Seeing 20/20 on 80/20

Jerry Fox, president of East Midtown Plaza, is between a pillow and a hard place. On the one hand, the maintenance cost of his tax-subsidized three-bedroom duplex is hovering around 1960 rental prices. On the other hand, because all the owners in his 784-unit complex enjoy a similary low maintenance, that income is not enough to meet both the co-op's day-to-day operating costs and also pay for major capital repairs.

It gets more complicated. When East Midtown Plaza, a Mitchell-Lama cooperative, needs to increase carrying charges to make repairs or capital improvements, the board has to petition the city's Department of Housing Preservation and Development for a maintenance increase. Then, depending on the extent of the work, the co-op has to apply for a loan from the U.S. Department of Housing and Urban Development.

For Fox, there is a clear and easy way out of the situation: let the owners collect the money they need to run the building by charging market rent on the ground-floor commercial space. For a store becoming vacant now, the co-op - a complex of six buildings between 23rd and 25th streets and First and Second Avenues - could charge twice the amount of its current rent.

There's a catch, however, and it's called 80/20. "I can't take the benefit of that increased revenue, because it puts me out of 80/20," complains Fox. "I have to take less money. Meanwhile, we are 30 years old and have major capital repairs and we have to get a loan."

For Fox, there is an easy way out of the problem: change the 80/20 formula, located in Section 216 of the tax code, to allow the co-ops to keep more outside (read: non-shareholder) income. Other directors have a more radical idea. Have the Internal Revenue Service abolish the 80/20 rule.

Oh, if only it were that simple.

Added to the tax code in 1942, the 80/20 requirement states that a co-op cannot generate more than 20 percent of its income from non-shareholders and still be considered a cooperative. Congress added the statute to give co-op owners the same mortgage and property tax deductions as single-family homeowners. But to prevent business corporations, such as real estate companies, from exploiting the statute, the federal government set up a formula for defining a bona fide cooperative. Under the formula, a co-op has to pull in 80 percent of its total income from tenant-shareholders, the portion known as "good" income. If more than 20 percent of the total income comes from non-shareholders (the portion considered "bad" income) the building and homeowners lose their tax exemptions.

In the world of 80/20, good income includes money the co-op collects directly from shareholders: maintenance, storage fees, move in/out fees, electric submetering, and bulk DSL and cable service. Bad income is any money the building collects from non-shareholders, such as rent from commercial leases or fees paid to the co-op through licensing arrangements with billboard and cellular companies.

Tracking good and bad income is a critical job: if the building violates the 80/20 balance it loses its status as a co-op. Shareholders can no longer deduct mortgage interest, property taxes, and individual loan interest on their income taxes and lose the exclusion benefit of not paying taxes on the first $250,000 ($500,000 if they are a married couple) on the sale of their unit.

BALANCING ACT

So is there any way out of the 80/20 box? The way buildings are dealing with the problem is straightforward: trying to maximize good income, so they can accept more bad income.

One way to do that is to institute transfer charges (flip taxes) as a way of increasing good income, "but they must be structured properly," warns Abe Kleiman, a principal in the accounting firm of Kleiman & Weinshank. Buildings have to be careful that they are not simply pulling in cash to make capital improvements, but taking in money that goes toward the overall day-to-day operations, adds Joel E. Miller, a tax attorney for more than 45 years.

Some techniques, such as levying assessments, may only indirectly increase good income. For example, if a building assesses its shareholders to build a pool or fitness room, the assessment would probably not be considered good income, according to Miller, because the IRS would "very likely consider it a capital contribution." However, once the pool or fitness room is built, the monthly fees charged to the shareholders to use the facilities is considered "good" income, because the fees are now part of the day-to-day operations.

Renegotiating a garage lease or laundry room contract is another way to reduce bad income. In the case of laundry room contracts, rather than leasing out space in the building to a laundry company, the co-op can flip the arrangement and convert the laundry room lease into a contract for maintenance service. By doing this, the laundry room operator no longer pays bad rent to the corporation, but instead gets paid by the corporation for providing maintenance on the machines. And the co-op collects the money directly from the machines, thereby receiving good income.

As for the garage arrangement, a co-op can amend the lease with the garage operator to reduce the garage operator's rent by the amount the shareholders pay for their monthly rental, and then charge the shareholders directly for use of the garage. It's a dual benefit and improves 80/20 on both sides, because, as Carole Newman, a principal in the accounting firm of Newman, Newman & Kaufman, points out, "the co-op is taking in less bad income from the garage and taking in more good income from the shareholders."

A LONG WAY HOME

At 61 West 62nd Street, the board president Neil Goldstein and the other directors spent nearly seven years working on a plan to reduce bad income and a year and a half ago met their goal. Today, the 27-story building, built as a residential rental in 1980, is a condop.

For Goldstein and others who worked on the deal, the long way around is the short way home. "What we chose to do was to convert the building's ownership into six separate components," he explains. The co-op, with 271 units, leases five commercial spaces and last year sold off the sixth, a professional office on third floor.

"We went through a whole series of processes internally, including very extensive and not always harmonious discussions with the shareholders [over the creation of the condop]," recounts Goldstein. The co-op had to negotiate with the mortgage lender to get permission to create the condominium, sell the third-floor office unit, and reallocate the mortgage.

Today, the co-op portion of the condop draws in bad income from a restaurant, a gym, a dry-cleaner, and a nail salon. Before the building converted to a condop, the annual charges were about $2 million, "and we were paying all of them: real estate taxes, salaries of the building's staff, the heating costs, the repairs, all the service contracts," Goldstein says.

Now there are some expenses that uniquely belong to the residential unit and the co-op pays them separately, and there are some expenses which relate to the whole building," explains the president. "The concierge and doormen who serve only the residential part are paid by the co-op. The building's insurance, heating system, [and] cooling tower benefit everybody in the building and the breakdown of those costs are administered through the condominium association.

"We still have to deal with 80/20, but instead of worrying about giving up $300,000 a year plus in bad income, the problem is only $50,000 to $60,000 a year," notes Goldstein. In another move to maximize the good and reduce the bad income, the co-op buys electricity wholesale and resells it to individual shareholders, billing them along with the unit's maintenance cost, thus passing on the bulk rate savings to the units while taking in more good income.

At 3 Hanover Square, a 204-unit property near the southern tip of Manhattan, shareholders were heading toward an 80/20 problem when the city provided some unlooked-for relief in the way of the property tax increase. For the treasurer, Jonathan Greenspan, it was easier to raise the maintenance 11 percent to close the new tax gap than to try and renegotiate 13 individual leases with the commercial tenants in the building.

"We're a building that's very careful about raising maintenance, and our 80/20 was only becoming an issue because our rents were rising on the commercial space. We were close to 80/20 and starting to talk about what we should do and lo and behold the city raised property taxes."

SHARES AND A SHORTFALL

There may be more dramatic solutions available to reduce bad income. For example, under certain conditions, commercial spaces, such as professional offices or stores, even though operated as nonresidential enterprises, may qualify as residential units. The co-op may sell shares to the lessee and begin collecting maintenance from the lessee-turned-shareholder. Once shares are allocated and sold, income from these units will be considered good income.

The devil, however, is in the details. While the commercial space would not have to be converted into a residence, shares could only be sold if the space can be converted easily into a residence and zoning restrictions do not prevent the conversion. And the cost of making the change cannot exceed 20 percent of the amount the unit could be sold for if it were only to be used as a residence.

"If you have a store, you just can't allocate shares [and call it a residence]," warns Miller. "The Internal Revenue Code says that all shares have to be allocated to a house or an apartment and the IRS has said, 'Under some circumstances we will say it is close enough to an apartment [to allow shares to be allocated].'"

Several conditions, however, must be met. The space has to have the general configuration of an apartment, it has to be convertible to a real apartment, and the conversion has to be permitted as of right under the local zoning laws.

"If you can fit within that, if you meet all those qualifications, the money that you used to be getting in bad income is gone. You are getting maintenance now," points out Miller. "And an additional benefit is that the amount that you sold the shares for doesn't count. It is not subject to tax."

There is a downside to this arrangement, however. Once the co-op gives up the space, the owner of the space benefits from any increase in the rental value. And the new tenant-stockholder gets to vote in all the co-op's decisions, just like any shareholder.

Depending on how creative a co-op wants to get, there are all kinds of ways to increase good income. A co-op can provide services such as window-washing and bill the shareholders directly, build a fitness center and charge annual fees, or add storage bins.

"If you are renting out space, tell the broker that any fee he has to collect, he has to collect from the tenant," suggests Miller. That's another way to reduce bad income. Another safe way is to have the commercial tenant pay his own gas and electric bill. You can also increase the co-op's reserves through tax-free municipal bonds: because 80/20 depends on "gross income," interest that accrues on such bonds (which is not included in gross income) is considered neither good nor bad income.

Recently, a subcommittee of the real property committee of the New York State Bar Association began drafting language that can be used in commercial leases. One example: "In a building where the 'good' income for the year is $1,000,000 and the only other bad income is $35,000 of interest, then the maximum additional amount that the co-op can receive in 'bad' income and still retain its status as a co-op is $215,000 [i.e. $1,000,000 divided by 4, less $35,000]."

BAD INCOME GETTING WORSE

There are many, however, who believe that the best way to deal with the 80/20 conundrum would be simply to have congress rewrite the law to take into account the variables faced by co-ops in the New York City real estate market. What was reasonable in 1942, when 80/20 was instituted, is much less reasonable today, argue co-op advocates. They say the 80/20 formula has financially hamstrung New York City co-ops because the commercial real estate market has become increasingly more valuable.

"What congress has managed to do with [Section] 216 is to force co-ops to take in less commercial rent than they can otherwise take in," complains attorney Stuart Saft, a partner with Wolf Haldenstein Adler Freeman & Herz and chairman of the Council of New York Cooperatives & Condominiums. "The treasury is not getting income taxes on commercial income, and the only one who is benefiting is the commercial tenant, who is getting a below- market rent."

One way out of the problem, maintains Saft, would be for the government to simply tax co-ops at the corporate tax rate if they surpass the 80/20 ceiling. This way, the attorney argues, co-ops would be able to pull in more income, the government would be able to collect more taxes and the commercial tenant "would be forced, shocking as it may seem, to pay market rent."

Miller doesn't believe that congress would alter the formula to allow co-ops to behave like a business, i.e., charging what they want for commercial space and taking the first 20 percent in bad income for free.

One way to address the problem, say co-op attorneys and advocates, would be to create a "principal purpose" test that can better set standards for when a co-op should be paying corporate taxes and when they should be exempt. Some co-op presidents and attorneys have suggested that congress could base the test on the square footage of the building: if 80 percent of the property's square footage is given over to residential purposes, then the building should be able to maintain its status as a co-op corporation.

The question, however, is whether New York's congressional representatives will be able to convince congress to tinker with the statute controlling the formula. They have been trying - in vain - since the early 1990s. "It's a complex problem and each building has unique situations," observes Kleiman.

"Section 216 of the IRS code was enacted in 1942, which was a very long time ago," notes Mary Ann Rothman, executive director of the Council of New York Cooperatives & Condominiums. These days, because commercial real estate is so valuable, New York City co-ops are giving their commercial tenants "a wonderful, undeserved economy."

Rothman agrees that it would make more sense to subject co-ops to some sort of principal purpose test, where the definition of what a co-op was could be tweaked to make more sense. "So we would like to see a principal purpose test. If the principal purpose of a building is to provide homes to shareholders, we would like that to be a co-op. It would be much more fair."