The Internal Revenue Code’s Section 216 authorizes cooperative apartment owners to receive a pass-through tax deduction for their proportionate share of the mortgage interest and real estate taxes paid by a qualifying co-op corporation. One of the qualifying tests is the requirement that 80 percent or more of the gross income of the cooperative in each taxable year is derived from the tenant-shareholders. Real estate commercial rents in recent years have caused many co-ops to be in jeopardy of failing to qualify under Section 216, because commercial rents received by cooperatives that are situated in commercially zoned areas are increasing to such an extent that many buildings are or will soon be receiving too much income (more than 20 percent) from these non-qualifying sources, and because it is very difficult for a cooperative to divest itself of these income sources without creating additional tax problems and other problems both financial and non-financial.
The predecessor to Section 216 was passed by Congress in 1942 with the intention of placing co-op apartment owners on the same footing as private homeowners with respect to homeowner deductions for mortgage interest and real estate taxes. Viewed broadly, the statute is part of a continuing public policy to encourage people to own their own homes, and is intended to place urban residents of multiple dwellings on a similar footing to suburban and rural residents of private homes. According to Joel E. Miller, a tax lawyer specializing in the income taxation of cooperatives and condominiums, because in a cooperative the real estate is owned by a corporation, rather than directly by individuals, Congress wanted to ensure that the apartment corporation was a bona-fide housing cooperative, providing benefits to tenants who are shareholders, and was not being used to shelter income from unrelated types of commercial activity. Accordingly, Congress included a number of tests in Section 216 designed to insure that a cooperative apartment corporation was exactly that. The requirement that 80 percent of the income be from tenant-shareholders appears to have involved an arbitrary number selected by Congress in 1942, and there is no apparent rationale as to why the limit should be 80 percent rather than some other number, in order to prevent the corporation from being used as a front for economic activities unrelated to residential housing.
The penalty for a cooperative that exceeds 20 percent of income derived from sources other than tenant- shareholders is that all tenant-shareholders lose all of their homeowner deductions with respect to their apartments for the tax year in which the cooperative fails to meet the test, even if the cooperative’s income is over by as little as $1. This is sometimes called “falling off the 80/20 cliff.” According to Mary Ann Rothman, executive director of the Council of New York Cooperatives & Condominiums (CNYC), loss of the deduction can anger shareholders “big time.”
The fear of Congress that a cooperative housing corporation might be used as a front for unrelated commercial activity does not appear to have been born out over time. Cooperatives have run into trouble with the 80/20 test in two general types of situations. In one scenario, the co-op sponsor defaulted on its maintenance payments. The typical reasons why sponsors defaulted were that they mortgaged the unsold units for such a high value that the mortgage payments could only be satisfied by sales of the units. In the recession and consequent declining market of the late ’80s and early ’90s this in many instances proved to be foolish both for the banks and the sponsors involved, and for the cooperatives that were the victims of this excessive optimism. In many instances the cooperatives were forced to foreclose on the sponsor’s units and take them over as rental units. Unfortunately, the rent received from these units is not deemed to be derived from tenant-shareholders, and was therefore “bad income” with respect to the 80/20 test. If the foreclosure involved more than 20 percent of the units, the innocent victims, cooperative shareholders, were in jeopardy of losing their tax deductions.