Eva Talel and Richard Siegler ()
A frequently asked question by boards and co-op apartment owners is whether a co-op corporation can be converted to a condominium. While this question has likely been asked since 1964, when New York adopted a Condominium Act1 permitting condominium entities to be created, it is now being asked with greater urgency—as the condominium form of development and ownership has become more prevalent in New York and co-op apartment owners perceive significant benefits to be had from condominium versus co-op ownership. These perceived benefits include: enhanced apartment values (as much as 20 percent, based on empirical studies2); and greater flexibility in transfers, leasing and apartment financing (which in most condominiums, unlike in co-ops, requires no board approval).
However, the purpose of this column is not to examine the purported superiority of condominium ownership, about which we and others have written.3 Rather, this column discusses the significant deterrents to converting co-ops to condominiums, in the hope that, for these co-op buildings which desire to do so, solutions can be found to remove the economic uncertainty (and therefore risk) which generally deters even consideration of such conversions.
Obstacles to conversion generally fall into two categories: those presented by the co-op’s proprietary lease, governing New York corporate law and outstanding mortgages on the co-op building and owner apartments, and those presented by the uncertainty of liability for shareholders and the co-op under federal income tax laws.
Proprietary Lease, the Business Corporation Law (BCL), and Mortgage Debt. A typical co-op proprietary lease requires a super-majority vote of shareholders (generally, two-thirds in interest) to terminate all proprietary leases and thereby end the co-op regime. In addition, under BCL §909, which governs the sale or exchange of all or substantially all of the assets of a corporation, the vote of the holders of two-thirds of all outstanding shares would be required.4
Even if a co-op were able to obtain the requisite shareholder approval for a conversion, dissenters might be entitled to appraisal rights under BCL §806(b)(6), which could require the co-op to purchase such dissenters’ apartments.5 The potential cost of dealing with dissenters, which would be borne by all shareholders, is one of the major non-tax hurdles to conversions.6
Further, even if the issue/cost of dissenters’ rights could be satisfactorily addressed, a major problem to be faced in accomplishing a conversion is satisfying any mortgage indebtedness of the co-op and dealing with loans to individual shareholders’. Thus, in order for a co-op corporation to become a condominium, it would not only have to repay the mortgage indebtedness on the building (which would likely include a pre-payment penalty), but would also have to arrange for a lender to provide a facility to enable shareholders to replace their co-op share loans with mortgages on the exchanged condominium units. Repaying the building’s mortgage would require pro-rata cash contributions from shareholders, and would therefore increase the amount of the mortgages on the exchanged condominium units, thus increasing debt service for the exchanged unit owners. Moreover, each exchanged unit mortgage would depend on the creditworthiness of the individual borrower; some co-op owners would likely not qualify to meet lending requirements.
However, the greatest impediment, by far, to co-op to condominium conversions is the uncertainty (and therefore risk) of liability for substantial federal income taxes. Absent assurance that the exchange of units by a co-op shareholder would be exempt from federal income taxation, at the individual/shareholder and co-op/corporate levels, it is unlikely that a conversion would be seriously considered by a prudent co-op board.
Income Tax Liability for Co-op Shareholders. The exchange of co-op shares for a condominium apartment is a taxable event and the shareholder is therefore taxed on the value of the exchanged condominium unit, just as if the co-op shares had been sold for cash. Under Internal Revenue Code (IRC) §121, $250,000 (or $500,000 for married taxpayers filing jointly) can be excluded from any resulting gain by qualifying shareholders.7 Therefore, in co-ops where a preponderance of shareholders have owned their apartments for long periods during which the value of their apartments has greatly appreciated, their respective federal income tax liability would be substantial. However, the income tax impact of an exchange on new/recent apartment purchasers would be small, if any.8
Income Tax Liability for the Co-op Corporation. Unlike the relative clarity of the direct income tax consequences for shareholders in a co-op/condominium conversion exchange income tax liability for the co-op corporation itself is far from clear. But what is clear is that any funds the co-op needs to pay such income taxes will have to come from its shareholders.
IRC §216(e),9 which became law in 1988, deals with “Distributions by cooperative housing corporations” and provides, in relevant part, that no gain is recognized by the co-op on distributions of a “dwelling unit” to a shareholder if the distribution is in exchange for the shareholder’s stock in the co-op and the distributed “dwelling unit” is used as the (former) shareholder’s principle residence “(within the meaning of §121).” While this provision may appear to shield a co-op from income tax liability it would otherwise have on the distribution/exchange of condominium units to its shareholders,10 §216(e) leaves many issues unresolved.
First, §216(e) expressly states that it applies “Except as provided in regulations.”11 To date, the Treasury Department has failed to issue any clarifying regulations as to what circumstances or transactions would be “excepted” from §216(e).
Further, §216(e) may not protect the co-op from income tax liability for distributions made to shareholders who are not using the dwelling unit as their primary residence at the time of and after the exchange.12 Similarly, §216(e) applies only to distributions of “dwelling units” but leaves that term undefined. This leaves open, at best, whether the co-op’s distribution of professional and/or commercial space or other “non-dwellings” is taxable.13 As a result, it may well be that some co-op distributions/exchanges will be tax tax-free to the co-op, while others are taxable. However, any such tax liability will be paid for by all co-op shareholders.
Proposed Legislation. In 2000, 2003 and again in 2005, the late Sen. Daniel Inouye of Hawaii introduced legislation to amend the IRC “to provide tax relief for the conversion of cooperative housing corporations into condominiums.”14 As explained in bills’ introductions to the proposed legislation, its goal was both simple and clear: to “remove the penalty of double taxation from the conversion of cooperative housing to condominium ownership, [because] a conversion from a cooperative shareholding to condominium ownership is taxable at the corporate level as well as an individual level.”15
The proposed legislation is equally simple and clear—it would have amended §216(e) (restated as subparagraph (1)(A), to eliminate the requirement that the “dwelling unit [be]used as the [shareholder's] “principal residence.”16 It would also have added a subsection B, providing that:
no gain or loss shall be recognized to a stockholder of such [co-op] corporation on the transfer of such stockholder’s stock in an exchange described in subparagraph (A).17
Further, proposed subparagraph (B)(2) addressed the co-op shareholder’s basis in the exchanged condominium unit—”the same as the basis of the stock in the cooperative housing corporation for which it is exchanged … .”18
Senator Inouye’s proposed legislation was not enacted into law. And while it would not have addressed all of the uncertainties posed by current §216(e), it would have addressed many of them so that passage of the proposed amendments may have sufficiently reduced the uncertainty and risks of such transactions to create a more viable consideration for co-op boards.
At the present time, great uncertainty and risk exists regarding co-op to condominium conversions. Depending on individual co-op shareholders’ apartment appreciation, the co-op’s and its shareholders’ mortgage debt, the extent to which co-op apartments are the primary residences of its shareholders, and the extent of space in the building which is not a “dwelling unit,” a co-op board may wish to consult with its counsel and accountants regarding whether a conversion is something to be raised with its shareholders. However, for the vast majority of co-ops, legislation amending §216(e) is the only viable solution for overcoming the obstacles to conversion.
Note From Richard Siegler
This article marks a conclusion for me. Having served as a NYLJ columnist for more than three decades, the time has come for me to relinquish my role, which will be continued by my co-author, Eva Talel, who has shared this column with me for more than 15 years. I am particularly grateful to Eva and the numerous legal associates who have researched topics and prepared first drafts. I also acknowledge Margaret Jones, a research librarian at Stroock, who has cheerfully assisted with legal citations for many years. It has been my great privilege to be the NYLJ columnist for cooperatives and condominiums.
1. N.Y. Real Prop. §339-d et seq. (West).
2. Michael H. Schill, Ioan Voicu, Jonathon Miller, “The Condominium v. Cooperative Puzzle: An Empirical Analysis of Housing in New York City” (Furman Center for Real Estate and Urban Policy, Working Paper July 21, 2006), published at 36 J. Legal. Stud. 275 (2007).
3. See, e.g., Siegler, “The Feasibility of Co-op to Condo Conversion,” NYLJ, March 5, 1997, pg. 3, col. 1, and commentators cited therein.
4. N.Y. Bus. Corp. Law §909 (West).
5. N.Y. Bus. Corp. Law §806(b)(6) (McKinney 2017).
6. For a creative solution to this hurdle, see Siegler, Note 3.
7. 26 USCA §121 (West). Qualifications required include that at the time of “sale”/exchange, the shareholder have owned and used the apartment as its principal residence for at least two of the last five years.
8. If a shareholder has been holding the co-op shares for investment or use in a trade or business, the exchange may be treated as a tax-deferred exchange under IRC §1031 (provided that the IRS continues to treat co-op shares as interests in real property). However, most co-ops do not permit the purchase of apartments by shareholders as a §1031 exchange and proprietary leases in co-ops generally require that the apartment be used as a residence by the shareholder; many co-ops expressly exclude operating a trade or business in the apartment.
9. 26 USCA §216(e) (West).
10. A co-op to condominium conversion did not present an income tax liability for a co-op until the Tax Reform Act of 1986 imposed a tax at the corporate level on corporate liquidations. Therefore, but for the exception created by §216(e), co-op corporations would clearly be taxed at the corporate level upon a co-op to condominium conversion. PLR 8812049(IRS PLR), 1987 WL 436409.
11. 26 USCA §216(e).
12. The legislative history of §216(e) explains that: “It is expected that the Treasury Department will prescribe regulations providing reporting or other procedures to assure that the intended relief [from corporate-level gain recognition] is provided only in cases where the … apartment is in fact used by the [shareholder] taxpayer as his principle residence both before and after the distribution”. Senate Budget Comm., 100th Cong. Reconciliation Submissions of the Instructed Committees Pursuant to the Concurrent Resolution on the Budget for the Fiscal Year 1988, H. Cong. Res. 93, Rept. No. 100-76 at 605 (Comm. Print 1987), and H.R. Rep. No 1104, 100th Cong., 2nd Sess. 241 (1988).
13. For a general discussion of these and other potential issues raised by the language of §216(e), see Miller, 596,3rd T.M., Cooperative and Condominium Apartments, pp. A-62 to A-64.
14. S.83, 109th Congress (2005), S.58, 108th Congress (2003), S.48, 107th Congress (2001), S. 3004, 106th Congress (2000).
15. 151 Cong. Rec. S255 (daily ed. Jan. 24, 2005).
16. S.83, S.58, S.48, and S. 3004.
17. S.83, S.58, S.48, and S. 3004.
18. S.83, S.58, S.48, and S. 3004.