HEADNOTE: The establishment of these corporations, to own and operate apartment buildings and similar units, has income tax and other consequences that CPAs will want to understand. The author deals with several typical problems affecting both sponsors and shareholders--gain or loss on transfer to the cooperative and on sale of the cooperative's shares; consequences of a pre-existing mortgage in excess of transferor's basis; use of an apartment for business or professional purposes, and classification of the unit as an apartment; and also conversion to a condominium. A cooperative housing corporation is not the same as a condominium. The owner of a condominium apartment owns a parcel of real estate, but the owner of a cooperative apartment owns shares in a corporation which in turn owns real estate. The two ownership forms have similar, yet distinctive, federal tax implications.

A comprehensive discussion of the federal tax treatment of condominiums is beyond the scope of this article. Suffice it to say that the owner of a condominium is generally taxed no differently than the owner of a single-family residential unit with regard to the deductibility of interest (Sec. 163), real estate taxes (Sec. 164), the rollover of gain on the sale of a principal residence (Sec. 1034), the one-time exclusion of gain from the sale of a principal residence (Sec. 121), normal depreciation or trade or business expenses, or if the condominium is rented.

Establishment of a Cooperative Housing Corporation

To understand the federal tax treatment of a cooperative housing corporation one must start with the corporation's origin. Generally, such a corporation is created when an entity, (usually a partnership), which owns real property transfers the property to the newly established corporation in exchange for the corporation's capital. The transferor is generally referred to as the sponsor or original seller. Such transaction is generally non-taxable under Sec. 351. This section provides that gain or loss is not recognized if property is transferred to a corporation solely in exchange for the corporation's stock, and immediately thereafter the transferor owns at least 80% of the corporation's stock. This article will specifically refer to cooperative apartment houses in the examples, since they are a more common type of cooperative corporation. (The federal tax effects are no different for cooperative apartments than for any other type of cooperative housing corporation.)

In some cases, the sponsor has a very low basis in the property transferred. Normally, this does not prevent the transaction from qualifying as a non-taxable event. However, Sec. 357 requires the current recognition of income if the property is transferred subject to a liability (i.e., mortgage) which exceeds the sponsor's basis.

It is not uncommon for an apartment building which was purchased by the sponsor many years ago to be subject to a mortgage far in excess of the sponsor's basis; in these situations the transfer would typically be a taxable event. The first specific area addressed elaborates on the viability of ways to avoid this unfavorable result.

Disposition of Shares

At the time the cooperative corporation is established, the sponsor generally controls all its shares. Next, the sponsor begins to sell shares to tenant-shareholders. Each share of the cooperative's stock must bear a reasonable relationship to the portion of the value of the corporation's equity in the real property transferred from the sponsor. For example, assume that an apartment building with a current fair market value of $10 million was exchanged for 10,000 shares of cooperative stock. The building transferred was not subject to any liabilities and the corporation is not assuming any debt related to the building. In this example, each share of stock would represent $1,000 of value in the building.

The sponsor's sale of stock is a taxable event. The sponsor must pay income tax on the excess of the amount realized over the adjusted basis in the stock. The sponsor's adjusted basis is generally equal to the adjusted basis in the property transferred to the corporation, provided there was no recognized gain or loss on the Sec. 351 transaction; if there was such a recognized gain or loss, the amount is taken into consideration in computing the sponsor's basis. The basis is allocated to the cooperative shares on a pro rata basis.

Tenant shareholders who purchase shares from the sponsor are entitled to a proprietary lease which allows them to occupy a particular apartment in the building. The lease typically requires the payment of monthly rent called maintenance. The corporation uses the maintenance received to pay for the building's operating expenses. A portion of the maintenance is used to pay the real estate taxes of the building as well as principal and interest payments of any mortgage outstanding.

Income Tax Considerations

Sec. 216 allows the tenant-shareholders to take a deduction for their proportionate share of the real estate taxes and interest payments made by the corporation, which are deductible under Secs. 164 and 163 respectively. This interest is deductible only on indebtedness contracted in the acquisition, construction, alteration, rehabilitation, or maintenance of the house or apartment building or the land on which the house or apartment building is situated. The Sec. 1034 deferral of gain on the sale of a principal residence and the Sec. 121 exclusion for a qualifying sale of a principal residence by a taxpayer at least 55 years old also apply to sale of stock in a cooperative housing corporation.

Additionally, if the cooperative apartment is used in a trade or business, or for the production of income (i.e., rented), Sec. 216 allows the tenant-shareholder to take depreciation deductions based upon his or her adjusted basis in the cooperative stock. The allowable depreciation deductions can never exceed the tenant-shareholder's adjusted basis. In determining the applicable depreciation method, the shares are considered to be real property. The applicable depreciation period is 27.5 years for residential real property and 31.5 years for nonresidential real property.

In order for the tenant-shareholders to take a deduction for their share of the real estate taxes and interest, the corporation must be a cooperative housing corporation as defined by Sec. 216. In general, such a corporation must have these characteristics: 1) only one class of stock; 2) each stockholder is entitled solely by reason of ownership of stock to occupy for dwelling purposes a house, or an apartment in a building owned or leased by the corporation; 3) no shareholder is entitled to receive any distribution not out of earnings and profits of the cooperative, except on a complete or partial liquidation of the cooperative; and 4) 80% or more of the gross income for the taxable year is derived from tenant-shareholders.

Another area of current concern involves how Sec. 216 defines the term "apartment" in a building. This is of specific concern to doctors and dentists who use their apartments as professional offices and not residences. Based on recent IRS private letter ruling policies it is not altogether clear if use of a unit as a professional office enables the tenant-shareholder to be deemed to occupy an apartment for dwelling purposes.

It is important to keep in mind that when tenant-shareholders are taking their Sec. 216 deductions, the cooperative housing corporation is required to file a federal corporate income tax return and report its income and expenses, as with any other corporation. Under Sec. 277, deductions attributable to providing services or goods to members of a social club or membership organization are allowed only to the extent of income derived from members.

A third area of current concern involves the applicability of Sec. 277 to cooperative housing corporations. A literal application would require cooperatives to deduct their operating expenses attributable to maintenance income only against such maintenance income. Any excess deductions could not be used to offset, for example, interest earned on the corporation's reserve fund or rent paid the cooperative for use of a parking garage located in the building.

A final area of current interest involves the possible federal tax effects to the corporation if it converts to condominium status. With the repeal of the General Utilities doctrine, corporate assets cannot be distributed to the shareholders without triggering a tax at the corporate level. However, the TAMRA of 1988 provided an exception for certain distributions by a cooperative housing corporation of a dwelling unit to a shareholder of such corporation in exchange for the stockholder's stock. Congress had co-op to condo conversions in mind when this exception was enacted.

Typical Example in Establishing a Cooperative--Previous Mortgage

Let us assume the following with regard to the creation of a cooperative housing corporation. The sponsor (a partnership) will transfer a building to the corporation in exchange for its shares. The building has a mortgage which will be repaid by the sponsor prior to transferring the building to the corporation. The mortgage is substantially in excess of the sponsor's basis in the building; the sponsor will pay the mortgage with funds received from a new, unsecured borrowing. The building is therefore being transferred not subject to a mortgage. In addition, at the time of the transfer the building is not the collateral for any debt. The corporation will obtain a new mortgage on the building at some future date. The corporation will then transfer the cash received from the mortgage to the sponsor. The sponsor will use this cash to pay off its unsecured loan. The sponsor and not the corporation will be liable on the new mortgage.

The first issue is whether this transaction is deemed to be, in substance, the transfer of property subject to a liability in excess of the transferor's adjusted basis. If the answer is yes, the transaction is deemed to be a currently taxable event. If the answer is no, the sponsor has no gain to recognize until it sells the cooperative's shares.

Sec. 351 provides that gain or loss is not recognized if property is transferred to a controlled corporation solely in exchange for the controlled corporation's stock or securities. If, in addition to receiving stock or securities of the controlled corporation, the transferor of the property also receives money or other property in a transaction that otherwise would qualify as a completely tax-free exchange, Sec. 351 requires the recognition of any gain realized on the exchange but not in an amount which exceeds the value of the money or other property received.

Sec. 357(c) requires, in part, that if property is transferred subject to a mortgage which exceeds the transferor's basis in the property, then the excess is considered to be a taxable gain.

The IRS and the U.S. Tax Court both have taken the position that even if the transferor (the sponsor in this case) is liable on the mortgage, the transferee (the corporation in this case) will be deemed to have acquired the property subject to the mortgage as long as the debt is secured by the property transferred. The leading case in this area is Smith, 84 T.C. 889. In that case, even though the transferor remained liable on the transferred mortgage, the Tax Court held that Sec. 357(c) nonetheless applied since the property was subject to the mortgage at the time of the transfer. The issue is whether our fact pattern is on all fours with the Smith case. Can a position be sustained that Smith does not apply to our facts since the property was not subject to any liabilities at the moment of transfer?

The IRS would probably respond with a definite no and seek to apply the step-transaction theory. Under this theory it is possible to argue that the effect of the sponsor's subsequent use of the proceeds received from the new mortgage to pay off the outstanding unsecured loan is no different than actually transferring the building subject to the mortgage. The Service would collapse the two separate transactions, the retirement of the original mortgage and the subsequent repayment of the unsecured loan, into one transaction. As a result, the Service would hold the sponsor currently taxable on the excess of mortgage over the sponsor's adjusted basis.

The longer the period of time between the two transactions, the less likely that the step-transaction theory can be effectively applied. However, Reg. Sec. 1.351-1(c) (5) warns that planned transactions, however delayed, will be considered as a single transaction. It should be noted that this regulation was drafted in the context of investment companies and not real estate transactions.

In addition to Sec. 357(c), another area of concern involves the issue of money or other property under Sec. 351. It is possible that the Service will view the distribution of the cash by the corporation to the sponsor as either taxable boot (money received), a return of capital, or another includible item resulting in current tax consequences to the sponsor.

The basis for the case refuting this position lies in Sec. 301, which requires that a distribution of property by a corporation to a shareholder be included in the gross income of the recipient to the extent of the corporation's current or accumulated earnings and profits. For this purpose, property includes cash. However, Sec. 301(b) (2) allows a reduction of the amount of any distribution by the amount of any liability of the corporation assumed by the shareholder. Under our facts, the cash distribution received by the sponsor would be reduced by the amount of the mortgage which the sponsor is assuming from the corporation. But the Service would argue that the sponsor never assumed anything and merely continued to be liable on the original mortgage.

The answers to the relevant issues involving this transaction are not clear. Structuring a Sec. 351 transaction as previously described is subject to substantial risk.

Qualification as a Cooperative Housing Corporation

Sec. 216 allows tenant shareholders of cooperative housing corporations to take deductions for their proportionate share of the real estate taxes and interest allowable as a deduction by the corporation. However, each shareholder must be entitled, solely by reason of ownership of stock in the corporation, to occupy for dwelling purposes an apartment in a building owned by the corporation.

Reg. 1.216-1(d) (2) provides that the requirements of Sec. 216(b) (1) (B) will be satisfied so long as each stockholder has the right, as against the cooperative housing corporation, to occupy the premises for dwelling purposes. This right is conferred to the shareholder solely by virtue of stock ownership in the corporation. The stockholder is not required to actually use the unit as a residence. In fact, the shareholder can be a corporation, trust, estate, or partnership. However, the key issue is whether the unit constitutes an apartment in a building. For example, would the shareholder's use of a unit as a doctor's or dentist's office constitute satisfying the unit as an apartment? This issue is relevant to many cooperatives since many typically have apartments being used for these professional purposes. If these professional units were not treated as apartments for purposes of Sec. 216, no cooperative shares could be allocated to them. This in turn would reduce the potential income which would be realized by the sponsor on the sale of the cooperative shares. Allocating shares to a unit which is not an apartment will disqualify the corporation as a cooperative and deny all shareholders their Sec. 216 deductions.

Rev. Rul. 74-241, 1974-1 C.B. 68, holds that, for purposes of Sec. 216(b) (1) (B), the term "apartment in a building" means an independent housekeeping unit consisting of one or more rooms containing facilities for cooking, sleeping, and sanitation normally found in a principal residence. The typical apartment used as a professional office does not have complete cooking or sanitation facilities, usually there is no kitchen and no shower facilities. However, a series of private letter rulings do not interpret the Rev. Rul. to require that the unit presently contain all of the described facilities. Rather, the rulings have concluded that, solely for purposes of Sec. 216(b) (1) (B) a nonresidential unit will qualify as an "apartment in a building" if: 1) the stockholder is entitled to make all conforming modifications to the unit solely by reason of stock ownership; 2) local zoning laws and pertinent building codes currently permit all of the modifications as a matter of right; and 3) addition of the necessary facilities would be reasonable under all of the facts and circumstances.

Based upon these prior rulings, as long as there was no legal, physical, or engineering obstacle to the installation of such facilities in the professional unit, the shareholder was deemed to have the right to occupy an apartment for dwelling purposes. The fact that the shareholders chose not to so use their apartments was irrelevant for purposes of Sec. 216(b) (1) (B).

More recently, the IRS has expressed some concern that Sec. 216(b) (1) (B) requires that a unit presently qualify as a housing unit. The IRS is troubled by the fact that if there is no present requirement for qualification as a housing unit a building could conceivably qualify as a cooperative without any residential units. The IRS has not formally announced their position on this issue.

In recent months, my experience indicates that the IRS will continue to issue favorable Sec. 216 private letter rulings provided there are no physical or legal restrictions to qualification as a residential unit. However, in many cases, the Service has only chosen to rule on buildings in which the professional units were either presently vacant or the current lease expired within one year from the date of the private letter ruling request.

As a practical matter, it is best to open discussions with the member of the Treasury department who is writing the response to a Sec. 216 request shortly after its submission. This will allow one to judge how a particular situation is reviewed with regard to qualification as a apartment. If an unfavorable ruling would be forthcoming, this communication would allow withdrawal of the request prior to its release.

Cooperative Housing Corporation Operations

Sec. 277 prohibits social clubs or other membership organizations from taking deductions attributable to furnishing services, goods or other items to members against any income received from non-members. This means that deductions attributable to providing services to members of a cooperative organization are allowed only to the extent of income derived from members. When Sec. 277 is viewed in the context of cooperative housing corporations, the potential tax results are not favorable to the cooperative.

The typical cooperative housing corporation receives taxable income from members in the form of maintenance payments. The cooperative can have other taxable income from interest on reserve funds or rent of a parking garage in the building. In many cases the garage is owned and operated by unrelated entities on a net lease basis. The unrelated entity will pay all directly related operating expenses such as electricity and heat. If Sec. 277 is applied, the result will be a significant increase in the cooperative's federal tax since it could not use of any its expenses attributable to maintenance income to offset interest income from the reserve fund or the net rent from the garage.

In Shore Drive Apartments, Inc., 76-2 USTC paragraph 9808 (M.D. Fla. 1976) the U.S. District Court held that Sec. 277 is applicable to cooperative housing corporations. As a result, in that case, interest from investments in U.S. obligations was deemed to be non-membership income.

As a practical matter, returns currently being filed by cooperative housing corporations do not follow the holding in Shore Drive Apartments, Inc., and do offset member related expenses against non- member income. However, adequate disclosure should be provided in these cases.

Neither the statute nor the regulations provide any definitive guidance in this area. But the IRS apparently takes the position that interest on a cooperative housing corporation's reserve fund does not constitute income derived from members. The legislative history behind Sec. 277 indicates that it was put in the law to prevent non-exempt social clubs from avoiding taxation of their business income by offsetting the income against losses created by non-arm's length transactions with members. Congress does not appear to have intended to include cooperative housing corporations in the purview of Sec. 277.

Termination by Conversion to Condominium Status

There may be situations in which the tenant-shareholders of a cooperative housing corporation want to convert to condominium status. For example, the shareholder's ability to deduct their ratable share of the corporation's real estate taxes and interest is only allowed as long as the requirements of Sec. 216 are met. In some cases, it is possible for the amount of nontenant-shareholder gross income to increase so that the 80% requirement is no longer met. In this situation conversion to condominium status would avoid the need to deal with Sec. 216 altogether.

Once a decision has been made to convert, all tenant-shareholders surrender their shares to the corporation in exchange for a deed for their unit, and the corporation is dissolved. With the repeal of the General Utilities doctrine, this transaction would have been viewed as a taxable distribution. But Sec. 216(e) was added to the Code in TAMRA of 1986:

"Except as provided in regulations no gain or loss

shall be recognized on the distribution by a cooperative

housing association of a dwelling unit to a stockholder

in such cooperation if such distribution is in exchange

for the stockholder's stock in such corporation and such

exchange qualifies for nonrecognition of gain under Sec.

1034(f)."

It appears that no gain or loss will be recognized by the cooperative when property that qualifies as a principal residence is distributed to tenant-shareholders in exchange for their stock, to the extent the exchange qualifies at the shareholder level as a Sec. 1034 rollover. There will be no current taxable income to the corporation to the extent tenants used their houses or apartments as a principal residence both before and after the distribution. This means that to determine the tax effect at the corporate level the cooperative must determine whether each tenant-shareholder is using the apartment as a principal residence. In a large cooperative apartment building with some shareholders using their apartments as principal residences and other using apartments as a second residence or as rental property, this will not be an easy task.

Conclusions

The four areas of concern discussed are all currently being faced by tax professionals involved with cooperative housing corporations.

First, it is clear that cooperative conversions are being structured as non-taxable Sec. 351 transactions using a similar sequence of events to those discussed. In addition to those areas of concern already covered, it is important that all applicable documents related to proceeds from a new mortgage consistently indicate that the corporation received the cash as nominee for the sponsor and that the sponsor, and not the corporation, is liable on the mortgage. Please remember that this article is not intended to provide assurance that this type of transaction will not be characterized as currently taxable upon review by the IRS.

Second, as to clients who are professionals whose offices are located in buildings turning cooperative, it is in the client's best interest to make inquiries of the sponsor as to the professional office's classification as an apartment. Has a private letter ruling been applied for? If not, what assurance does the sponsor have that the professional office qualifies as an apartment in a building? Remember that each private letter ruling is directed only to the requesting taxpayer and may not be used or cited as precedent. Confusion could be avoided in this area if the IRS issued a Rev. Rul. providing clear guidelines.

In addition, despite a court case holding to the contrary, in practice Sec. 277 is not being applied to cooperative housing corporations, provided full disclosure is indicated on the return.

Finally, the conversion from cooperative to condominium status, which was generally a non-taxable event to the cooperative corporation prior to TRA 86, may now trigger tax at the corporate level depending on individual tenant-shareholders' ability to qualify under the rollover provisions of Sec. 1034.

Morton Zachter, MBA, CPA, is a Tax Manager at Drescher, Dorkin, Kaplan & Co. He is also an adjunct Assistant Professor of Taxation at the Stern Graduate School of Business Administration at New York University. He has previously written articles for The CPA Journal.