When a Board Has Two Hats

The sponsor at the Jackson Heights cooperative was in trouble. He owned a considerable number of the Queens co-op’s 84 units and was claiming that the corporation owed him $283,000 because his costs exceeded the income he was getting from renting his units. The co-op refused to pay him, the sponsor then defaulted, and the co-op acquired the units.

It was 1990 – a time when real estate values were declining and when most agreed it was not the greatest time to own property in New York. In this case, selling the units was not a viable option, since all were occupied rentals. But was dealing with the renters itself any better as a choice? If the sponsor couldn’t afford to do it, how could the co-op?

Indeed – the story of what happened at this co-op had been all too common in the late 1980s and early 1990s, says attorney Bruce Cholst, a partner at Rosen & Livingston. Co-ops were often left holding the bag after sponsor defaults. In fact, that has been the most common way for a co-op to gain units ownership, notes attorney Dennis Greenstein, a partner at Seyfarth Shaw. And a co-op’s ownership can create big problems for the board that manages those units.

As the landlord of these often highly rent-regulated apartments, the co-op is subject to the laws regarding such apartments just “like any other landlord,” notes Greenstein. So the board must wear two hats: as representative of the co-op’s shareholders and as landlord of the tenants in the cooperative-owned rental units.

The biggest problem a co-op faces when it owns units – especially a large number – is that their income can create difficulties under the so-called “80/20” rule. “Eighty/twenty” refers to a provision in the federal tax code saying that in order for the building to maintain its status as a co-op, 80 percent of its income must come from its shareholders. Any money that comes from other sources – including rent from units owned by the cooperative – is considered “bad” income. If the co-op finds itself owning a great number of units, the 20 percent income cap can be exceeded – and quickly.

If that happens, the co-op and its owners can lose substantial tax benefits. For example, shareholders may lose the right to deduct their pro rata share of the co-op’s mortgage and real estate taxes, as well as the right to deduct the interest on their own mortgages. Also, the mortgage company may refuse to refinance the co-op’s mortgage, and shareholders may even find it hard to get loans themselves.

But there are ways for a co-op to address the 80/20 issues, notes Mark Shernicoff, an accountant with Zucker & Shernicoff. A co-op could set up a “limited liability” corporation to own the units or look for a “white knight” to buy the defaulting sponsor’s units. Attorney Cholst says a board could also decide to give a unit to its super (if the co-op doesn’t already have a designated super apartment) or use its owned units as a playroom for shareholder’s children, a gym, a community room – or even as a room in which the board can conduct business. Shernicoff says that the Jackson Heights co-op created a subsidiary that owned the units. That subsidiary then collected rent from the tenants and paid the co-op the maintenance fees for those units (but be warned: the IRS has not yet ruled on this last strategem).

Everyone agrees, however, that the best way to deal with such units and avoid an 80/20 issue is to sell. The money raised from these sales,
– which is “good” income – can really “boost a co-op’s reserve fund,” says Greenstein. Plus, you “want to see every apartment occupied by shareholders,” says Harold Gellman, president of the Jackson Heights cooperative.

If rental tenants occupy the units, there’s not much the co-op can do until the renters move out, Gellman notes. As its units slowly had become vacant over the years, Gellman’s board opted to renovate them before putting them on the market. They weren’t in good shape and Gellman estimates that costs to renovate a one-bedroom ran about $12,000 to $13,000. Yet the co-op made its money back when it sold them, so spending the money to renovate was a good investment.

In the end, though, you may be saved by pure dumb luck (although as one wag put it, “Chance is a fool’s name for fate”) – not uncommon in the ever-changing real estate market. Lynn Whiting, director of management for The Argo Corporation and current manager of Gellman’s building, notes that the co-op is “sitting pretty now,” as the units it owns have increased tremendously in value. While the cooperative had once been “practically giving apartments away,” it is now “getting good prices” when it sells the units it still owns, says Gellman. That’s in part because of the improved economy, the co-op’s stable maintenance fees, and the increased popularity of the Jackson Heights area. So, in the long term, the sponsor’s default had a silver lining. Or, as Gellman puts it: “Our misfortune became our good fortune.”