Co-op to Condo: The Conversion Myth

Although seemingly simple, actually converting a cooperative to a
condominium is a daunting – and infrequently completed – task.

In New York City, condominiums sell better than cooperatives. At least that’s what some people think. As a result, many cooperative shareholders and boards are investigating the process of converting their buildings from cooperatives to condominiums. Although seemingly simple on its face, actually accomplishing such a conversion is a daunting – and infrequently completed – task. Here’s why.

One would assume that since cooperatives and condominiums both involve the common ownership of housing, converting one to the other should be simple. But that is not the case.

A cooperative is an ordinary business corporation, which is usually formed in New York in accordance with the Business Corporation Law. The corporation owns one or more buildings and complies with Section 216 of the Internal Revenue Code, which is the basis for the ability of the shareholders to deduct their proportionate share of the corporation’s real estate taxes and mortgage interest. It also allows the shareholders to obtain a basis adjustment of $250,000 for an individual shareholder or $500,000 for married shareholders as a reduction of the gain on a sale. The building is owned by the corporation and controlled by the board of directors. The shareholders have stock in the corporation and a proprietary lease, which gives them the exclusive right to the use of certain defined space in the building. The shareholders do not have a deed for their apartments.

Conversely, a condominium, a form of real property ownership, is formed under Section 332 of the Real Property Law. Each unit-owner receives a deed for his or her unit and, as such, has the right to deduct the mortgage interest and the real estate taxes they pay and have the same basis adjustment as a cooperative. The unit-owners actually own their apartments, however, and have a right to the use of the common elements. The board of managers has the right to manage the building subject to the precise terms of its authority as described in the declaration of the condominium.

Metamorphosis

In order for a cooperative to convert to a condominium, the following steps have to be followed:

(1) The cooperative shareholders must vote to permit the conversion, which would require the vote necessary to sell the building, which is usually an affirmative vote of 80 percent of all of the shareholders.

(2) The shareholders would have to agree on the terms of the declaration and bylaws that would replace the proprietary lease and bylaws.

(3) An architect would have to draw plans of the building indicating the location and boundaries of each of the units and all of the common areas.

(4) The shareholders would have to agree on an allocation of the common interests among the unit-owners.

(5) A request for a “no action” letter would have to be submitted to the New York State attorney general.

(6) Each shareholder with a loan on his/her apartment would have to obtain the consent of the lender to allow the loan to be converted to a mortgage on the former shareholder’s unit.

(7) The mortgage on the building would have to be paid.

(8) Each shareholder would have to deal with the individual tax consequences of the conversion.

On the surface, eight simple steps. Still, dozens of cooperatives have started on the path to conversion yet very few, perhaps a handful, have actually completed the process. Each fail for a different reason tied to these eight steps.

Four Ways to Fail

Obtaining a shareholder vote. One would think that, after hearing about the large appreciation in the value of the apartments after a cooperative-to-condominium conversion, many, if not most, shareholders would automatically vote in favor of the conversion. That is not usually the case.

Frequently, those who fail to vote in favor of it fall into two groups; those who are against any change and those who are apathetic or just too busy to care. Because the vote needs to be 80 percent of all shares, someone’s failure to vote is the functional equivalent of voting against the conversion. Those who actually vote against it are usually those who are unhappy about some aspect of the other steps, or are concerned that the change will have a detrimental effect on their quality of life.

Negotiating the terms of the declaration and bylaws. The declaration of the condominium is the document that establishes the condominium form of ownership and specifies the unit dimensions and the general and limited common elements. It also provides for the easements for the use of the various components of the building and the allocation of the percentage interests in the common elements upon which the unit-owners’ obligation to pay common charges is based.

The bylaws establish the board of managers, the relationship among and the power of the board of managers, the procedure to hold annual and special meetings, the obligations to make repairs and alterations in different parts of the building, and the items that are contained within the common charges and the votes required to authorize the board to take certain actions.

Negotiating the terms of the declaration and bylaws is a particularly nettlesome procedure because so many shareholders have different ideas of the power and authority that the board should have and who should be responsible for repairs, maintenance, and alterations to the building. In cooperatives, this is generally not as much of a problem because the proprietary lease and bylaws were written by the sponsor of the original offering with absolutely no input from the shareholders.

That is not the case on a conversion from a cooperative to a condominium, however, and the shareholders become very concerned and vocal over such issues as:

(a) Who pays for repairs to the inside of an apartment after damage to the apartment that is not the shareholder’s fault?

(b) Can the board make repairs, alterations, additions, and improvements to the common elements and, if not, how large a vote of the unit-owners is necessary before the money can be spent?

(c) Can the board borrow money and make assessments and, if not, what size vote of the unit-owners is required?

(d) What control will the board have over who can buy or lease an apartment?

(e) What penalties will the board be able to enforce for a unit-owner’s failure to comply with the terms of the bylaws?

(f) Can the units be used for anything other than residential use by unit-owners and their families or can some businesses be operated in a unit?

(g) What are the qualifications for board members?

(h) What is the ability of the board to sell or lease common spaces?

(i) What authority do the condominium’s officers have to act in the absence of specific authority?

These are just some of the more obvious questions. There are dozens of others and many of them are much more nuanced. The conversion cannot proceed until these questions are answered and the declaration and bylaws completed. Not surprisingly, considering the nature of the questions, this discussion/argument is one of the primary reasons for the limited number of conversions to condominiums.

Architect’s plans. One would assume that there can be no issues involved in the architect’s preparation of drawings indicating the size and location of each unit and the various limited and general common elements. Usually, that is true. However, there are instances where a shareholder believes that he/she does or should have exclusive control over certain space, which others consider to be common property.

Then you also have to deal with the issue of terraces, balconies, gardens, backyards, and roof space adjacent to a penthouse. Are these part of the unit and the unit-owner’s responsibility to repair and maintain, or are they limited common elements and the obligation of the condominium to repair and maintain? Each of those issues also goes to whether there are any limitations on its use.

Allocation of common interests. This should be so easy: someone has five percent of the corporation’s stock so he/she should have five percent of the common interests, which would mean this person was paying five percent of the corporation’s maintenance before and now will be paying five percent of the condominium’s common charges. It is simple in theory, but not necessarily so in practice. Again, the sponsor originally did the allocation and the purchasers of the corporation’s shares were stuck with it. Now, every gripe that anyone has ever had over the allocation will come to the surface.

Those shareholders on lower floors or with smaller apartments, will want a greater disparity in the allocation. Everyone will want the allocation for those with special access to be increased, so that terrace, balcony, garden, and roof space would be treated as if it were inside the apartment. Those on lower floors will feel they should not have to pay for elevator repairs.

Four More Ways to Fail

“No action” letter. This is the easiest step, but you have to get through all of the other steps in order to arrive here. The “no action” letter is required because the city recorder will not file the declaration establishing the condominium without a letter from the attorney general. In this instance, obtaining the letter should not be a problem because nothing is being sold to the general public. Two frequently asked questions: Will the original offering plan have to be amended by the cooperative? Will the cooperative have to produce an offering plan? The answer to both questions is no. Since nothing is being sold as a result of this conversion, an offering plan need not be prepared. However, if there are any unsold shares, the sponsor (or holder of unsold shares) will have to amend the offering plan to describe the condominium before the sponsor can sell the unsold units.

Share loans. Each shareholder who has financed his or her shares will be obligated to seek the lender’s consent and agreement to convert the lien on the shareholder’s shares or chattel mortgage or security agreement into a mortgage on the owner’s unit. The lenders should not object to this action because they are getting better security for their loan. However, it will require an application by the shareholder and the bank or other lending institution and will undoubtedly involve the payment of a fee to the bank as well as the bank’s attorney’s fees. This will be more difficult in those situations where the loan has been sold into the secondary market or bundled as part of a securitization, which will increase the time and expense necessary to accomplish this step.

Satisfying the building’s mortgage. The next step is to pay off the mortgage on the building because condominiums cannot have building-wide mortgages except in very unusual circumstances. Unless the corporation has a reserve fund that is large enough to satisfy the mortgage, this step will necessitate an assessment on the shareholders in order to generate the needed funds. Unfortunately, if the mortgage contains a prepayment penalty or a defeasance provision, the shareholders will also have to find the money with which to satisfy these payments that, considering the current state of interest rates, could be substantial.

Income tax liability. This is the step that usually comes as a surprise to anyone contemplating the conversion of a cooperative to a condominium and that is the tax payable by the individual shareholder on the gain on their apartment. There is no tax for the apartment corporation on the conversion (based on the language contained in the Internal Revenue Code). But the individual shareholder will be obligated to treat the conversion as a sale of his/her cooperative apartment and will have to pay income tax on the gain between the original cost plus capital improvements and the fair market value of the apartment at the time of the conversion minus the basis adjustment permitted on the sale of a principal residence of $250,000 for an individual or $500,000 for a married couple.

That means that shareholders who purchased their apartments from the sponsor 10 or 20 years ago will probably be paying a hefty tax on the conversion even though they are not seeing any cash as a result of the conversion. This phantom gain could be enough of a reason for many shareholders to forego the theoretical appreciation built into a condominium.

Finally, a word of caution: there is no certainty that the same apartment would sell for 20 percent more if it were a condominium because there are no two identical situations. Plus a co-op shareholder’s maintenance includes the mortgage on the building and the real estate taxes paid by the corporation, so, on its face, the cost of operating a condominium is less expensive than a cooperative, but that is only because the condominium unit-owner is making three payments (common charges, real estate taxes, and interest), and only one of them is paid to the condominium.

A final word of caution: comparisons are not in the “apples to apples” school, but really “apples to oranges.” That’s because most recent conversions are condominiums and most older conversions are cooperatives, so those offering comparisons are comparing different vintages of housing and different years in which they were converted.