Casualty Deductions

May co-op shareholders take a deduction on their tax returns as a result of paying an assessment to the co-op in connection with the repair of a retaining wall? That was the question raised in Alphonso v. Commissioner of Internal Revenue.

The Wall Falls

Christina A. Alphonso was a tenant-shareholder of Castle Village Owners Corp., located in upper Manhattan. It consists of several high-rise buildings. Castle Village, like most co-ops in New York, is a cooperative housing corporation, as that term is used in Internal Revenue Code Section 216. Among other things, Section 216 allows certain “pass through” deductions – such as the expenses of the co-op for payment of real estate taxes and interest – that co-op shareholders may take on their tax returns.

Castle Village had a retaining wall, roughly 70 feet high and 250 feet wide, that separated the complex from public roads 65 feet below. On May 12, 2005, that retaining wall collapsed, causing significant damage. To cover repair costs, Castle Village assessed each shareholder for a portion. Alphonso’s assessment was for $26,390.

The Deduction

Alphonso listed a casualty loss of $26,390 on her 2005 tax returns. After she applied certain reductions, she claimed a casualty loss deduction of $23,188. Under the Internal Revenue Code, an individual taxpayer is allowed to deduct non-business losses of property that arise from a casualty. Roughly 200 other tenant-shareholders did the same.

The commissioner of the Internal Revenue Service (IRS) disallowed Alphonso’s deduction, saying that the loss did not qualify as a casualty loss under the Internal Revenue code, since “a loss from a casualty arises from an event due to some sudden, unexpected or unusual cause. Damages caused from gradual erosion or inundation is not a casualty loss. The cause of the collapse of the Castle Village Retainer Wall was determined to be the result of a gradual weakening of the wall.” A $3,059 deficiency was charged to Alphonso.

What Is a Property Interest?

Alphonso filed a petition in the United States Tax Court for a redetermination. The commissioner relied on its initial argument – that the incident was not a “casualty” – but also claimed that the collapse of the retaining wall occurred on property owned by Castle Village. Accordingly, only Castle Village could claim a casualty loss deduction. There was no “pass-through” for this expense. The commissioner argued that Alphonso did not have an ownership interest in Castle Village property; she merely had the right to use it. She owned nothing “beyond the proprietary lease she received as a shareholder of Castle Village.” To support his argument, the commissioner distinguished mortgage interest and real estate taxes, which shareholders were specifically entitled to deduct under Section 216 of the Internal Revenue Code.

In opposition to the commissioner’s motion for summary judgment, Alphonso argued that under the proprietary lease, she held property rights in the use of the apartment and related grounds. She submitted the lease, which stated that Castle Village was the owner of the land and buildings, set forth the number of shares owned by Alphonso, and provided for the lease to Alphonso of a specific apartment, which she could use exclusively. The lease further provided that Alphonso was to pay Castle Village’s “cash requirements” as determined by its board of directors, among other things, for the operation, maintenance, and care of the corporate property and for the payment of its obligations.

In addition, the house rules stated that the use of areas located on the grounds of Castle Village was limited to “building residents and their guests.” Alphonso asserted that she thus held property rights in the apartment and grounds, so that her “loss was the damage to the grounds which directly affected the apartments and the inability to use the related grounds.” She also argued that mortgage interest and real estate taxes were not the only tax deductions available to shareholders; they also had the right to deduct as qualified residence interest any interest paid on personal debt secured by the shares and the right to exclude from taxable income the first $250,000 of gain realized on the sale of the shares.

The tax court rejected Alphonso’s arguments and granted summary judgment to the commissioner. To support its decision, the tax court relied on a Pennsylvania tax case in which the taxpayer was a member of an incorporated social club that created an artificial lake on a tract of land.

The Tax Court Is Reversed

Alphonso appealed the tax court’s decision, and argued that the proprietary lease was evidence that she possessed shared property rights in the Castle Village complex, which was a sufficient property interest to entitle her to claim a casualty loss deduction. On appeal, the United States Court of Appeals for the Second Circuit reversed the tax court and concluded that Alphonso had a property interest in the grounds of Castle Village that entitled her to claim a casualty loss deduction (“assuming that the collapse of the retaining wall qualifies as a casualty”). The court stated that, when dealing with real estate, the term “property” – while not defined in the Internal Revenue Code – extends to a taxpayer’s leasehold interest. The court found that Alphonso had “multifaceted interests” under the proprietary lease. These interests included the exclusive right to reside in her apartment, and the right, shared by all tenants, to use the Castle Village grounds.

The court also discussed the dual nature of cooperative ownership, where the interests of the shareholder and the tenant are inseparable. Finally, the court noted the concession by counsel for the commissioner that if this were a condominium, in which the tenants own land and other elements as tenants in common, casualty loss deductions would have been permitted. The court argued that this concession was consistent with the principle that the nature of a property interest was dependent upon the nature of the rights enjoyed by a person, or a defined group of people – for instance, tenant-shareholders who share rights to use common areas.

The Takeaway

We do not normally report on tax cases; however, we believe that this decision is significant. Putting aside whether Alphonso can ultimately demonstrate that the wall collapse was a “casualty,” it is important that the appeals court determined that the shareholders had a property interest in the wall and the common areas owned by the cooperative corporation such that they could take a casualty loss deduction. If it had been determined that only the co-op had a property interest, it would have left the shareholders with little comfort, as cooperative corporations themselves typically operate on a break-even basis and have little or no net income, so that the right to take a loss has no practical benefit to the co-op.

The lease required tenant-shareholders to pay “cash requirements,” which included maintenance of the property owned by the co-op. It was also important that the house rules, which are incorporated into the proprietary lease and which grant shareholders their leasehold interest, specifically permitted shareholders use of the grounds.

This decision may have an impact on the ability of co-op shareholders to claim losses in connection with money paid for co-op assessments for, among other expenses, hurricane-related damage.

Note: To ensure compliance with requirements imposed by the United States Treasury Department in Circular 230, we inform you that any tax advice contained in this article is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Code or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein.

Elizabeth Akerman, a law school graduate awaiting admission to the New York State Bar Association, assisted in the preparation of this article.