A Condo Flip Tax?

When Gerry Fifer’s Upper West Side condominium decided to upgrade the building’s entire plumbing system – an ambitious project costing several hundred thousand dollars – the board decided to pay for the work by imposing a special, five-year assessment on unit-owners. Unlike co-ops, condos have “few ways of raising revenue besides increasing common charges” or imposing assessments, notes Fifer, president of her board. After all, it’s not like her condo could build a reserve fund by, say, imposing a transfer fee on unit sales. Or could it?

Conventional wisdom has held that co-ops can and condos cannot restrict the sale or sublease of apartments by screening prospective buyers, limiting the number of sublets, or imposing fees for subleases or transfers (the latter often misleadingly called flip taxes). But a recent court decision, Demchick v. 90 East End Ave. Condominium, appears to open the door for condos to impose co-op-like restrictions on the sale or lease of units. And this decision may be good news for condos looking to raise money, because some attorneys believe it gives them legal support for imposing transfer and leasing fees.

While the implications of the Demchick decision may affect all condos, the facts are unique. According to the brief opinion, the condo has 43 residential units: 38 large, expensive, multi-bedroom ones and five small, relatively inexpensive studios. The condo was marketed as a luxury building with many amenities, including studios for the household help of the larger units. But while the condo’s leasing agent told some buyers that the studios could not be sold to people who didn’t live in the condo, neither the condo’s offering plan nor its bylaws contained that restriction.

When the condo board learned that the owner of a studio was considering selling it, the board proposed – and a majority of the unit-owners voted in favor of – an amendment to the condo’s bylaws that restricted the sale or lease of the studios to owners of the larger units. One resident, who owned a larger unit and a studio, objected and sued, asking the court to set aside the amendment on the grounds that it was an unreasonable restraint on “alienation” – that is, the sale or lease of real property, such as condo units.

Although the lower court agreed with the resident, the appellate division refused to set aside the amendment. The court noted that Real Property Law, Section 339, permits condo bylaws to contain provisions on the “alienation, conveyance, sale, leasing, purchase, ownership and occupancy of units” as long as those provisions don’t violate state civil rights law or the rule against unreasonable restraints on alienation. And the court said the amendment was reasonable, because it was meant to preserve the building’s character.

Arthur I. Weinstein, a New York attorney and vice president of the Council of New York Cooperatives & Condominiums (CNYC), believes the Demchick decision is “quite significant” since it is a departure from the commonly held belief that the rule against unreasonable restraints on alienation barred condos from imposing any restrictions on the sale or lease of units. The only exception to that rule is a condo’s right of first refusal, which is generally useless since few condos have the “cash to back it up,” he notes. But, he adds, this decision suggests that other restrictions may also be permitted – provided they are reasonable.

Attorney Marc Luxemburg, a partner at Snow Becker Krauss and president of the CNYC, agrees with Weinstein’s analysis of the implications of the Demchick case, and says that the decision clarifies a misconception among real estate attorneys that a condo can’t impose the same restrictions on the sale or lease of units as a co-op does. He explains that they tend to ignore the “unreasonable” part of the rule against restraints on alienation or believe that any restriction is per se unreasonable. However, this decision shows that the word “unreasonable” isn’t superfluous and that reasonable restrictions may be permitted.

Attorney Steve Wagner, a partner at Wagner Davis, says that the ruling is “consistent with [his] understanding of the law.” He notes that, while the standard for restrictions in co-ops is the Business Judgment Rule, the Demchick decision suggests that the standard for restrictions in condos is a “reasonableness test.” (Of course, what is “reasonable” may be up for debate.)

Weinstein warns that it is dangerous to predict how courts might rule on other restrictions, but he believes that there will be a lot of pressure by condo boards to test this decision, and that transfer and leasing fees are the most likely areas to be tested first. Luxemburg and Wagner agree.

Before this decision, imposing transfer and leasing fees was seen as “uncharted water,” says John Janangelo, president of property management for Bellmarc, which manages about 25 Manhattan condos. He notes that several condominiums his company handles already impose such fees, and this decision seems to support their ability to do so. A transfer fee is imposed at a 328-unit Upper East Side condo managed by Dorothy Vermeer, vice president and secretary at H.J. Kalikow & Co., a developer. By imposing such fees, condos can raise funds to offset operating costs and develop a reserve fund. Then they won’t have to raise common charges or impose assessments when money is needed for renovations, repairs, or capital improvements, explains Janangelo.

Fifer, the Upper West Side condo president, agrees that the ability to impose such fees would be welcome. Her condo board members investigated the possibility of getting a loan to pay for their plumbing upgrade, but it was too expensive. And over a year ago, they discussed imposing a transfer fee when their managing agent suggested it. But the board never actually put the transfer fee to a vote of the unit-owners. In light of the costly plumbing work, Fifer now wishes they’d done so. “A transfer fee would have helped,” she says, adding that “it’s better to generate revenue for a reserve fund for this type of work.”

As for other types of restrictions, such as bans on sublets or pied-á-terres, Vermeer believes that her building is too large for such restrictions to be easily imposed. She says it makes more sense to impose such restrictions in smaller condos where the unit-owners may want more control over the occupancy. Fifer doesn’t think extensive restrictions are warranted in condos. She wouldn’t want to see them becoming exactly like co-ops. “Each type of ownership has its pros and cons,” she notes. Besides, condos already have house rules to regulate unit-owners and their behavior, Fifer points out. She’d suggest that a condo enforce its house rules and, if necessary, consider beefing them up before imposing co-op-like restrictions.

While the Demchick decision may be a positive sign that such restrictions will be upheld if legally challenged, condos won’t move in that direction overnight, notes Luxemburg. Instead, he expects that it will take two or three years for any real action in this area to happen. And imposing restrictions in a condo may not be easy, Janangelo warns. The board in one condo his company manages recently tried to impose a transfer fee, but was unable to get the two-thirds majority needed to amend its bylaws to do so.

Still, if the board of a condo Wagner represents wanted to impose a transfer or leasing fee, he says that, in light of this decision, he’d feel more confident telling his clients that they could legally do so. However, while the decision “eliminates doubt on a condo’s ability to [impose such fees],” it’s important to note that a condo board must properly impose any fees or restrictions. That is, it must amend its bylaws by a vote of the unit-owners, which typically requires a “supermajority,” he explains.

Weinstein takes a more cautious approach. If the board of a condo he represents wanted to impose a transfer or leasing fee, he’d tell it that there was a 50 percent chance that it would be sued if it did so, but in light of the Demchick decision, a 60 percent chance it would win. Nonetheless, he’d counsel it to “proceed with caution” – or better yet – “wait and see” how the courts rule on other co-op-like restrictions in condos.