80/20 Vision Keeping an Eye on Income

Say the words "80/20 rule" to a New York City co-op board, and you may be met with groans and furrowed brows. A provision in Section 216 of the Internal Revenue Service (IRS) tax code, the 80/20 rule limits the amount of commercial revenue a co-op building can take in during a year to 20 percent of the building's total cash inflow. The other 80 percent has to come from the shareholders' fees, maintenance charges, or special assessments. If a building's outside income slides one percent past 20, shareholders forfeit valuable tax write-offs and abatements.

"80/20 goes back to the 1940s," says Gerald Marsden, a partner with the Manhattan-based financial firm of Eisner & Lubin LLP, "and it really hasn't been changed since, except for little things here and there."

Origins aside, 80/20 is often a thorn in co-ops' sides, because given property values in New York City, some co-ops are sitting on potential goldmines, if only the buildings could capitalize fully on their commercial spaces. Because of the rule, however, buildings are forced to charge rents far lower than what they could get on the open market.

How It Happened

The 80/20 rule came about when the federal government determined that people living in housing cooperatives were, in fact, homeowners.

"It's my conjecture," says Marsden, "that somebody convinced somebody in Congress to push 80/20 through, saying, "˜We'd like to get the tax benefits of home ownership - the deduction for real estate taxes, the deduction for mortgage interest, and the ability to get $250,000 or $500,000 in effect tax-free when we sell' - making owning shares in a co-op more like outright home or condo ownership."

In order for the government to consider this, says Richard Montanye of the Roslyn, New York-based accounting firm of Marin & Montanye LLP, "There had to be a way to ensure that [a residential co-op] was not a different type of enterprise, handing shareholders what would amount to a shelter for outside income from commercial tenants or interest." That would give the shareholders a distinct advantage that no one else had, says Montanye.

According to Mary Ann Rothman of the Council of New York Cooperatives and Condominiums (CNYC), "Section 216 of the Internal Revenue Code was developed to enable [co-op owners] to get the same homeowner federal tax deductions as individuals have when they pay real estate tax - and when they pay the interest on the mortgage or their home. Section 216 wanted to extend this privilege to co-ops, but not give away the store. You can only pass on shareholders' proportional share of the interest paid on the building's underlying mortgage and the real estate tax paid if your building qualifies."

Today, 80/20 may seem almost arbitrary, but the growth of the number of co-ops, and the value of the properties, has plenty of people in the industry convinced the rule needs updating.

"I'll assume that in 1942, this was a fair ratio for the vast majority of co-op buildings, of which there weren't a lot anyway," says Rothman. "As time passed and New York City has become a very, very lucrative place to be, it would be possible to get very, very high rents in some of these stores."

But as it stands, buildings are routinely forced to rent out their commercial spaces for a third of what they could get without the restriction. Contracts for things like parking lots aren't maximized, for example, and if a phone company wants to rent space on the roof of a building for antennae, that revenue falls under 80/20 as well.

Working With 80/20

There are ways to get around 80/20. One is to compare "good" income (from residents) to "bad" (from commercial ventures). Buildings sometimes raise maintenance fees, but that is often met with resistance from shareholders. Buildings also issue shares to those renting the commercial space, thus turning "bad" income into "good" income.

Alan Fried, a partner with the New York-based law firm of Ganfer & Shore LLP, says some buildings set up separate corporations, and the co-op enters into the lease with their corporation for all the commercial space, which the corporation subleases. In that situation, Fried says, "you've got this income flowing into the corporation, but it doesn't necessarily flow up to the co-op, and of course that kind of setup has its own set of implications, because if the co-op owns the other corporation, the IRS could say this is all one entity."

"You have to qualify the tenant," advises Faith Consolo, vice chairman of Garrick-Aug Worldwide, a commercial space and leasing expert. "Some tenants offer the highest rent, and they look good, but they have no financials." She recommends getting strong financials, a good security deposit, and giving them criteria for which to build an attractive store.

Even buildings with good financials can pose difficulty when it comes to 80/20 compliance. In that case, according to Jeffrey Heidings, the president of New York-based Siren Management, says, "you're not going to just throw away money because you're going to lose your tax deduction." Heidings recommends structuring a deal that capitalizes the rent flow in the first year. For example, "instead of doing fifteen years at one hundred thousand, I'll capitalize ten years, a portion of it, and get a million dollars in the first year, lose my 80/20 for one year, and then take a diminished amount of money the rest of the time so that it restores 80/20," he says.

Such tactics are tricky, however. Even if managers watch the figures like a hawk, playing close to the edge to maximize rental income while still staying on 80/20's good side can backfire.

"If 18 or 19 percent of a building's revenue comes from stores," says Rothman, "they have to keep a very careful eye on the maintenance as it comes in from their shareholders. If it happens that someone stops paying their maintenance for a number of months, the whole building could run afoul of 80/20." This results in the board having to choose between raising monthly fees and reducing the commercial rent for the remainder of the year.

"It may not be a problem for people today," says Marsden, "but one of the benefits of home ownership or co-op ownership is these tax abatements and [the shareholder's] ability to sell, so even if it doesn't affect them today, it could significantly affect the marketability of their apartment."

Margie Russell, executive director of the New York Association of Realty Managers (NYARM), concurs, adding, "I would advise property managers - on a quarterly, not just annual basis - to evaluate their long-range needs. They don't want to skate too close to the 80/20 threshhold." In fact, Article IV of the NYARM Code of Ethics, co-authored by Howard Schechter and Andrew Brucker [of the Manhattan-based law firm of Schechter & Brucker PC,] says that a manager has a duty to disclose information to the owner upon learning of any fact that affects or may affect them, whether adversely or not. The building's manager, she says, is then responsible to disclose such information to the owner.

That disclosure can help soften the blow if a building has to give up its tax abatements for a year in order to reap the long-term benefits of having a market-rate commercial tenant, or can give a prospective buyer the full picture of what he or she is investing in. But a building teetering on the edge of losing valuable tax credits might not make as attractive a prospect as one living comfortably within the 80/20 parameters.

Fighting for Change

For the past 20 years in New York, co-op community advocacy organizations and some of the larger law firms serving co-op clients have been working to get the 80/20 rule eliminated, or at the very least altered so as to be less of a financial hindrance to buildings with ground floor retail space to rent.

Those opposed to 80/20 have also had their backers in Congress. Rothman calls the late Senator Patrick Moynihan "a hero" for his efforts to change the 80/20 rule. "He got it into lots of pieces of legislation," says Rothman, adding that Rep. Charles Rangel has also been in the cooperatives' corner.

Success in the legislature has proved elusive and efforts by late Sens. Jacob K. Javits and Patrick Moynihan have never seen fruition. "It's just that there are really very, very few housing co-ops in the U.S. outside of New York City - probably 90 percent of co-ops in the nation are here - and it's very hard now to get any changes because the interest in Congress is very small."

According to Douglas Kleine, executive director of the National Association of Housing Cooperatives - a group actively lobbying the federal government for 80/20 reform - efforts to reinvent 80/20 have gone largely unanswered. To revive the issue, the NAHC is currently seeking a Republican sponsor to shepherd a reform bill through the partisan process.

"In this particular Congress - and this is a two-year session - we tried to take a more comprehensive approach to this bill," says Kleine. "What we have to do is make it more specific and more definable and less in need of regulation to make sure we get what the law means. Either there ought to be a better way of applying it, or there ought to be some alternative way of calculating the income so it's not looked at [by the IRS] as some abusive tax shelter."

According to Rothman, a big part of the indifference and partisan stonewalling of 80/20 reform has to do with whom the rule affects most acutely. "Not only is it a New York problem, it's a Manhattan problem, and then maybe for a few important commercial streets in Queens and Brooklyn. But that doesn't mean it isn't a problem. Not only would it not hurt the federal government to change the rule, they'll get more taxes if we let [commercial tenants] pay more revenues. The beneficiaries [of the current rule] are the Duane Reades and the stores that pay much less than market value for their spaces."

Rothman points out that remedial 80/20 language has been part of a number of bills over the years, but always as a minor addendum tacked onto a revenue or larger fiscal reform bill. Those bills with 80/20 riders have for the large part been vetoed - but not because they had anything to do with 80/20. They were struck down because of their primary content, which legislators found unacceptable for one reason or another.

Rothman says suggestions to alter the rule - such as proposing 80/20 based on square footage instead of revenue - have been made, but ultimately she thinks the provisions could be completely eliminated. "It's our strong feeling that 80/20 is outdated and has needed to be changed for some time." The question at this point is whether anyone outside the Big Apple can muster enough concern for the city's co-ops and resident shareholders to push reform through the layers of legislature and make them stick.

Anthony Stoeckert is a freelance writer living in New Jersey.

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2 Comments

  • What are the tax consequences for a Holder of unsold shares if it cannot qualify as a tenant-stockholder?
  • vbertolinojr@optonline.net on Thursday, March 22, 2012 12:41 PM
    total income (97%) comes from shareholders so when the co-op recieved a property rebate check of $675,266 ,would the shareholders qualify for a check based on the # of shares they own.