thus paying very different flip taxes. Yet they both spent the same time in the building and presumably used up the same amount of infrastructure.

If you take using a percentage of the selling price, proportionality is again a question. Consider the case of a family of four that sells its small apartment for $400,000. At the same time in the same building, a large apartment occupied by a single person sells for $1 million. With a three percent tax, the smaller unit's seller would pay $12,000 and the larger apartment's would pay $30,000. Yet the family of four is likely to have used up four times as much infrastructure as the single shareholder in the larger apartment.

Another argument is that shareholders are treated differently. Selling shareholders are punished for leaving while those who stay gain a benefit simply by not leaving. "I was a board president for ten years, and I always opposed a flip tax," says Steve Kessler, director of operations for John J. Grogan & Associates.

His chief objections, though, have to do with the fact that sponsors are exempt from flip taxes. "They are holders of unsold shares and they have preferential treatment. To me, it always seemed like a way to make the shareholders pay to improve the finances of a building so that the sponsor could profit."

Issues to Consider

The following questions are among the issues often raised when considering a flip tax:

Who pays? "The only time I have seen flip taxes become a problem in a sale is when it is unclear who will pay it," says Douglas. "If the buyer and seller have agreed on a price and all of a sudden the buyer is told he has to come up with more money, he or she is not going to be happy."

For a number of reasons, including protection from running afoul of the 80/20 rule, the seller pays the flip tax to the co-op. There is nothing preventing the seller from collecting the amount from the buyer, however. It just needs to be discussed.

"If you have commercial space in the building and 80/20 compliance is an issue for your building, you definitely need to have the money being paid by the seller," says Abe Kleiman, a principal in the accounting firm of Kleiman & Weinshank, referring to Section 216 of the Internal Revenue Code that precludes co-ops from collecting more than 20 percent of their revenue from non-shareholders (see "Seeing 20/20 on 80/20," on p. 40).

It is an issue for co-ops with commercial tenants. "Compliance with the 80/20 rule is extremely important. It's what allows shareholders to deduct their portion of the building's property taxes and mortgage interest on their personal returns," says Kleiman. "Good income comes from shareholders and bad income comes from non-shareholders. You definitely want the flip tax money to come from the seller who is a shareholder and not from the buyer who is not yet a shareholder."

Where does the money go? Given that flip taxes are an irregular and unpredictable income stream, many co-ops consider the funds money to be added to the reserve funds as it is collected. In fact, many buildings look at flip taxes strictly as sources of capital. Others see them as a benefit to the co-op and feel that they should be used in whatever way needed.

"I don't think you should restrict what gets done with the money says Brill. "Let the board decide how to use the money in the best way possible. Using it for operations can lower maintenance and that can be a real benefit to all shareholders."

How does a flip tax affect sales? "I have never had anyone tell me to show them only apartments in buildings with flip taxes," says Douglas. "And I have never had anyone tell me to show them only buildings without flip taxes. Most people are aware of them and they don't feel strongly one way or another and the absence or presence of a flip tax won't affect whether or not someone buys a particular apartment."

An East Side Story

"I have been on the board in my building for 20 years," says Seh. "I remember when our treasurer and president had to sign personal guarantees with the bank to get financing for our building. That should never happen again."

In the time since then, Seh, who has been president for the last 16 years, has seen the value and financial health of the building steadily increase. "I think we are the only building in New York that gave its shareholders three maintenance-free months in 2000 and 2001 and two free months in 2002. We replaced the windows in the building with no cost to the shareholders, put in new elevators without an assessment, and refinanced the mortgage to bring our interest rate down from 12.5 percent to 6.5 percent," he says. "Also, we did not assess the property tax abatement rebates for two years and we are in the midst of a lobby renovation."

The building's reserve fund that had been over $3 million is now below $1 million and Seh feels it is time to protect the future finances of the co-op. "The brokers keep telling me that the values of the apartments in the building are going up, the shareholders have all gotten plenty of benefits from the co-op over the last couple of years, I don't see how they can complain about putting something back when they sell."

Seh is campaigning for a flip tax of one percent of the sales price. "We don't have a lot of turnover in the building, so it's not going to generate a huge amount of money overnight. What it will do, though, is continue to rebuild the reserve fund so that we don't have to be concerned if we need to finance a major project."

Seh's chances of succeeding appear to be good. In 1998, at an annual meeting, the shareholders approved amendments to the bylaws and the proprietary lease that lowered the required number of shares for major decisions (such as the implementation of a flip tax) from two-thirds of the shares to 51 percent. "It's not a given that we will win," says Seh, "the board is with me, but the shareholders may not go for it."

A West Side Story

Getting a flip tax passed even in the best of times is not easy, as the story of 50 Riverside Drive illustrates. This 94-unit prewar building at West 77th Street has seen steady increases in apartment values and regular turnover for the last several years.

"Our goal was to pass a two percent tax on sales price," says John Myers, the building's treasurer and head of its engineering committee. Once the board approved the idea, they began a campaign in the summer of 2001 to educate the shareholders to the benefits of the tax and to encourage a building-wide dialogue about the proposal so that all views, for and against, could be heard and discussed at open meetings.

"Anticipating some of the standard arguments against flip taxes, we tried to address concerns that such a mechanism favors one 'class' of shareholder over another and to demonstrate that a flip tax is, fundamentally, a 'deferred assessment' that every seller pays at the time of sale when funds are available as opposed to unexpectedly, when unanticipated capital assessments can cause real financial hardship and affect household budgets," says Myers.

"We prepared materials that showed shareholders how much would have been raised by a flip tax over the previous five years if we had had the tax in place," he adds. "Next, we showed shareholders what capital projects we had undertaken during those five years and capital projects we expected to have to fund over the next three- and five-year horizons. The money that would have been raised if we had had the tax in place would have comfortably covered the cost not only of the work that had been done but also all the work that would need to be done for the next three years without capital assessments." The board also provided a list of 124 comparable buildings that all have flip taxes.

Unfortunately for the flip tax proponents, the building's bylaws require approval from 75 percent of the shares to effect a change in the lease. "We got about 72 percent of the shares to approve," says Myers. "It was so close that we decided to try again a few months later, but the second time around we got even fewer votes due to the activism of opponents of the flip tax."

"It was basically a clash of short-term perspective and the long-term view. People who expect to stay in a cooperative for the foreseeable future take the longer view about building capital funds and financial stability. If shareholders, whether young families thinking of moving up or retirees thinking of cashing out, see themselves as relative short-timers in the building, they don't see that it's in their interest to have a flip tax.

"Several of the opponents of the flip tax did, in fact, sell at the peak of the market and a pro-flip tax shareholder suddenly became an anti-flip shareholder when he became a seller due to relocation. What they fail to see is that a building with a history of frequent assessments and low or diminishing capital reserves raises red flags with buyers that, particularly in difficult markets, lowers sales prices. Most buyers see a flip tax as a positive mechanism that contributes to the financial stability of the cooperative and are willing to pay for that peace of mind."

Would he be in favor of trying again to raise a flip tax? "Personally, I would vote for it since I firmly believe it is equitable, it would be in the best interest of the cooperative, it would provide funds for the major capital expenses that our prewar cooperative absolutely cannot avoid, it would improve the financial stability of the cooperative and would have a favorable impact on our property values. But given our 75 percent hurdle for approval, it's extremely difficult to overcome a small, determined minority against it and I don't think it will be revisited any time soon."

In the end, then do you try to pass or not to pass a flip tax? That is the question for many co-ops. It is hard to refute the argument that a flip tax can be a welcome source of income. But, as with any other major policy question, not all shareholders will agree on it. So be warned. Unless you approach the matter carefully, you may be flipping yourself out of the frying pan and into the fire.