Why Co-ops Almost Never Become Condos

Several times a month I’m approached by co-op boards who want to convert their cooperative corporation into a condominium association. A major reason is that condo apartments are now valued from 15 to 20 percent higher than co-ops. But I have bad news for these co-op boards. The Internal Revenue Code makes it virtually impossible to accomplish the conversion without paying taxes on the “phantom gain” in value.

By the late 1980s, there were in excess of 6,500 cooperative corporations and perhaps 50 condominium associations in New York City, so New York’s Congressional delegation did not focus on the conversion issue when the Tax Reform Act of 1986 was debated and enacted. Now there are more than 1,000 condominium buildings, and a co-op offering is a rarity.

This has led to a great deal of interest in converting cooperatively owned buildings into condominiums in order to magically increase the value of the apartments. The process to do so is neither difficult nor expensive, and yet almost none of the 6,500 cooperatives have done it primarily because of the income-tax consequences. The Internal Revenue Code treats the exchange of a co-op's shares for a deed to a condominium unit as a sale of the co-op apartment and the purchase of the condo unit – even though the owner remains in the same apartment. Therefore, the former shareholder is taxed on the “phantom gain” he or she would have realized based on the profit that would have been made if the apartment were actually sold for its fair market value.

I believe that this was a mistake that occurred 30 years ago when Section 216(e) was added to the Tax Code, which permitted the tax-free conversion of co-op corporations into condominium associations – but no one considered that it was the shareholder who would face “phantom gain” while continuing to own the same apartment but in a different entity. Eliminating the tax on “phantom gain” would actually generate revenue for the government because the same apartment would be worth 20 percent more, so the taxes paid on the actual sale would be 20 percent higher. Fixing Section 216(e) is the proverbial win-win for everyone.

The other advantage of converting from a co-op to a condominium is that all of New York’s mandates that are focused on protecting tenants in rental housing would no longer apply to co-op buildings because they would cease to be based on a rental concept.

There has been a fear among many co-ops that being a condominium means that the board will not be able to approve purchasers, but that is not the case. The only reason that co-op boards have the power to reject buyers and condominium boards do not is because that was the way the sponsor’s lawyers wrote the documents establishing the co-op or condo. In general co-ops can have condo rules, and condos can have co-op rules.

But there is only way to remove the “phantom gain” roadblock from co-op to condo conversions: by amending Section 216(e) of the Tax Code.

Stuart Saft is a partner at the law firm Holland & Knight.