A Condo to Flip For

My board read with great interest the article on flip taxes in the December ‘06 Habitat. But I couldn’t tell whether any of the buildings described were condos like us. Can condos raise money with a flip tax? If so, how can we establish one, and are there any limitations on what or who we can charge?

Flip taxes, as currently imposed, are a bit of a misnomer. They principally emerged, and possibly got their name, during the 1980s “go go” co-op conversion binge, when sponsors sought to entice current rental tenants (“insiders”) to purchase their apartments at discounted prices (“insider prices”). As part of this package, it was sometimes deemed only fair and proper for “flippers” – those buying at the insider price and quickly selling out at the market price – to leave a bit of their profit on the table for the co-op and those purchasers who remained committed to the future well-being of the co-op. Hence, flippers were required to pay “flip taxes” either established by the sponsors at the time of the conversions or sometimes authorized for the boards of directors to readily adopt later on.

In 2007, co-ops regularly adopt and modify flip taxes. So, the rationale is not simply to force “flippers” to share part of their profits from conversions. Now, flip taxes are used more as general revenue raisers in these times of ever-escalating fixed charges for fuel, taxes, capital repairs, and the like. And the taxes frequently will be imposed on shareholders regardless of whether they profited on the sale of their units – and sometimes even on purchasers. And, to reflect this evolution – and the public’s general distaste for any new taxes – flip taxes are often referred to as transfer fees.

The authority for co-ops to impose flip taxes is beyond dispute. Early challenges ranged from shareholders seeking to invalidate the imposition outright to questions about the way they are calculated. In a 1986 response to a pivotal Court of Appeals decision, the New York State legislature amended the Business Corporation Law Section 501(c) to indicate that co-ops shall not be deemed to have violated the “one vote per share” principle “because of variations in fees or charges payable to the corporation upon the sale or transfer of shares and appurtenant proprietary leases that are provided for in proprietary leases, occupancy agreements or offering plans or properly approved amendments to the foregoing instruments.” This not only removed the challenges to their calculation, but also validated the idea of flip taxes generally as a perfectly proper fund-raising device for co-ops.

So now, years later, after a recent spate of condo conversions and developments, and finances getting tighter by the day, the question more frequently arises as to whether condos also can impose flip taxes. The straightforward but relatively rare situation for condos, as well as co-ops, is whether the offering plan or other governing documents originally confer express authority for the condo to impose such a flip tax.

Assuming the authority does not originally exist, then the question arises about whether the condo’s governing documents can be amended to impose a flip tax. For co-ops, flip taxes are generally adopted by amendment of the standard co-op proprietary lease provision governing transfer and assignment of the stock and leases allocated to apartments. This usually requires the affirmative vote of shareholders owning at least two-thirds of a co-op’s outstanding shares. It is much more debatable whether a condo can amend its governing documents to impose a flip tax. Condo units are deemed by law to be real property, which invokes legal principles barring unreasonable restraints on alienation of real property. Co-op apartments, by contrast, are deemed personal property for this purpose and generally not subject to these principles.

A condo contemplating the adoption of a flip tax should first consider New York State Real Property Law, Section 339-v, which provides that a condo’s “bylaws may…provide for…[p]rovisions governing the alienation, conveyance, sale, leasing, purchase, ownership or occupancy of units, provided, however, that the bylaws shall contain no provision restricting the alienation, conveyance, sale, leasing, purchase, ownership and occupancy of units because of race, creed, color or national origin.”

On its face, RPL, Section 339-v, seems to allow imposition of a flip tax on sale of condo units. They certainly constitute “provisions governing the alienation” of condo units. And it is of little concern, as we have assumed, that such a flip tax may not be found in the condo’s original bylaws. RPL, Section 339-u, provides for “modification of or amendment to the bylaws” provided it is “set forth in an amendment to the declaration and such amendment is duly recorded.” And condo declarations generally provide that such declarations and bylaws can be amended by the affirmative vote of unit-owners owning a specifically designated super-majority of the common interests allocated to all units.

Without more, that seems to be quite comparable to the procedures that co-ops must follow to adopt a flip tax. A condo secures approval from unit-owners in the same fashion as a co-op secures approval from shareholders to adopt a flip tax. However, for condos there is the legal prohibition on unreasonable restraints on alienation of real property, which includes condos but not co-ops. And, at least in theory, if a restraint is challenged as unreasonable by one particular unit-owner, then it should not matter that a super-majority of others has voted for and accepted the restraint.

There is no New York court decision of which I am aware that has yet directly decided whether a condo-imposed flip tax is an unreasonable restraint. But New York courts have decided whether certain other restraints on the sale of condo units should be deemed unreasonable restraints, and these cases provide useful guidance regarding condo flip taxes.

In one early challenge to condo unit transfer restrictions, Anderson vs. 50 East 72nd Street Condominium (1986), a condo board exercised its right of first refusal and thus precluded potential purchasers from acquiring a unit. They sued, claiming that the right of first refusal was a violation of New York’s statutorily imposed rule against perpetuities. The appellate court affirmed the lower court’s finding that a preemptive right, such as a condo board’s right of first refusal, is not the type of unreasonable restraint on property that the law was meant to invalidate.

In doing so, the court noted that a condo’s right of first refusal does not invoke the same concerns as does an option of unlimited duration: “A pre-emptive right…with respect to a condominium owner, does not impair the value or use of the land so as to restrain its alienability. The owner is not restricted in the use of the property and can never be forced to sell. It is only when the owner freely decides to sell that the pre-emptive right may be invoked, and, if exercised, the owner still receives the same price and terms as the bargain he struck. Moreover, the board cannot hold up the sale, as it must exercise the pre-emptive right promptly, in this case within thirty days.”

On its face, this decision is a victory for condo boards imposing ever-so-slight restrictions on the transfer of condo units. Courts will judge these impositions based on their reasonableness not just on the literal language of some statute that evolved from, in the words of the court, “the post-feudal agrarian period…”

On the other hand, the condo board in Anderson was enforcing rights at least somewhat less onerous than a flip tax, for which it cannot be said (as it was said in Anderson) that “the owner-seller will still receive the same price and terms as in the bargain he struck.” With a condo flip tax, the owner would not realize the “same price” but rather the price reduced by the amount of the flip tax.

Still, the flip tax does not restrict property to nearly the degree of the option against which the Anderson court railed. In few situations would a condo unit-owner choose to neglect the care and development of his property simply because he was required to leave a very small percentage of the sale price on the table when he chose to sell. A flip tax is a tax, not an option of unlimited duration.

In the end, the Anderson language is a net positive for one other reason. The Anderson court recognized the need for the law to adapt long-standing real estate law principles to “the realities of contemporary commerce and economics” applicable to this ever-burgeoning form: condo ownership of property. The court noted that the right of first refusal “is one that is generally used in connection with the condominium management and has been held to be a valid interest.”

For now, it cannot be said that flip taxes are “generally used” by condos. But perhaps the question under discussion and this response will help change that, providing further support for the validity of condo flip taxes.

The appellate court next visited condo transfer restrictions in Four Brothers Homes at Heartland Condominium II vs. Gerbino (1999). There, a condo board sued to enforce a bylaw provision that restricted leasing, as well as occupancy by non-family members, of condo units. The unit-owners countered that the restriction was improper because of “a significant restraint on the ability of homeowners to fully alienate their property” and thus an “unreasonable restraint on alienation” barred by long-standing common-law principles. The court held the provision not unreasonable according to the standards that Anderson set. The court also significantly stated that the condo unit-owners, “in choosing to purchase the home, willingly gave up certain rights and privileges which traditionally attend fee ownership of property…”

This provides another layer of comfort for promoters of condo flip taxes because leasing and occupancy restraints surely could diminish unit values, at least somewhat. After all, one reason that condos are far more attractive to investors than co-ops is that they can be freely leased (and sold) with limited restrictions beyond the right of first refusal. On the other hand, the owners in Four Brothers purchased their unit fully aware of the leasing/occupancy restrictions.

By contrast, if a condo were to impose a restriction on leasing after the purchase by the owner in question, then the owner’s expectations arguably would be dashed even if the restriction were properly adopted by amendment to the condo bylaws or other governing documents. The adoption of a flip tax by the condo’s owners would frequently constitute a comparable surprise to condo unit-owners, who in purchasing probably believed that they would never be subjected to this type of tax on the sale of their units. Still, the more prevalent condo flip taxes become, the less likely it will be that a unit-owner could claim surprise.

In 2005, the appellate court gave condo flip tax promoters significant reason to abandon their doubts. In Demchick vs. 90 East End Avenue Condo, a condominium was comprised of thirty-eight “large, expensive, multi-bedroom units” and five “small, relatively inexpensive studios” intended “for the household help of the purchasers of the large units.” So, five of these large-unit purchasers owned their units in tandem with one of the smaller units. The selling agent allegedly told some purchasers that they could sell the smaller units only to other owners of the larger units. But the condo’s governing documents contained no such prohibition.

When one of the five large-unit owners gave indications of wanting to sell a smaller unit on its own and possibly to an outsider, the board quickly adopted a bylaw amendment prohibiting this. The owners of another of the tandem units sued to invalidate the bylaw amendment. They claimed that it constituted an unreasonable restraint on their use of the smaller units.

The lower court agreed, mainly because of the “unlimited duration” of the restraint on selling the small units, even though the court conceded that the restraint served a “valid purpose.” But the appellate division, citing Anderson and Four Brothers, reversed the lower court’s decision. It characterized the “purpose” of the restrictions as preserving “the character” of the condominium and did not find that “unreasonable.” It dealt with the unlimited duration of the restriction by stating that it “can be modified or removed at any time by a duly called meeting of the unit owners to further amend the bylaws.”

The court ended with the statement that “there appears no New York cases on point,” but stated that two cases – one from Massachusetts in 1983 and one from Florida in 1993 – “have found such a restriction not to be an unreasonable restraint...”

The out-of-state cases that the Demchick court cited do provide some added comfort to flip tax promoters.

In Franklin vs. Spadafora (1983), the Massachusetts Supreme Court upheld a condo bylaw amendment restricting unit-owners to ownership of no more than two units. The goal was to promote owner occupancy by limiting investor ownership of units that would be occupied by renters. The court found the amendment a reasonable restraint.

Particularly relevant to the issue of condo flip taxes was that the court was not concerned about the unlimited duration of restriction because it could be rescinded by further amendment to the bylaws, just as the restraint in Demchick. Likewise, condo flip taxes, although of unlimited duration, can be rescinded by further bylaw amendment.

The Spadafora court ended with the following comforting language: the restriction “represents a reasonable adjustment between the rights of unit owners to use their property and the desire of the owners of a majority of the beneficial interest to attempt to create a residential atmosphere within the condominium development.”

Likewise, imposing a flip tax constitutes an “adjustment” under which selling unit-owners are required to contribute a small percentage of their sales revenues to the condo. Indeed, the Spadafora court analogized condo bylaws to “municipal bylaws affecting economic relations...” and indicated that their constitutional reasonableness should be so judged. It is plain that New York City and State can and do impose condo (as well as co-op) unit transfer taxes. Arguably then, so can condos, without any unreasonable or unconstitutional taking of the property of selling unit-owners.

Demchick also cited Metropolitan Dade County vs. Sunlik Corp. (1992), which dealt with a restriction on the sale of certain real property except to entities affiliated with the telephone company. The intermediate Florida court analyzed the duration and scope of the limitation and found it not an unreasonable restraint. But the case contained as many reversals and dissenting opinions as a hotly contested United States Supreme Court decision. Metropolitan Dade stands as a cautionary tale that when judging the “reasonableness” of a restraint on anything, reasonable minds almost surely will differ.

So, what does all this mean for condo flip tax proponents? There is much positive here. The restriction on the sale of the smaller units that the Demchick court approved was absolute, of potentially unlimited duration, and could severely reduce the sale price that a seller could receive for a smaller unit. That is far more onerous a restraint than a simple condo flip tax.

Moreover, the Demchick restraint was adopted by the condo board after the challenging unit-owners had acquired their units. So owners arguably did not expect when purchasing that they would be subject to the restraint. Indeed, the selling agent admittedly did not tell the challenging unit-owners when they purchased that they could sell smaller units only to large unit- owners.

Likewise, at most long-standing condos considering adopting flip taxes, their unit-owners did not expect that restraint when they purchased. Demchick thus supports the important proposition that condo unit-owners are on notice that boards may pursue unit-owner approval of bylaw amendments that restrain sale of units in ways not anticipated. So, if a potential condo- unit purchaser wanted to be absolutely sure that he could never be subject to a flip tax, he should only purchase in condos with bylaws or other governing documents prohibiting flip taxes.

Indeed, with the fading of the concerns about unreasonable restraints on alienation of condo units, and the recognition that condo unit-owners are not immune from even unanticipated restraints, you can expect that at least some new condos are being organized with documents that expressly limit new restraints.

Otherwise, condos could continue to evolve to be much more like co-ops, thus further reducing the distinctions and further confusing and limiting the true choices of purchasers.