Andrew Brucker, Partner, Montgomery McCracken Walker & Rhoads

You might ask me: what do taxes have to do with co-ops? The answer is: everything. Co-ops exist today because of the tax code.

If  Section 216 applies and you are a cooperative housing corporation, which is defined in the tax code, then you get certain benefits. For example, you can deduct your pro-rata portion of the interest paid on the underlying mortgage. You can also deduct your pro-rata portion of the real estate taxes. Another benefit, by the way, is that when you sell your apartment, you can get certain tax benefits on capital gains. You get an exemption up to a certain point.

So there's a great benefit to being a cooperative corporation under Section 216. Probably 99 percent of all co-ops are created under the Business Corporation Law, but guess what? The law never uses the term “cooperative corporation.” That’s a creation of the tax law. This started in 1942, and it's been amended since then, but this is part of being a co-op. Now the reason I'm bringing up Section 216 is because many co-ops do things without thinking about the tax ramifications. Keep in mind, if you lose your status as a 216 cooperative corporation, you would lose all those benefits I just discussed. So keeping your status as a 216 cooperative corporation is very important.

I'll give you some examples. We had a co-op that came to us, and one of the shareholders had expanded his unit substantially. Now in normal situations, you would just charge them some money to buy some shares, and you give them a couple of more shares. The problem is that the taxes are going to go up substantially enough that it matters. So if he's just paying his pro-rata portion of those taxes because there's additional shares, it's not fair because everybody else is paying a great portion of those increased taxes.

If you look real carefully at Section 216, there's a little exception to the normal rule. They will let you make a special allocation for taxes instead of regular maintenance.  So that's what we did. We said the shareholder alone pays the increase in taxes caused by the increase in his square footage. Because of that, the cooperative saved itself a lot of money. The shareholder is paying what is fair and equitable, and everybody goes home happy.

The other issue is space. Sometimes a shareholder wants to take on additional space, so the co-op assigns shares for use of a hallway or the roof. The problem is you can't just come up with any kind of number. Under Section 216, there has got to be a reasonable relationship between the assigned shares and all the shares in the building. In other words, you can't do anybody a favor. It's got to be fair and equitable to everybody. Some boards forget this, and they'll just assign a certain number of shares because the president is the one who's expanding his unit and they want to be nice to the president. That's not the way to do it. The way to do it is to get an appraiser or real estate professional to say, “Yes, that extra 20 square feet in the hallway that he's taking should be four shares.” If you get that letter and put it in the file, the Internal Revenue Service can never come and try to take away your classification as a 216 co-op.

The other problem is that suddenly, because commercial space is worth more, people are giving out leases to commercial enterprises that are paying a lot of money. In the old days there was the 80/20 rule, which said that at least 80 percent of a co-op’s income had to come from shareholders, while no more than 20 percent could come from other sources, such as commercial rent – or the co-op loses its 216 status.

They changed the rules, and many people believe 80/20 is dead. It's not dead, they just changed it a little bit. There's the 80/20 square footage rule, which says you can ignore the money if your commercial space occupies less than 20 percent of your total square footage. There's also the 90 percent of expenses rule. If a co-op is expending 90 percent or more on shareholder items – and not expenses having to do with that commercial space – you're safe too.

So if anybody tells you 80/20 is dead, don't believe them. You have to be aware of how the rules have changed, because if you lose that 216 status, you will lose your deductions for your pro-rata portion of the real estate taxes, your pro-rata portion of the interest on the underlying mortgage, and, of course, the favored capital gains treatment when you sell your apartment.

The moral of this story is whenever you do anything in a co-op, consider Section 216. If you have any questions, speak to your your accountant or your lawyer, and make sure that you're not jeopardizing your status as a 216 cooperative housing corporation.