Tax-deferred Real Property Exchanges: Do Co-ops Qualify?

Written by admin on January 13th, 2012

Commission v. Shor, 43 N.Y.2d 151 (1977); Ehrsam v. City of Utica, 37 A.D. 272 (4th Dep t 1899). However, an interest in a cooperative apartment is much more than its individual components of stock ownership and leasehold interest. It is the marriage of these interests that creates the unique entity. To state that the only aspect of a coop which borders on real property is the leasehold interest is to ignore the overall scope of the ownership interest. Consequently, many practitioners, upon reading Shor, come away with the misleading impression that an interest in a New York cooperative apartment is purely personal.

The Shor Ruling

In Shor, the Court of Appeals ruled that for the purposes of securing a judgment lien interest on a cooperative apartment, docketing the judgment in the County Clerk s office was not sufficient. In order to secure a judgment creditor s interest in a cooperative apartment, a creditor must have delivered an execution on the judgment to the Sheriff.

In reaching this conclusion, the Court was merely looking to the current state of banking law, which treats the stock certificate and proprietary lease as personal property. However, the reasons for doing so have less to do with the actual classification of the interest with the protection of a lender s interest.

At the time Shor was decided, a lender would take possession of the stock certificate and proprietary lease as security for the loan in connection with the closing, instead of recording a mortgage as in a typical purchase of a real property interest. Were an interest in a cooperative apartment treated as real property for security purposes, mere possession of the stock certificates, without recording, would subordinate the lender s security interest to the claims of other creditors. Shor, 43 N.Y.2d at 158.

This method of securing the lender s interest was problematic when an owner of a cooperative apartment sought secondary financing. Secondary lenders were reluctant to lend money if they were not in possession of the stock certificate and proprietary lease. Accordingly, New York Uniform Commercial Code 9-304 was amended, effective Oct. 1, 1988, to provide for the filing of a UCC-1 financing statement in the Register s or County Clerk s office to perfect a security interest in the cooperative apartment. This method of securing a lender s interest in a coop closely resembles the recording of a mortgage to secure a lender s interest in a traditional real property interest.

Although the Court in Shor was unwilling to change the manner in which judgment liens and security interests in cooperative apartments were determined, because to do so would drag the public “into a rigidly fenced corral, kicking,” the Court did not pronounce an owner s interest in a coop to be personal property. Quite to the contrary, an interest in a cooperative apartment was labelled sui generis, of its own kind or class, acknowledging that the interest defied any one exclusive classification.

Further, the Court explained that “[f]or some special purposes, the real property aspect may predominate. Grenader v. Spitz, 537 F.2d 612, 617-620, cert den, 429 U.S. 1009; cf. United Housing Foundation v. Forman, 421 U.S. 837, esp 854-860, reh den, 423 U.S. 884.” Shor, 43 N.Y.2d at 154. The issue presented in Grenader and United Housing Foundation was whether the shares of stock in a coop were to be considered securities for the purposes of New York and federal securities law.

The panel in Grenader most clearly articulated the view that “the continuing obligation to pay a monthly rental fee to maintain the tenancy of the lessee strongly supports the conclusion that this was basically a real estate transaction and not an investment in a security.” Although the Court of Appeals was reluctant to change the statutory scheme protecting lenders, it is apparent that for most other purposes, an interest in a cooperative apartment is treated like an interest in real property.

Further Support

In support of the premise that an interest in a cooperative apartment is evolving toward real property, one need only look to the following statutes which protect cooperative apartment owners:

CPLR 5206 provides for a homestead exemption from creditors;Public Authorities Law 2402(5) provides that a “mortgage” includes a loan by a bank to a borrower to finance the purchase of stock in a cooperative corporation;Real Property Law 254-b limits late charges on loans secured by cooperative apartments;Real Property Law 279(5) permits the issuance of graduated mortgage loans for the purposes of financing the cooperative ownership of real estate; Article 36B of the General Business Law creates a statutorily implied warranty in new home sales, including cooperatives.

Although by no means an exhaustive list, these statutes clearly show the New York Legislature s continuing attempt to give cooperative apartment owners the same benefits that owners of traditional interests in real property enjoy.

The last persuasive argument that the IRS sought to make in Rev. Rul. 66-40 was that “nowhere in the Tax Law has the [New York] legislature characterized a leasehold as taxable real property.” Once again the treatment of an interest in a cooperative apartment as two separate interests, that of a stockholder and lessee, leads to an inconsistent result. Although owners of coops do not pay real estate taxes directly, a portion of their maintenance charges is directly attributable to the payment of real estate taxes by the cooperative corporation.

The IRS recognizes this unique situation by allowing an owner of a cooperative apartment to take a tax deduction for his or her proportionate share of the real estate taxes allowed as a deduction to the corporation, and the interest allowable as a deduction to the corporation for the indebtedness incurred in connection with the acquisition, construction, alteration, rehabilitation or maintenance of the land and apartment building. IRC 216. The U.S. Supreme Court in United Housing Foundation, id. at 855, stated that these tax benefits enjoyed by the coop owners are “nothing more than that which is available to any homeowner who pays interest on his mortgage.”

In conclusion, although most of the precedents relied on in Rev. Rul. 66-40 have been rejected by the evolution of case and statutory law, the IRS has continued to cite the ruling for purposes of classifying an interest in a New York cooperative apartment as a personal property interest. Inasmuch as the definition of real property is governed by state law, it would appear that the true nature of the coop, namely, that of a dwelling or business space, should predominate based on the current state of New York law. Accordingly, there appears to be overwhelming legal authority to support the conclusion that a cooperative apartment contains a sufficient real property identity to be considered real property for the purposes of an IRC 1031 tax-deferred exchange.

Todd R. Pajonas is the President of Legal 1031 Exchange Services, Inc., a qualified intermediary for IRC 1031 tax deferred exchanges.

Legal 1031 Exchange
Services, Inc.

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