The New Deal

With changes in the law creating the possibility of more commercial income, boards face a different way of reporting it and, possibly, increased taxes.

Ellen covas is treasurer of a small seven-unit co-op with a DVD rental shop on the ground floor in the heart of now-trendy Williamsburg, Brooklyn. Until recently, her 24-year-old co-op was having such a hard time complying with the law concerning real estate tax and mortgage interest rate deductions that it was considering turning itself into a condominium or even a combination condo/co-op to comply.

Her building was not alone.

For the last 65 years, a property could qualify for cooperative status – and its shareholders could deduct real estate taxes and mortgage interest payments from their taxable income – only if the co-op received 80 percent or more of its income from residential shareholders and no more than 20 percent of its income from other sources, such as commercial tenants and rental apartments. The Internal Revenue Service (IRS) rule – “80/20,” for short – frequently frustrated boards, which often could not charge market-rate rents for commercial spaces since the extra income would put them over the 20 percent threshold.

No longer. In late 2007, President George W. Bush signed the Mortgage Forgiveness Debt Relief Act (also known as HR 3648), which, among other things, reconfigured one of the most infuriating regulations in the New York co-op world.

Covas calls the changes to the 80/20 rule “a godsend” and “a little gift.”

She adds: “We totally didn’t qualify under the old 80/20 rule, so it depressed our property values because people couldn’t deduct anything. One of my neighbors tried to refinance his mortgage before the change went into effect, but he couldn’t because of [our failure to comply with] the 80/20 rule.”

Aside from immediate tax benefits and increased property values, Covas’s co-op expects to get more rent from its commercial space when the current lease expires in August. “We’ve warned [the DVD shop] that we’re going to ask for market rent,” she notes. “It’s kind of sad because we like the tenant, but I have a fiduciary responsibility.”

Everybody in the co-op world is talking about the new 80/20. Some say the changes provided an immediate shot in the arm. Others warn that it will take several years for the full benefits to emerge. But just about everyone agrees that the revisions are going to provide a welcome and long-overdue windfall for co-ops across New York City.

How It Works

The old 80/20 rule survives under HR 3648, which goes into effect for the 2007 tax year. But now there are two additional ways for a property to qualify for co-op status: the first is if 80 percent or more of the total square footage of the property is used or available for use by tenant-shareholders for residential purposes; the second is if 90 percent or more of expenditures are for the benefit of tenant-shareholders. In essence, many co-ops are now free to demand market rates from their commercial tenants and residential renters.

Anthony Wolff, who has been board president of the 55-unit co-op at 223-231 West 21st Street for the past quarter century, welcomes the prospect of not having to jump through the old 80/20 hoops. “We used to sort of skirt it [the 80/20 rule] because we had a fair amount of what we call ‘bad income’ – two rental apartments we bought from the sponsor and a doctor’s office in the basement,” Wolff says. “‘Good income’ meant maintenance income. We always added to that any money the co-op took in from shareholders – laundries, late fees, storage fees, the one percent flip tax – to bolster our ‘good income’ and make sure we complied with 80/20. Now we don’t have to do that. This new law is going to get rid of that exercise in sophistry.”

“So much human capital and time went into complying with 80/20 that could be much better spent,” agrees Stephen Vernon, board treasurer at Nagle Apartments, a 111-unit co-op in upper Manhattan. “Under the idea of keeping maintenance affordable, sometimes our good income was not sufficient to cover our capital needs. That put pressure on how much bad income [rent] we could take in,” adds Vernon, an accounting manager at American International Group, whose cooperative has 12 rental apartments and a commercial garage. “There were a couple of years when we had to forgive a month’s rent for our renters and commercial tenant. We were, in effect, penalized by the 80/20 rule.”

Part of the penalty was a series of maintenance increases – eleven percent in 2004 and four percent in both 2006 and 2008. To buttress this “good” income, the co-op submetered electricity and charged shareholders for parking, use of the laundry, and other services. Even so, more than $1 million in maintenance had to be deferred.

“Now that’s all gone,” Vernon says, “and we can work on things that better the life of the building.” Apartment rents will probably be raised, he says, and the garage lease will be renegotiated when it expires in 2013. Meanwhile, long-range plans are in place for repairing the roofs of the residential buildings and garage, and possibly installing solar roof panels and “greening” the heating plant. “It’s not going to all of a sudden open the floodgates,” Vernon says of the new law. “It’s going to be a slow creep. It’s not going to be apparent in the first year, but certainly in five years, it will be. It’s not a magic wand, but life’s definitely going to be better.”

The Fair Deal

The change is potentially bad news for many commercial enterprises and renters in co-op buildings. “This is a major change,” says Joel E. Miller, a veteran co-op.condo attorney from Queens. “Many co-ops will have no trouble meeting the new square-footage or expenditure tests. And now the co-op can charge any rent they want to because there’s no limit on outside income, which is a big change.”

Besides commercial and residential renters, potential losers in this brave new world could be the small army of co-op lawyers and accountants who have worked hard – and sometimes creatively – to protect their clients’ tax exemptions under the old 80/20 rule. In fact, Miller says, one distraught colleague phoned him the day Bush signed the bill into law, lamenting that it would drive him out of business.

“Personally, I’m relieved,” Miller says, “because what we were doing to qualify co-ops under 80/20 were things that might be challenged by the IRS. Now, if co-ops can pass one of the other two tests, they’re not going to need a lawyer to help them comply with 80/20.”

But, as Miller sees it, that doesn’t mean the demand for co-op attorneys or accountants is likely to evaporate. “Right now, most New York co-ops are not paying taxes on their outside income,” he says. “Now that it’s unlimited, the IRS might start taking a closer look at that income. It could be considered as dividends by the IRS.”

Elsie Stark, for one, is eager to generate such dividends, even if they wind up attracting the attention of the IRS. “We’ve been exploring using some of our excess common space and converting it into rentable space for doctors’ offices,” says Stark, board president at the 485-unit Howard cond-op in Rego Park, Queens, noting that her board, like most boards, is constantly struggling to offset rising costs of everything from energy and taxes to capital improvements.

“We also have quite a bit of outdoor space that we might be able to convert into parking spaces that we can rent out. In our area of Queens, parking spaces are at a premium. It will be a challenge to find creative ways of making the most of the rule change. But regardless, the change seems to be positive.”

It is precisely because of co-ops like the Howard – those without bottomless pockets – that the Council of New York Cooperatives & Condominiums (CNYC) threw its considerable lobbying muscle into passage of HR 3648.

“Many low-income co-ops were put together with commercial tenants as a way of providing services and keeping shareholder costs down,” says Mary Ann Rothman, executive director of the CNYC. “This new law will allow co-ops to realize additional commercial rent. It’s probably not a happy moment for commercial tenants, but it’s a happy moment for co-ops.”

--HABITAT SIDEBAR--

Tax FORM 1120C,

Schedule G:

Lifting The Income Veil

By Laurie Wiegler

While numbers and semantics are still being argued – and vary greatly from co-op to co-op – New York City boards could very well be nervous, confused, or both because of a new spin on what has been a rather benign problem until Tax Year 2007: how to account for non-patronage income.

WHO ARE THE NON-PATRONS? Patronage income, derived from co-op members, includes funds paid by these “patrons” as well as services on the premises that can be used by the group. Whether it’s a garage or dry cleaner, as long as it’s proven to be a viable business for co-op members, it has gotten the same tax break as standard patronage income.

Theoretically, commercial income – derived from such non-patronage sources as a grocery store or real estate office independent of the group – could have been taxed at a higher rate. However, by most accounts, the average co-op has been operating on a break-even model.

Now, the Internal Revenue Service (IRS) has cracked down with a new form, 1120C and its accompanying Schedule G, as a replacement for Form 1120, thereby obliging co-ops to clearly delineate income derived from these non-patronage sources. How much this affects the co-op community varies greatly from board to board.

Accounting for Change

According to accountants Peter Spiess, director of PKF, and Abe Kleiman, partner at Kleiman & Weinshank, the new form is the result of landmark cases that drew attention to the unique issues facing housing co-ops, specifically Thwaites Terrace House Owners vs. Commissioner. This ruling ultimately helped co-ops have more flexibility in determining what types of income might qualify as patronage and non-patronage.

Before Thwaites, Kleiman says, “the IRS took the position that cooperative housing corporations are subject to Section 277 of the Internal Revenue Code, [which] was designed for membership organizations such as health clubs.” The IRS started doing audits and applying Section 277. In many of these cases, co-ops were being taxed on income that was not derived from its members or its shareholders, “and that was primarily interest income and income from commercial tenants,” he adds.

“Section 277 had been a long-standing assertion by the IRS, based on the concept that as membership organizations – or ‘social clubs’– co-ops could not offset non-member income with member deductions,” Spiess notes. All of that proved to be inappropriate for the co-op model and members spoke out, claiming they should be treated more like standard co-ops than as run-of-the-mill membership-based organizations.

When Thwaites was decided, it resulted in co-op housing corporations being subject to Subchapter T and not Section 277 of the Internal Revenue Code. With this ruling, Spiess says the distinction was really one of terminology: patronage versus non-patronage versus member versus non-member, as it had been under 277. “With the patronage, there’s a little bit more latitude on interest income on normal reserves that co-ops might establish,” Spiess says.

A key factor in determining whether interest income is patronage income has to do with its relevance to the co-op’s overall operations.

“You need to show the relationship the interest has to operating your business. If you can show it was set aside to pay next month’s bills, next month’s capital improvements, then you have a pretty good argument that it’s patronage,” says accountant Robert Mellina, a partner with Zeidman, Lackowitz, Prisand & Co.

The Heart of the Matter

While CPAs are advising clients to consult their accountants and start drawing a clear delineation between patronage and non-patronage income, the new form won’t carry much weight for most co-ops in the city. Spiess says that’s because most of these co-ops don’t have significant commercial space allocations. “The Park Avenue co-ops and Fifth Avenue co-ops generally don’t have commercial space, but for Lexington Avenue and other co-ops that will have ground floor space, this certainly affects.” Kleiman agrees that it’s more specific to those co-ops, maybe 10 percent, that have a more significant commercial space allocation.

Even so, all co-ops need to figure out how much of this will affect them and get their books in order. “I got an emergency phone call from my accountant saying this is an issue we had to deal with,” recalls Adelaide Polsinelli, board president of the 350-unit 2 Fifth Avenue. “Of course, we had no idea what he was talking about. We all heard this 80/20 rule was going to be changed. [But] what we learned was that what the government giveth with one hand, they taketh away with the other.”

Spiess stresses that, when differentiating patronage from non-patronage income, the chief determinant is the income’s relationship to the main purpose of the cooperative, its “principal business activity.” Yet most co-ops, since the 1996 ruling, have taken the position that all income is effectively patronage-sourced, but with the new form “the IRS may have taken the first step to challenging this position.”

So how will co-ops honestly account for what’s what? Determining patronage from non-patronage varies on a case-by-case basis and is all “fact-driven,” Kleiman notes, adding: “You may have one co-op that has the dry-cleaning store and you can make the argument that it’s an amenity to the shareholder. It would be as if the co-op said, ‘We are renting the space out to a dry-cleaning store at below-market rent because we want to have the amenity there.’ So, you can make the argument it’s for patronage. But if you are smack dab in the middle of Manhattan and there are five other dry-cleaners nearby [you might not have a claim].”

PKF, in a memo to its clients, offers some examples of patronage income:

• Maintenance charges and special assessments

• Interest income: on funds held to advance the co-op’s purposes

• Sublet fees, late charges, flip taxes, storage charges, laundry income, and the like

• Garage parking – if its main purpose is to serve tenant-shareholders, subtenants, or guests.

In some cases, though, determining patronage income isn’t clear-cut.

Queens real estate attorney Joel Miller says that if, for example, a business such as a dry-cleaners is in a building that’s in the middle of nowhere, it’s obviously patronage income. But the problems can arise at other times – specifically when a co-op moves into a building that already has shops included.

“Right now, I haven’t made up my mind if it’s patronage or not,” Miller says, referring to such buildings. He adds that this is a point of contention between some New York real estate professionals, who are currently debating the issue.

While the new form won’t have tremendous effect on an estimated 90 percent of co-ops – the impact of the change is still being weighed. Many professionals agree that it is one of the more confusing alterations in IRS code in some time and that all co-ops need to run it by their CPAs, especially since most are still trying to understand the new 80/20.

And for you conspiracy buffs: experts insist there is probably no connection between the 80/20 and 1120C changes. Purely coincidental, says Spiess, who notes that form 1120C regulations were completed much earlier in the year. “I would find it hard to believe that the treasury department was thinking about the new 80/20 rules when they were working on the 1120C.” Still, it is odd, isn’t it?