A post-conversion co-op engagement. (conversion of apartment buildings to cooperative status)by Weiss, Judith Fellner
A cooperative housing corporation (co-op) is a form of real estate ownership evidenced by shares of stock or membership interests, initially purchased by tenant-shareholders from a sponsor. Ownership of shares in a co-op is accompanied by a proprietary lease that gives each shareholder the right to occupy a defined interior space. Unlike condominiums and homeowners' associations, co-ops usually own the building, underlying land, and improvements.
The co-op is responsible for maintenance, repair, and any required improvements to the property. Repairs and improvements within each apartment's interior space is the responsibility of the tenant- shareholder. The co-op is also responsible for payment of real estate taxes and any debt service on the underlying mortgage on the PrOperty. Tenant-shareholders are assessed monthly maintenance fees to pay for these expenditures; they also elect the Board of Directors which governs the co-op. Although the Board has direct responsibility for managing the coop, it usually retains a real estate management company to control finances, collect maintenance fees, and pay bills.
A CPA can serve co-ops in a variety of ways, from audit, review, or compilation of financial statements, to tax preparation, to business consulting. in addition, the financial statements of the co-op might be prepared on a GAAP or OCBOA basis. For the purposes of discussion, the article presents a discussion of factors for the CPA to consider when engaged to provide audit, tax and business advisory services to coops. However, many of the procedures would also be appropriate in a review engagement.
Planning the Audit
An exposure draft of an AICPA Audit Guide for Common interest Realty Associates (CIRAS) is (at the time of this writing) in the final approval stages. It will be a valuable resource to practitioners and should be referred to by those involved in engagements of the kind described in this article.
Upon accepting an engagement to audit a co-op, the practitioner should obtain a copy of the sponsor's offering prospectus and all amendments thereto. In some areas this document is known as the Sponsor's Black Book. This document will provide the auditor with considerable background information about the co-op. The auditor will obtain information about the sponsor, other parties related to the sponsor, the managing agent, if any, important contracts, number of apartments, shares issued, cost of building operations and existing financing. The document will also include copies of the original by-laws and the proprietary lease.
A review of minutes of Board meetings will provide the auditor with information and insight about the Board's thoughts and actions. Information on special and capital assessments, discussions about, or authorization for, major repairs as well as other issues usually appear in the minutes. The auditor may also learn about the existence of capital budgets, future commitments, and pending litigation.
Applying analytical procedures to unadjusted current information just prior to or at the end of the accounting year is an efficient method of determining the extent and type of audit procedures that should be followed. A comparison of that information to prior years' actual results and the current year's operating budget will help the auditor to identify potential areas of misstatement. Information obtained from the Board's minutes may help to explain some of the variances.
As a result of the recent softening in the real estate market and the effects of local control and stabilization laws, many sponsors have failed to meet their sales projections. Consequently, they are holding large blocks of unsold shares in buildings that were converted from rental units to co-ops in recent years. Because the sponsor's obligation to the co-op for monthly maintenance fees on unsold shares often exceeds the sponsor's revenues from rentals on apartments representing those shares, many sponsors have been experiencing negative cash flows. As real estate prices continue to fall, sponsors who see carrying costs increase and profits diminish will also be unlikely to support proposed increases in maintenance fees and may eventually consider abandoning their investments in unsold shares. The auditor should consider how the sponsor's potential inability to dispose of unsold shares affects the viability of the co-op as a going concern. it may be advisable to confirm the delinquent receivable with the sponsor and to obtain an affirmation in writing that the sponsor intends to and has the ability to meet its obligations to the co-op over the next year.
In some states, the auditor can obtain some level of comfort about the sponsor's commitment to his or her investment by reviewing required filings with state authorities' In New York State, for example, a filing with the Attorney General is required for all unsold shares held by the sponsor or its assignee, that account for 10% or more of the co-op's shares. The filing requires disclosure of, among other things, shares owned, current rents received from tenants, current payments of maintenance fees to the co-op, as well as a statement on how current the sponsor is regarding obligations to the co-op, and whether the sponsor's shares are used to collateralize an obligation. From that report, the auditor can obtain financial information about a sponsor that was not readily available prior to June 1990. Substantiation of Asset Balances
One of the most important assets of a co-op is its cash. Some managing agents commingle the operating accounts of all their buildings into one agent" account. This practice presents problems for auditors and the co- op. The managing agent may be tempted to use funds of one co-op having a positive cash balance to pay bills of another co-op with a negative balance. Also, the auditor may find it difficult to confirm the balance of the co-op's portion of a commingled cash account because the information usually cannot be obtained from independent sources. In some cases, the managing agent is affiliated with the sponsor. As a result, the auditor should verify that expenses paid on behalf of the co-op were in fact incurred by that entity.
Many building managers have little time to enforce collection of maintenance fees, late payment fees, and fees for repairs chargeable to tenant-shareholders. Therefore, it is important for the auditor to review the status of significant outstanding receivables. Instituting new policies, such as applying payments received from tenant- shareholders to outstanding late fees or to charges for repairs before they are applied to current maintenance fees, can help solve a collection problem. in addition, a review of the co-op's lien filing procedures for nonpayment of maintenance fees is suggested. If a co-op is having problems collecting current maintenance fees promptly, the Board may instruct the managing agent to ask the co-op's attorney to start lien or foreclosure proceedings after a specific period determined by the Board. Such action may be all that is necessary to eliminate the problem.
During the initial years of a co-op's operations, the sponsor usually controls the Board of Directors. Consequently, it may be very difficult for tenant shareholders to enforce collection procedures against the sponsor because it controls the Board as well as the management company. if an auditor concludes that the co-op's ability to continue as a going concern is at risk because of late and potentially uncollectible receivables from the sponsor, the auditor may want to seek the advice of legal counsel before proceeding with the engagement.
The co-op's largest asset is its real estate, including improvements. For this reason, adequate insurance of these assets is essential. The auditor should review the adequacy of coverage and consider advising the Board to consider consulting with an insurance professional as to whether the co-op has adequate insurance. Providing for Future Major Repairs and Replacements
A primary duty of the co-op's Board is to maintain and preserve its real estate. Therefore, a plan should be established for funding future major repairs and replacements. Failure to plan might some day be construed as a breach of the Board's fiduciary responsibility. The concept of funding for future major repairs and replacements can be presented to the Board as an investment in the co-op's future. The auditor should explain the effect of neglect on the owners' ability to sell or refinance their units. In addition, because assessments designated for future major repairs and replacements are considered capital contributions for tax purposes and are added to the owners' tax basis of their units, future individual income tax benefits should be evaluated and communicated to the affected parties. Unless required to do so by the co-op's articles or by-laws, most Boards will postpone funding for future major repairs and replacements until there is a current need, and then will finance such repairs and replacements by borrowing or levying capital or special assessments. Under the draft AICPA CIRA Audit and Accounting Guide, disclosure of information about future major repairs and replacement needs is required. The auditor should inquire as to the existence of the long term capital budget items. Substantiation of Liability Balances
As a result of the separation and potentially different interests that exist between the Board and the managing agent, examination of the co- op's accounts payable account is an important aspect of the audit; expanded procedures in the accounts payable area should be considered. Most managing agents maintain their books and records on the cash basis. Accordingly, a detailed search for unrecorded liabilities is very important. During an initial engagement, the auditor should review "unpaid bill files" and subsequent disbursements to ensure adequate year-end cut-offs. The auditor may gather additional information by interviewing officers, confirming balances with a larger than usual sample of vendors, and examining significant post-balance sheet date invoices up to the point of completion of field work.
Reviewing all loan agreements is an integral part of an engagement. Most co-op conversions are structured so the co-op continues to have a mortgage and/or loan payable. This enables the sponsor to receive the largest amount of proceeds from conversion while minimizing the amount of cash required for tenant-shareholders to purchase their shares. Although a mortgage payable is a substantial financial statement item, the auditor may notice that tenant-shareholders pay little attention to it, because they are more concerned with future maintenance charges.
Co-ops rarely make meaningful amortization payments in the initial years of their mortgages. Boards prefer to keep maintenance fees on the units to a minimum, increase the individual income tax deductions under Sec. 216, and pass as much of the mortgage liability as possible to succeeding unit owners. Consequently, refinancing a large portion of the initial mortgage is a wide-spread practice. As maturity of the mortgage comes closer, the auditor can alert management to the necessity for an upcoming refinancing and the related problems and costs the co-op may face in obtaining such refinancing.
The principal users of a co-op's financial statements are present and prospective tenant-shareholders and financial institutions that grant mortgages to shareholders or to the corporation itself. When a rental building is converted, especially in large urban centers where there are rent control and stabilization laws, as little as 15% of the shares in the offering plan may have been sold. In such cases, the sponsor continues to hold a majority of the shares and thus controls the Board. Consequently, information about the finances of the co-op may not be easily available to tenant-shareholders and audited financial statements may be their only independent source of information about the co-op's finances.
The Balance Sheet
Components of the current assets portion of the balance sheet are of most interest to tenant-shareholders and creditors. Insufficient cash for operations and for future major repairs and replacements indicates a need for increases in future maintenance fees. Further, large maintenance receivables may indicate poor collection procedures or potential problems of the sponsor.
Amounts due from the sponsor, such as funds for future major repairs and replacements or material receivables for maintenance fees on unsold units, should be disclosed separately. Such disclosures may be useful to users in their evaluation of the independence of the Board and of how much they can rely on future budgets and other information supplied by the Board.
Statement of Operations
A co-op's statement of operations is the statement most closely scrutinized by tenant-shareholders. It provides an annual review of the Board's efforts to keep maintenance fees to a minimum, and in turn, the foundation for the upcoming year's budget. Maintenance fees from tenant- shareholders are the co-op's principal source of revenue. A comparison of the authorized maintenance fees with those actually collected or accrued is a basic part of the engagement. A comparison of these amounts to the budget is also recommended.
Be assured that tenant-shareholders will closely examine the expense section of a statement of operations. Again, a comparison of actual expenditures to budgeted amounts as well as prior years' operations provides a relatively easy way for the auditor to spot a posting error that will be obvious to tenant-shareholders. Scanning the repair and maintenance accounts can pinpoint expenditures that should be capitalized. Reconciliation of easily traced expenses such as mortgage interest, real estate taxes, payroll and management fees is recommended. This will give insight as to how much the auditor can rely on information provided by the Board and the managing agent. Because the tenant-shareholders are more concerned with cash flow than income, it has also become common practice to provide a line item indicating the excess or deficiency of revenue over expenses before depreciation and amortization. That presentation enables users to ascertain whether maintenance fees are sufficient to fund the co-op's operations during the year.
Statement of Cash Flows
SFAS 95, "Statement of Cash Flows," specifically exempts not-for- profit organizations from applying the statement until further guidance has been provided for such entities. However, the AICPA's proposed CIRA audit and accounting guide will require application of the provisions in SFAS 95 to the financial statements of CIRAs-which include condominiums, homeowners' associations, and co-ops. Further, the FASB in its recent discussions on the project dealing with display in the financial statements of not-for-profit organizations made a preliminary decision requiring that such entities present a statement of cash flows.
Going Concern Considerations
It is not uncommon to find large operating deficits in the initial years of a co-op, because sponsors frequently use unrealistic budgets to keep projected maintenance fees of a recently converted building to a minimum. Unless tenant-shareholders are willing to face reality, the auditor may need to consider whether the co-op can continue as a going concern. When placed in this position, most Boards will approve hefty increases in maintenance fees to cover the deficit. However, it may be necessary to wait until these assessments are approved before issuing the financial statements and the auditor's report without disclosure of a potential going concern problem.
INCOME TAX CONSIDERATIONS
For income tax purposes, tenant-shareholders may be entitled to deduct a portion of their maintenance fees that represent their allocated shares of real estate taxes and mortgage interest paid or accrued by the co-op. In addition, tenant-shareholders may depreciate the property occupied if used in a trade or business or for production of income. As a result, portions of the property may be depreciated concurrently by the corporation and by tenant-shareholders.
Co-ops are generally taxed as corporations and therefore file Form 1120. They are taxed on any excess of maintenance fees from tenant- shareholders over operating expenses incurred. In addition, they are taxed on other income, such as interest and dividend income and rent derived from commercial leases. The corporation is allowed to deduct a share of its expenses attributable to such income.
Income from maintenance fees may be reduced on the tax return by patronage dividends to tenant-shareholders if declared and paid within eight-and-a-half months after the end of the fiscal year. The dividend must be paid 20% in cash and the remaining 80% constructively by a qualified written notice of allocation to tenant-shareholders. Tenant- shareholders are not required to report such dividends on their personal returns unless the property is used in a trade or business. Excess expenditures over maintenance fees in a taxable year are carried forward and can be used to reduce excess maintenance fees in subsequent years.
A corporation must meet certain requirements to qualify under Sec. 216 to be treated as a cooperative housing corporation for income tax purposes in a particular year. These requirements are as follows: 1. it has only one class of stock outstanding; 2. Each stockholder is entitled to occupy for dwelling purposes an apartment in a building, owned or leased by the corporation, solely as a result of ownership of the corporation's stock; 3. Stockholders are not entitled, conditionally or unconditionally, to distributions other than from earnings and profits of the corporation, except on a complete or partial liquidation of the cooperative corporation; and 4. 80% or more of gross income for the taxable year must be derived from tenant-shareholders.
The 80/20 test should be examined each year. Leasing of commercial space at current market rates can disqualify what has previously been a qualified cooperative housing corporation. The auditor should consult with the Board and managing agent if he or she believes the corporation has failed this test.
With a little planning, the work involved in providing tenant- shareholders with necessary information about amounts deductible on individual tax returns for mortgage interest and real estate taxes can be minimized. Substantially all work necessary in this area can be done when accruals are prepared or reviewed. A short visit or possibly a call to a managing agent at calendar year end can complete the information collection process. The best time to get the names, social security numbers, number of shares and length of periods they were held by the various tenant-shareholders, is when a reconciliation of maintenance fees accrued and receivable is being prepared. An allocation of these items to member and non-member income is required.
The portion of amounts deductible that passes through to shareholders is initially reduced in the calculation of the co-op's Sec. 277 non- member income. Rev. Rul. 90-36 gives the auditor guidance in the calculation of this tax.
Once the portion of interest and real estate taxes attributable to non-member income is determined, the accountant can calculate the amount to be passed through to the tenant-shareholder. That amount is calculated by dividing total membership income by all allocated income and multiplying the resulting fraction by mortgage interest and real estate taxes. These total pass-through amounts are allocated first to each block of shares and then to the individual(s) who owned those shares in various periods during the calendar year. The period is usually denominated in months, because an adjustment is made at the closing following a sale of shares. Information about capital contributions made during the year can also be provided to ensure tenant-shareholders are fully informed of the increase in tax basis of their shares for capital contributions made to the co-op.
By using the accompanying checklist as a guideline, accountants can provide clients with better service while limiting the time spent on the engagement. The checklist is meant to serve as a supplement to other materials-disclosure and audit completion checklists, for example, used in practice to assure compliance with professional standards.
This article was prepared under the auspices of the Real Estate Accounting Committee, Arthur Klampert, CPA, Chairman.
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