Housing Cooperative

A housing cooperative is a form of home ownership in which a corporation holds title to a residential property and each resident owns shares in that corporation together with a proprietary lease, sometimes called an occupancy agreement, that entitles the shareholder to occupy a specific unit. The number of shares attached to each apartment is fixed when the cooperative is formed and usually reflects the apartment's relative size or desirability. Federal tax law calls the entity a "cooperative housing corporation" and the resident a "tenant-stockholder", both defined in Internal Revenue Code section 216, and almost everyone else calls the whole thing a co-op.

The names are worth untangling once. "Co-op" is the term buyers, brokers and boards use, and it is the right word in ordinary speech. "Cooperative housing corporation" is the Internal Revenue Code's name for the entity, and it is a tax definition rather than a description of the ownership form: a building can be organized as a cooperative and still fail the section 216 tests in a given year, in which case it is a cooperative that is not a cooperative housing corporation for that year. "Tenant-stockholder" is the Code's word for the resident, and it captures the oddity precisely, because a co-op resident really is both at once.

What section 216 requires, and why boards care. Section 216(b)(1) defines a cooperative housing corporation as one having a single class of stock outstanding, whose stockholders are entitled "solely by reason of his ownership of stock in the corporation, to occupy for dwelling purposes a house, or an apartment in a building, owned or leased by such corporation", which pays out nothing except from earnings and profits other than on liquidation, and which meets at least one of three further tests for the year: 80 percent or more of gross income derived from tenant-stockholders, 80 percent or more of the total square footage used or available for tenant-stockholders' residential use, or 90 percent or more of expenditures made for the acquisition, construction, management, maintenance or care of the property for the tenant-stockholders' benefit. A building with substantial commercial space, or one taking large income from a cell tower or a garage rented to the public, can approach the edge of the first test. Falling off all three costs every resident the deduction for that year, which is why the ratio is a standing board concern rather than an accounting detail.

What the deduction actually is. Section 216(a) allows a tenant-stockholder to deduct amounts paid to the corporation to the extent they represent that shareholder's proportionate share of the real estate taxes the corporation may deduct under section 164 and the interest it may deduct under section 163 on indebtedness contracted to acquire, construct, alter, rehabilitate or maintain the building or to acquire the land. Section 216(b)(3) sets the proportionate share as the shareholder's stock over total outstanding stock, with a special rule where the corporation allocates taxes or interest unit by unit in a way that reflects actual cost. The corporation reports the two per-share amounts each year. Both halves then run into the same limits any other homeowner faces on deducting property tax and mortgage interest, which are subjects of their own.

The building's mortgage is the part outsiders miss. A cooperative typically carries a single mortgage, called the underlying or blanket mortgage, secured by the whole property and owed by the corporation. It is serviced out of the monthly maintenance charges, so a resident who paid cash for their shares is still paying a share of a mortgage. Two consequences follow. The advertised share price understates what the apartment costs, because the resident's economic position includes a proportionate slice of corporate debt. And when that mortgage matures, the corporation refinances at whatever rate exists then, which can move every resident's maintenance charge at once, independently of anything happening in their own finances.

Financing a purchase is a different product. Because the buyer is acquiring shares and a lease rather than real property, the loan is a share loan secured by the stock certificate and the proprietary lease. In most states that collateral is personal property rather than real estate, though not in every state: the model act used as a template in various jurisdictions expressly contemplates cooperatives whose owners hold real estate as well as those whose owners hold personal property. Either way the practical effects are the same. Fewer lenders make these loans, the enterprises that buy conventional mortgages treat a security interest in cooperative shares and the proprietary lease as within their charter, and both they and individual lenders apply eligibility standards to the cooperative itself, covering matters such as deferred maintenance, unfunded repairs and outstanding assessments. A financially weak cooperative can therefore be hard to buy into and hard to sell out of, no matter how strong an individual buyer is. Federal consumer-credit rules do reach the loan: Regulation Z's definition of a dwelling at 12 CFR 1026.2(a)(19) expressly includes a cooperative unit used as a residence, so the disclosure and underwriting protections attached to a home loan are not lost by the form.

The board is a real constraint on resale. A cooperative's documents ordinarily require board consent to a transfer, and boards commonly require disclosure of a buyer's full finances, impose minimum post-closing liquidity, cap how much of the purchase price may be financed, and restrict subletting. Refusals do not generally require reasons, subject to fair-housing law. This is the trade a co-op makes: the same control that lets a building keep its finances tight also means an owner cannot simply accept the highest offer.

The corporation holds title and, usually, one mortgage on the building. Shares are allocated to each apartment and sold to residents, who sign a proprietary lease. Each month residents pay a maintenance charge covering operating costs, reserves, property taxes and the debt service on the blanket mortgage. Once a year the corporation tells shareholders the per-share amounts of deductible taxes and interest under section 216. When a resident sells, the buyer applies to the board, the board approves or refuses, and on closing the stock certificate and lease are transferred rather than a deed recorded.

A hypothetical example of the section 216 pass-through, with round numbers and no particular building. A cooperative with 12,000 shares outstanding pays $900,000 in real estate taxes and $1,200,000 in interest on the blanket mortgage during the year. A resident owns 240 shares, which is 2 percent of the outstanding stock (240 ÷ 12,000). Their proportionate share is therefore $18,000 of taxes (2% of $900,000) and $24,000 of interest (2% of $1,200,000), a total of $42,000 reported to them as potentially deductible under section 216. Whether any of it produces an actual tax saving then depends on whether they itemize and on the separate limits that apply to property tax and mortgage interest deductions generally. If the corporation had failed all three of the section 216(b)(1)(D) tests that year, the figure available to the resident would have been nothing.

Pros

• The quoted share price excludes the resident's share of the building's own mortgage, so the cash needed at closing is measured against a smaller number than the equivalent condominium price for the same space.
• The corporation's control over who buys, how much they borrow and whether they may sublet tends to produce a stable, owner-occupied building.
• Section 216 passes the resident's proportionate share of the corporation's property taxes and mortgage interest through to the individual return, which puts a co-op owner in broadly the same tax position as other homeowners.
• Costs of running the building are shared and negotiated once for the whole property rather than unit by unit.

Cons

• The share price understates the cost, because every resident also carries a proportionate share of the corporation's mortgage through the maintenance charge.
• When the blanket mortgage is refinanced, every resident's monthly charge can move at once for reasons unrelated to their own finances.
• Fewer lenders make share loans, and the ones that do may cap the percentage financed, so the buyer pool is narrower.
• The board can refuse a buyer, generally without giving reasons, which makes resale slower and less certain than accepting the best price.
• The section 216 deduction depends on the corporation passing one of three annual tests, which is outside any individual resident's control.
• The corporation's financial and physical condition affects a buyer's ability to finance a unit, so a badly run building constrains your resale independently of your own creditworthiness.