Co-op to condo conversion: saving glory or tax abyss?

A dialogue is starting to develop in the city's real estate community regarding the conversion of cooperative residential buildings into condominiums. Since the mid-1980's, when co-op conversion was in its heyday, the public's perception of co-ops has been tarnished by scandal and financial woes.

Meanwhile, condominiums have become the investment vehicle of choice by foreign-era end corporations that can't own co-ops, and maverick residents who could never pass the scrutiny of stuffy coop boards.

A color map that plots out the city's condominiums is available at the Japanese bookstore across the street from Grand Central Terminal. But no such map is sold of co-ops.

Investors quickly buy out apartments in brand now buildings - constructed now as condominiums, not co-ops. At the same time, cooperative apartments all the over city languish on the market.

Often, buyers bought at the height of the market, and now cannot move because most units are still sponsor- or investor-owned and the apartments are worth far less than they paid.

Cooperatives' strict subletting policies have also caused angst for residents who couldn't sell but needed to move because of jobs or family.

In this climate comes a rumbling of events to come. The natives are restless and are looking for ways out. And one of those options that is being talked about, and is even being tried by at least one building, is the conversion from a cooperative to a condominium.

Alike But Different

First understand that these two may look alike and sometimes talk alike, but they are owned, financed and taxed differently.

A co-op corporation owns the building, which is usually, but not always, on one tax lot. A multi-building complex such as garden apartment complexes in Queens can have several tax lots. None the less, one overall co-op corporation is the owner.

That corporation provides a proprietary lease to shareholders in the corporation for their space, i.e. apartment unit. The shareholder pays a maintenance figure, usually based on the number of shares, that includes charges for the property taxes and upkeep of the entire building, and most likely includes payments to a reserve fund for future repairs.

Each shareholder may have what is called an "end-loan" on the apartment, while the entire building may carry an "underlying mortgage," the proceeds of which may also fund extensive repairs.

The co-op is ruled by a board of directors through by-laws of the corporation in combination with certain other rules in the proprietary lease.

A co-op corporation must also meet certain Federal Internal Revenue Service rules to keep its non-taxable status. These rules include Subsection T and Section 216, which are slightly different, but basically say that income from the members of the group - good income - is not taxable, while certain "bad" income from outsiders, such as retailer rents and garage rents from the public, are.

There is also the so-called 80/20 rule, which deems that at least 80 percent of the income for the building must be "good" income, i.e. from shareholders. The other 20 percent can come from the retail store rents or public garage space, not exclusively for the shareholders.

In particular this past year, rising retail rents are starting to threaten the non-taxable status of cooperatives, which are consequently seeking a way out.

A condominium building, on the other hand, is broken up into separate tax lots that take into account a portion of the building's common areas. Each unit owner gets a separate tax bill from the city, which is paid directly by the unit owner. The building itself does not carry an underlying mortgage but shareholders may have a consumer loan on their own unit.

The condo is ruled by a Board of Managers, also through by-laws, but most often, the guidelines are much simpler and less restrictive than those penned for coops.

Barbara Corcoran, president of the Corcoran Group, one of the largest city residential brokerages, says candidates for conversion include buildings that have unmarketable co-op units with above-market maintenance charges, or a disproportionate number of sponsor units.

"The trick is to get lower maintenance," says attorney Richard Siegler.

"These buildings would gain enormous benefits if they could turn themselves into condos," Corcoran said. "It creates an opportunity to create a large pool of buyers, including investors and foreigners that are not available to the co-op."

But didn't people buy into co-ops in order to decide exactly who gets to share their hallways and elevators?

Those co-ops, if financially solvent, probably would not be candidates for such a conversion, says real estate lawyer, Stuart M. Saft, head of the real estate department at Wolf Haldenstein Adler Freeman & Herz, who represents many co-ops.

"The Fifth Avenue building is a building that might not necessarily do it because they don't want to give the residents the right to sell to whomever they want," he said. "The building that can least afford to do it is the building that needs it most."

Where co-op unit owners feel trapped because sponsor ownership is high, the number of rental units is high and banks will not lend to new buyers, conversion to a condominium with help from the sponsor could work to everyone's advantage.

Nevertheless, the new condominium could still end up with absentee investor owners and full of renters without carefully written by-laws. "The condo is a better animal, but the banks are becoming a little more concerned, even in condominiums, about who is living in the buildings," said Richard Mintzer, a licensed real estate broker and mortgage broker with Brookside Mortgage who is helping a building in such a situation convert and the shareholders get new consumer loans that will include their pro-rata share of the underlying mortgage.

Still, one of the major reasons boards are considering the change is that brokers believe condominium apartments are simply worth much more money.

"Condos trade for more," said Corcoran. "When you compare the same block and same kind of apartment, generally, there is a 25 to 30 percent difference in price, conservatively."

Dalia Newman, a broker with Corcoran's West Side office, and colleague Sherry Matays, conducted a survey after a board asked Newman to research such an undertaking.

The research showed that co-op apartments in the Fifth Avenue and Park Avenue and 57th Street areas would increase in value "spectacularly" upon conversion to a condo. How much? The numbers are staggering. A million dollar co-op could turn into a $2 million condominium, Newman says.

But those buildings, with their infamous snooty boards, might not want to give up complete control over their neighbors. "So they will have an attitude. They will not have money," said Newman.

When it comes to making a sale to an undesired party, the condominium board of managers has the right of first refusal, said lawyer Raymond T. Mellon, a partner with Zetlin & De Chiara. "So you always have to get a waiver of the rights when selling, but you don't have to go through the approval process which is making people crazy," he said. Buildings that are atoll or where the prices are not high and have undesirable apartments are not candidates for the conversion, Newman says, because the difference in the market prices would be marginal.

For those buildings with financial problems, while conversion may look good from the outside, the numbers here to work.

"Maybe they are looking at it as a panacea, but they can't walk away from the financial problems, noted Jeffrey S. Mitzner, vice president First American Title Insurance Company. From a title point of view, he said, the conversion is not difficult so long as there is a consensus.

On the other hand, it might be easier for a smaller building, with fewer unit owners, to come to a consensus.

"It works fine if everyone wants to do it," said Siegler, who in 1991 helped a luxury coop turn itself into a two-unit condo - i.e. a cond-op - in order to sell the retail space. Even with capital gains and other taxes, after the $17.25 million sale, the shareholders were over $10 million ahead on the deal. "On a large scale it's very hard to do."

Agreed Mary Ann Rothman, executive director of the Council of New York Cooperatives that services both condominiums and co-ops, "It's a rather daunting task to get a large group of people to do such a thing. My personal feeling is that the controls available through a coop structure - the unpleasant things like the scrutiny of people before they come in - make life livable in those high-rise communities where you are piled on top of each other. So there are aspects of coops that make people better able to protect their security and their investments."

Costs Are High

Reconversions are hard to do because there are also a lot of legal matters that need to be addressed. Those of course, generate high legal fees, and for the less determined and less financially able shareholders, become the major obstacle to conversation. Legal fees from "soup to nuts, can run $20,000 to $ 50,000," says Saft.

Corcoran, however, says, "The booty is too large for the fees to stand in the way."

For many buildings, however, there are other obstacles. "As anxious as the co-op is when they start, when they find out the details, they decide it isn't such a great idea," said Saft, who says he's been "down this road" a few times with boards.

Conversation Simple, But Work

While a conversation is "not reinventing the wheel," it still takes a lot of work, says Saft.

The shareholders of the corporation first have to vote and approve the changeover. "I believe at the minimum it requires a 3/4 vote, but I believe it would be difficult to accomplish without everyone being in agreement." Saft advised that the board should be negotiating with the lender in the beginning of the process "because there is so much red tape involved."

Each shareholder must go back to their own lender - remember, each unit may carry its own private end-loan - and ask them to change the way the debt is carried and give up one form of ownership for another. It also means that in all likelihood, each unit owner may have to assume a portion of the current underlying mortgage on the entire cooperative.

If the building has an underlying mortgage on it, Saft said, at the point where the co-op is signing the declaration of condominium, which is the equivalent of a deed, the mortgage has to be paid off.

Either the building will get financing place on each apartment or each shareholder has to contribute money to pay it off, or the lender could turn the one mortgage into 100.

"Usually, you bring in a new lender at that point," said Saft.

Maintenance charges would be reduced because the current bill includes payments towards the underlying mortgage. The private loan payments, however, would increase.

Those older co-ops that require cash purchase would again be in a better position to changeover the ownership vehicle.

And those with sponsors in place either holding many apartments and/or the underlying mortgage, might be able to work out an easier deal with fewer parties who have more to gain.

Indeed, the cooperative that Newman has been working with on the Upper West Side had the sponsor still holding the mortgage and many of the units.

"He saw the financial benefits of converting to a condominium," said Mintzer, the mortgage broker who is helping the building's cooperators get new condo consumer loans. "If you have a big institutional first mortgage, it's much more difficult because no lender today wants to take a haircut."

Assuming that everyone is in agreement, Saft says to hire an architect to prepare detailed plans of the building on mylar to be filed by the city. This would lay out the parameters of each unit and the common areas.

"In a co-op you don't have that, as the co-op owns everything," Saft explained. In a condo, things like a limited common element - such as a terrace that is used by one unit - has to be described, as well as what is common and what is in the unit.

A declaration of condominium has to be prepared that sets forth that the building is being converted to a condominium under the real property laws of the state, and that by-laws are being formulated and contains other information. "It's the equivalent of a deed," said Saft.

Then, attached to the declaration, is a set of by-laws that are "far, far more detailed."

The co-op by-laws only deal with the operation of the corporation, explained Saft, while the condominium by-laws area combination of the propriety lease and by-laws.

The Buildings Department must approve the architectural filings, and the Dept. of Health has to determine if the plans have appropriate bathrooms, kitchens and access.

The by-laws, attached to the declaration and the plans, then go to the city assessor's office, and they assign a separate tax lot to each condo unit. An attached exhibit to the declaration sets forth a percentage of the common elements assigned to each unit and then the assessor applies that to the tax lots. Unit owners will then be billed directly - or to their private lender - for their property taxes.

Then the lots are recorded with the county clerk or city register and then the building is a condo. Each unit owner turns over the propriety lease and stock certificate and gets a deed for their unit.

Pass Go to Attorney General

Because this is not a new conversion and no one is selling anything, the board would also seek a "no action" letter from the New York State Attorney General's office.

According to Jonathan Beyer, bureau chief of the Real Estate Financing Division of the AG's office, the building would not even have to seek such a no action letter if there are no sponsor apartments involved, all the units are privately held, and no sales are being made to "the public."

A sponsor is required to file an amendment to the cooperative plan every year, however, and so the building would have to seek the no-action letter since units are still being offered to the public.

Don't Forget the Tax Man

Saft says one of the traditional reason for wanting to convert to a condominium is because it is the best way of eliminating an 80/20 problem.

But the sale by the condominium of the retail unit would trigger tax consequences, as it did for Siegler's building some years ago.

While simply converting the residential co-op unit to a condo would probably not trigger a taxable event under the IRS code 1034 that makes it similar to simply trading up to a more expensive house once every two years and exempts such transfer, Siegler says, "the ancillary goodies," such as the absorption of common areas into personal holdings, "would be taxable."

That may or may not be true depending on the "goodies," says Joel E. Miller, a lawyer who concentrates in tax law. "The question is how much is included in the dwelling unit," said Miller. "And the law doesn't say "condominium unit," it says "dwelling unit."

Boards might want to have the IRS queried for a private letter ruling, but aside from the legal fees, it's at least $3,500 to ask for this from IRS, Miller said.

"It takes months and months and you are dealing with people who are afraid to say something that will come back and bite them," said Miller.

Learn More

There are many questions that are complicated and without clear answers, the lawyers and experts agree.

That is one reason The Association of the Bar of the City of New York's committees on Real Property Law, Cooperative and Condominium Law and Symposia are sponsoring a free panel on "Converting Co-ops to Condos: Panacea or Boondoggle?" on March 19 at 6:30 p.m. at its building at 42 West 44th Street, to which all are invited.

The panel, which was organized by Mellon, includes attorney Flora Schnall of Parker Chapin Flatteau Klimpl as its moderator; Siegler of Stroock Stroock & Lavan; Corcoran; Miller; Marissa J. Piesman of the New York State Attorney General's office; and Kenneth Horn, principal and mortgage broker with Alchemy Properties Inc.