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Wednesday, January 9, 2008
80-20 is out. What will co-ops gain from the new rules?
"I am extremely pleased that the tax code will treat people who live in co-operative housing the same way as homeowners and condo owners are treated when it comes to their renting out part of their property"
The Mortgage Forgiveness Debt Relief Act of 2007 passed in December, contains a provision pushed through by House Ways and Means Chairperson Charles Rangle, which specifically affects co-operative housing by changing the criteria to qualify for co-op status known as the "80/20 rule". The rule meant that co-operative buildings were required to get 80% of their income from tenant-shareholders, and could not show revenue of more than 20% from other sources, like collecting commercial rents on retail or office space in the same building. That's now changed. Broadening the rules may help the Boards of cooperative buildings have greater confidence about compliance, and simplify everyones lives. It is unlikely however, to create any real windfall in commercial income for the co-ops in most cases. Under the new law almost all NYC co-ops look like they will qualify under one of these new criteria:
what do the changes mean for shareholders?
If the building did not meet the old 80/20 threshold, the shareholders were in danger of loosing their tax benefits. Real estate attorney Michael Dym explains, "Shareholders lose the ability to deduct the interest portion of their mortgage payment and a portion of maintenance attributable to paying the underlying mortgage and real estate taxes on the co-op's building. In short, assuming the co-op ran afoul of 80/20, under the old rules, they would loose the principal tax benefits of homeownership." It was similar to the way other corporations work where the tax benefits of owned real estate, cannot be passed along to shareholders. This however, differs greatly from a how rental income is utilized by an owner of mixed-use real property, where collecting market rent from a retail store or medical office, can greatly offset the costs of operation and ownership of the property. The new, broadened, criteria for co-ops, will make it easier for co-ops to collect market rents and still permit the pass-through of those tax benefits to shareholders, who's buildings might have been in violation under the old law.
how will the new rules affect valuations?
Perhaps even more problematic for co-op owners is that is that some lenders would not give mortgages on units in co-ops that were in violation of 80/20, as they were not considered true co-ops anymore. This would mean only all cash buyers, or people willing to pay higher rates, with larger down payments, would consider buying into the property— significantly narrowing the possible number of buyers. The net result being a below market value for the individual apartments. Judd DeRario, a broker at The Manhattan Mortgage Company, explains "Prior to the new legislation, many banks would not lend in coops that violated the 80/20 provision. Those lenders that did were able to charge a premium as a result. With the inclusion of some of these coops into the new IRS rules, I expect lending standards to expand, enabling purchaser of these coops to obtain the most competitive terms available" So for co-op owners which shift into compliance because of the new law, the value of their units should increase because of easier financing and a wider pool of potential buyers if marketed properly.
In theory, the old 80/20 rule might have mandated artificially low rents for some commercial spaces in co-op buildings. Yet that inference may not be the case. In reality many coops I've heard about, which are in the position to collect good commercial rents, have gone through some creative legal structuring of separate corporate entities, which to avoid violating the old 80/20 rule. Attorney Michael Dym confirms that "In reality, most co-op's converted after 1987 were condops— commercial space was striped off and retained by the sponsor as a condominium, and the residential apartments as another multiple dwelling condominium, run co-operatively by the shareholders. The co-ops that do have significant commercial income streams have long ago employed one of several work-around strategies." It is possible for buildings where the commercial space was retained by the cooperative, to have done the same. Other work-arounds have been used too. Dym continues, "One building on Third Avenue added utilities to the maintenance bill. Thus, shareholders didn't have the burden of a maintenance increase, but the additional reported income to the co-op kept it within 80/20 . You can see the machinations these kinds of strategies entailed. But no more. That's the best part of this change in the law."
So will the changes in tax code really result in an increase in shareholder values by virtue of subsidizing operating costs; or is it just going to simplify the structure and procedures in dealing with profitable retail spaces for coops, without much of a net change in share values? I think the latter to be more likely, except in the case of a few smaller buildings where the expenses of 'condop-ing' the building were previously too high, and the shareholders just unwilling. Michael Dym concurs, "In a select few co-ops— many on Madison Ave and some in Soho, the commercial income is substantial and a lot more than 20% of total income. Most co-op's with a large commercial income stream have been navigating 80/20 successfully, without artificially reducing rents, for years. I always referred to 80/20 as the cloud with the silver lining. I do think a few co-ops— mostly smaller So-Ho and Village buildings with commercial space, will see a windfall; but I don't think it will have a big impact on most co-op's."
In the end, expanding the qualifying criteria for co-ops benefits shareholders, mainly by reducing the complexity of compliance and oversight associated with it. In a few cases it may add value too for some co-ops which were in violation of the rules. Either way, it's a win for co-op dwellers.
related links:
Co-ops Get a Break on Revenue Rules New York Times
Habitat Magazine
Summary of The Mortgage Forgiveness Debt Relief Act of 2007 download (.pdf 48kb)
Mortgage Forgiveness Debt Relief Act of 2007 The White House press release
