Are cooperative apartments membership organizations for purposes of sec. 277?

Sec. 216 provides that tenant-shareholders of a cooperative housing corporation (co-op) can deduct their pro rata share of the corporation's real estate taxes and interest paid on indebtedness incurred to acquire the house or apartment. The tenant-shareholders own shares in the co-op; the co-op owns the apartment building; the tenant shareholders' stock ownership entitles them to lease a specific apartment unit from the co-op; and the tenant-shareholders pay monthly rent (maintenance) to the co-op. The purpose of Sec. 216 is to put tenant-shareholders on the same footing as home-owners in deducting real estate taxes and mortgage interest attributable to their cooperative units. A limitation on using Sec. 216 is that income from sources other than tenant-shareholders cannot exceed 20% of the co-op's gross income.

Note: Do not confuse co-ops with condominiums. In a condo, each owner is deemed to own the bricks and mortar making up a particular apartment unit. There is no mortgage on the property as a whole, and each owner gets a separate bill for real estate taxes.

Co-ops file regular corporate tax returns on Form 1120, U.S. Corporation Income Tax Return. Typically, co-ops operate on a cash flow breakeven basis, but with depreciation generating a taxable loss. On a $10 million apartment building, for example, depreciation can create a large deduction. One issue is whether Sec. 277 operates to deny this deduction as an offset to income from investments and rent from tenants who are not tenant-shareholders. In some areas (e.g., New York City, where cooperative apartments are common), rent from ground-floor retail space in prime locations can involve significant amounts. Sec. 277, enacted in 1969, provides that for a "social club or other membership organization which is operated primarily to furnish services or goods to members..., deductions...attributable to furnishing services...to members shall be allowed only to the extent of income derived...from members...." A principal purpose of Sec. 277 is to keep social clubs from offsetting losses from furnishing services to members against income from investments and from nonmember business (such as golf outings and company dinner dances). If Sec. 277 applies to co-ops, the depreciation attributable to tenant-shareholders' apartments could not offset rental income from commercial tenants.

In Rev. Rul. 90-36, the IRS took the position that Sec. 277 applies to cooperative housing corporations defined in Sec. 216(b) (1). Several arguments could support this position:

* It is an equitable result. If homeowners rent out their garage, they cannot deduct depreciation attributable to the house.

* When Sec. 216 was amended in 1976, the committee reports stated that "the committee does not believe that a clarification of the rules relating to the cooperative housing corporation's ability to take depreciation deductions with respect to property leased to tenant-shareholders will create tax avoidance possibilities because the provisions of existing law (sec. 277) generally prevent nonexempt membership organizations from offsetting nonmember income with losses from dealings with members."

Issues involving the applicability of Sec. 277 have not been completely resolved, however. In Trump Village, TC Memo 1995-281, the Service asserted that Sec. 277 applied to a New York cooperative apartment--state subsidized "Mitchell-Lama" housing. The co-op presented three arguments, one of which was that Sec. 277 did not apply to co-ops described in Sec. 216. The Tax Court held for the taxpayer on the ground that it qualified under Sec. 1381 (a) (2) as a cooperative subject to subchapter T, and thus the Sec. 277 limitations did not apply; see Buckeye Countrymark, 103 TC 547 (1994), and Landmark, 25 CI. Ct. 100 (1992).

The IRS has acquiesced in Trump Village and no longer will take the position that co-ops subject to subchapter T are subject to Sec. 277 (see IRB 1995-44). However, the Service limited this acquiescence to cases in which the housing co-op reflects all the "traditional characteristics" of cooperative operation: subordination of capital; democratic control by worker-members; and the vesting in and allocation among worker-members of all fruits arising from their cooperative endeavor.

While many co-ops routinely apply Sec. 277 in preparing their tax returns, the issue awaits further clarification. Even for co-ops that qualify under subchapter T (meeting the three requirements), the IRS has argued that depreciation deductions may not offset investment or other nonmember-related income. Cases involving corporations organized as cooperatives are pending in the Tax Court or at Appeals in the Service. Co-ops should watch carefully for further developments.