Taxation of a Cooperative Housing Corporation
Understand the distinct tax structure for housing co-ops and how it creates specific financial outcomes for shareholders, including annual deductions and tax on a sale.
A cooperative housing corporation, or co-op, represents a distinct form of property ownership. Unlike a condominium owner who holds a deed to a specific unit, a person buying into a co-op is purchasing shares of stock in a corporation that owns the entire building. This share ownership grants the individual a proprietary lease, giving them the right to occupy a specific apartment.
The Internal Revenue Code provides special regulations for qualifying co-ops, treating them as conduits for certain expenses. This structure allows the corporation to pass through specific tax deductions to its tenant-stockholders. The tax implications for the corporation and its shareholders are intertwined, governed by requirements that must be met annually to maintain this status.
Qualifying as a Cooperative Housing Corporation
For a corporation to be recognized as a cooperative housing corporation and for its shareholders to receive associated tax benefits, it must satisfy four main tests under Internal Revenue Code Section 216 each year. Failure to meet these tests in a given year disqualifies the corporation and its shareholders from the special tax treatment for that period.
The first test is that the corporation may have only one class of stock outstanding, which ensures that all shareholders have similar rights. An exception exists for stock issued to a governmental entity to secure financing, which is not considered a second class of stock for this purpose.
A second requirement is that each stockholder must be entitled, solely because of their stock ownership, to occupy a unit for dwelling purposes. The shareholder does not have to physically live in the unit; the right to occupy it is sufficient to meet the test.
The third test involves a restriction on distributions. No stockholder can be entitled to receive any distribution from the corporation other than from its earnings and profits, except in the case of a complete or partial liquidation of the corporation. This rule preserves the co-op’s character as a housing entity.
Finally, the corporation must meet the 80/20 rule. Historically, this meant at least 80% of the corporation’s gross income for the tax year had to be derived from its tenant-stockholders. This “good income” consists of maintenance payments, while “bad income” is revenue from other sources like commercial tenants or laundry facilities. The law was updated, and a corporation can now meet the rule by satisfying one of three alternative tests. It can meet the original 80% gross income test, qualify if 80% or more of the total square footage of its property is used by tenant-stockholders for residential purposes, or qualify if 90% or more of its expenditures are for the acquisition, construction, or maintenance of the property for the benefit of shareholders.
Tax Deductions for Tenant-Stockholders
One of the financial advantages of co-op ownership is the ability of tenant-stockholders to deduct their proportionate share of the real estate taxes and mortgage interest paid by the corporation. This pass-through of deductions effectively places the co-op shareholder on similar footing to a traditional homeowner for tax purposes.
The corporation, as the legal owner of the property, pays the property taxes on the entire building and the interest on any underlying mortgage. A qualifying co-op can allocate these expenses to its shareholders. Each shareholder can then deduct their portion of these payments on their personal income tax return, provided they itemize deductions.
The calculation of a shareholder’s proportionate share is based on the number of shares the tenant-stockholder owns in relation to the total number of outstanding shares of the corporation. For example, if a shareholder owns 100 shares in a co-op with a total of 10,000 shares issued, they are considered to own 1% of the corporation and can deduct 1% of the qualified expenses.
Annually, the cooperative housing corporation provides each tenant-stockholder with a statement detailing their share of these deductible expenses, often accompanying IRS Form 1098. To claim these deductions, the shareholder must file Form 1040 and itemize on Schedule A. The mortgage interest is reported on the line for home mortgage interest, and the real estate tax portion is reported on the line for state and local taxes. The deduction for state and local taxes, which includes property taxes, is capped at $10,000 per household per year.
Tax Treatment When Selling Co-op Shares
The sale of co-op shares receives a favorable tax treatment that mirrors the sale of a traditional home. For tax purposes, the disposition of stock in a cooperative housing corporation is not treated like a typical sale of corporate stock. If the owner has used the co-op unit as their principal residence, they can benefit from the capital gains exclusion available to other homeowners.
To determine the gain or loss on the sale, the shareholder must first calculate their adjusted basis in the co-op shares. The initial basis is the original purchase price paid for the stock, which is then increased by the cost of any capital improvements made to the specific apartment. Capital improvements are significant, permanent upgrades that add value to the unit, such as a new kitchen or renovated bathroom, as opposed to routine repairs.
The capital gain is the difference between the net proceeds from the sale and the adjusted basis. The net proceeds are the selling price minus any selling expenses, such as brokerage commissions and legal fees. Under Section 121 of the Internal Revenue Code, a shareholder may be able to exclude a significant portion of this gain from their taxable income. An individual can exclude up to $250,000 of the gain, while married couples filing a joint return can exclude up to $500,000.
To qualify for this home sale exclusion, the shareholder must meet both an ownership test and a use test. The ownership test requires the individual to have owned the co-op shares for at least two of the five years leading up to the date of sale. The use test requires that the individual must have lived in the co-op unit as their principal residence for at least two of the same five-year period. These two-year periods do not have to be continuous.
Advanced Co-op Tax Topics
Beyond the primary rules, several other tax situations can arise for co-op shareholders.
Renting Out a Co-op Unit
If a shareholder chooses to rent out their co-op unit rather than occupy it, the tax situation changes. The unit is then treated as a rental property, and the shareholder may be able to claim depreciation deductions against the rental income. Depreciation is an allowance for the wear and tear on the property. Calculating the depreciable basis of a co-op unit is complex, as it involves an allocation of the building’s basis.
Corporate Financial Events
A financial event at the corporate level, such as the refinancing of the building’s underlying mortgage, can directly impact shareholders. If the co-op refinances to a new mortgage with a different interest rate, the amount of interest paid by the corporation will change. This, in turn, alters the amount of the mortgage interest deduction that is passed through to each tenant-stockholder annually.