Benefits to Continuing as a Cooperative

Many housing cooperatives are being asked to consider converting to the condominium form of ownership. Approaching the pay-off of the original blanket mortgage, increasing property values, and scarcity of share loan financing are three factors that cause the question of converting to condo to be raised.

This information sheet is intended to help cooperatives be sure they have thought through all the consequences and side effects of converting to condominium, and all the benefits of remaining as a cooperative.

The cooperative advantage of community control

  1. Cooperatives have greater control over who buys in and who moves in. Cooperatives are granted more power by the courts and the lending community in approving new shareholders and residents. Very few condominiums have a right of first refusal or right to approve new owners, because lenders do not want to see those rights in condo documents. As a result, a drug dealer can pay cash for a condo and move in next door to you, and there is nothing you can do about it.
  2. Cooperatives have much more control over absentee ownership and sublets. Most condos have only limited rights to restrict rentals and sublets. Condos can restrict short-term rentals (60 days), but lenders, FHA, and VA do not finance units where condos restrict long term rentals. As a result, the typical condo has about one third of the units owned by investors and absentee owners. Remaining as a cooperative allows subletting restrictions to remain in place and keeps the cooperative involved in controlling sublets.
  3. Because cooperatives have fewer renters than condos, there are more owners to tap for volunteer involvement. Some condos experience absentee ownership of 50% or more.
  4. Because cooperatives can control sublets, cooperatives can also use the screening process ensure that tenants will be good tenants. More absentee ownership in condos and the lack of screening powers means more rules violations by renters in condos, and more money spent on legal fees to enforce rules.

Cooperative advantages in lower taxes and financial management

  1. Cooperatives have lower real estate taxes. Cooperatives get a single tax bill based on the value of the building. The value of the building is determined by comparing it with rental buildings that have been sold and examining the income stream from carrying charges. Condos are assessed on the value of each unit, with value determined by comparing unit sales. When a unit next to you is sold, your tax assessment can go up. Condos have higher real estate taxes than identical buildings that are cooperatives because the sum of all the condo unit taxes is more than the single tax on the cooperative building.
  2. It is easier to finance repairs in a cooperative. Condos can get short term financing at commercial rates in some markets. Condo associations often finance repairs by hitting owners with special assessments of a few thousand dollars per unit. Cooperatives can get long term financing at rates closer to residential mortgage rates.
  3. When a cooperative borrows, the shareholder gets a personal income tax deduction for the mortgage interest paid by the cooperative on your behalf. When a condo association borrows, the owners get no deduction.
  4. It is easier to build up reserves in a cooperative. IRS taxes the interest on condo reserves at a rate as high as 30%. So in condos, you have to make greater reserve contributions toward the same roof replacement, because reserve earnings are taxed. Housing cooperatives just finished a successful 9-year battle to be treated like all other cooperatives and have reserve earnings be counted as patronage income, which can usually be offset with depreciation and not taxed at all.
  5. Cooperatives can not only take a depreciation expense to shelter otherwise taxable income, but cooperatives can also use the patronage refund to credit any surplus back to members. IRS Revenue Rulings for condo associations restrict the ability of condo associations to give a patronage refund. Condo associations cannot take a depreciation expense, and so have to pay income taxes on any outside income.
  6. Cooperatives have an easier and surer collection process for carrying charges through eviction. In all but one state, condo associations have to go through a lengthy judgment and foreclosure process to collect overdue monthly charges, and even if they are successful, the foreclosure sale may not produce enough money to pay off the owner’s mortgage and the overdue charges. In the few years of a condo association’s existence, the association often has to write off thousands of dollars in uncollectable charges.

What really happens as a result of conversion to condo?

  1. When a cooperative building converts to condo, the cooperative will owe corporate income tax on the gain from the sale—the difference between the depreciated value of the building and the sales price to a third party converter. Your share of the proceeds will be “after tax.”
  2. You will pay substantially more to live in the same place. The conversion process adds costs, such as engineering studies, land surveys, appraisal fees, recording taxes, fees lenders charge (points and loan fees), marketing costs, title insurance, converter’s profit, and attorney’s fees, all of which are added into prices of units.
  3. You will pay more property taxes. The higher sales prices bring higher real estate tax assessments.
  4. Forced displacement. Some members of the cooperative will not be able to qualify for financing the purchase of a cooperative unit converted to condo. They will have to leave and cope with high rents elsewhere in town.
  5. Catch 22. Those who were beneficiaries of Section 8 assistance will no longer qualify for Section 8 because of the payment received for their shares. More displacement.
  6. From displacement and the fact that some residents will take the proceeds and walk away, there will be units still to be sold. The converter will have to sell those units in the marketplace. If you want to sell in the first year or two, you may find yourself competing for buyers with the converter. There is no guarantee that you will get your price. In fact you may find that the converter is cutting prices in order to get out.
  7. It may not work. There is no guarantee that all units will be sold. At the Carlyle in Arlington, Virginia, unsold units were auctioned off, and even then not all were sold. At Woodward Heights in Michigan, the converter went bankrupt before he could meet the pre-sale requirement; then the lender took over the building, and everyone became renters.
  8. If you plan on selling within a few years, you should know that financing will be difficult for your buyer. Lenders will evaluate the condo under strict secondary mortgage market guidelines for condo associations which are new and where the converter has not been gone for at least years.

Questions to ask

  1. Is the market what you think it is? A 40-year old cooperative is not the same as a 3 year old condo. Be sure you are comparing apples to apples. When were your kitchens and baths last upgraded? Do you have central air and energy efficient appliances and buildings? Will your unit accommodate an in unit washer/dryer? What will it cost to install and operate a swimming pool, and if that is a desired amenity, why not do it and remain a cooperative?
  2. Who really benefits? The consultants, financers, and real estate professionals. There will be two closings (cooperative to straw man developer, straw man to condo buyer) with surveys, engineering, appraisals, loan fees, legal documents, commissions, meeting state consumer protection disclosure requirements, etc. A conversion will produce fees equal to 30% or more of the price of the condo units.
  3. Who really benefits? Those who leave! A major argument for condos is higher prices for resale of the apartments or townhouses. But that hurts those who stay (higher real estate taxes and higher mortgage payments) and only benefits those who cash out. Isn’t cooperative living for living, not speculating, profiting, and moving out?

Get independent professional help

  1. Income tax advice. The transactions are tricky. Some aspects have not been ruled on by IRS. A promise of tax avoidance is just a promise until seven years have gone by, or in the case of fraud, forever.
  2. Get a good zoning attorney. The conversion may require rezoning and waivers. There likely are new building codes to comply with or seek exemption from.
  3. Get a corporate attorney who can advise whether the statute that your cooperative is incorporated under permits distribution of assets to members. Most state non-profit corporation laws say that the cooperative has to distribute assets to another non-profit corporation, not the members. In addition, if your cooperative was originally intended to provide housing for low and moderate income families, that purpose was probably stated in your corporate charter or articles of incorporation. If that clause is not removed by amendment (which may take a high percentage of members to vote “yes”), the cooperative can be sued for taking actions that are not in keeping with its purpose.
  4. Get an independent appraiser and market assessment professional to study the value of the cooperative and the value of the proposed condo units.
  5. Get experienced help—but wait–there have been so few conversions that it is hard to find experience. Does that make you feel like a guinea pig?

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Benefits to Continuing as a Cooperative

Many housing cooperatives are being asked to consider converting to the condominium form of ownership. Approaching the pay-off of the original blanket mortgage, increasing property values, and scarcity of share loan financing are three factors that cause the question of converting to condo to be raised.

This information sheet is intended to help cooperatives be sure they have thought through all the consequences and side effects of converting to condominium, and all the benefits of remaining as a cooperative.

The cooperative advantage of community control

  1. Cooperatives have greater control over who buys in and who moves in. Cooperatives are granted more power by the courts and the lending community in approving new shareholders and residents. Very few condominiums have a right of first refusal or right to approve new owners, because lenders do not want to see those rights in condo documents. As a result, a drug dealer can pay cash for a condo and move in next door to you, and there is nothing you can do about it.
  2. Cooperatives have much more control over absentee ownership and sublets. Most condos have only limited rights to restrict rentals and sublets. Condos can restrict short-term rentals (60 days), but lenders, FHA, and VA do not finance units where condos restrict long term rentals. As a result, the typical condo has about one third of the units owned by investors and absentee owners. Remaining as a cooperative allows subletting restrictions to remain in place and keeps the cooperative involved in controlling sublets.
  3. Because cooperatives have fewer renters than condos, there are more owners to tap for volunteer involvement. Some condos experience absentee ownership of 50% or more.
  4. Because cooperatives can control sublets, cooperatives can also use the screening process ensure that tenants will be good tenants. More absentee ownership in condos and the lack of screening powers means more rules violations by renters in condos, and more money spent on legal fees to enforce rules.

Cooperative advantages in lower taxes and financial management

  1. Cooperatives have lower real estate taxes. Cooperatives get a single tax bill based on the value of the building. The value of the building is determined by comparing it with rental buildings that have been sold and examining the income stream from carrying charges. Condos are assessed on the value of each unit, with value determined by comparing unit sales. When a unit next to you is sold, your tax assessment can go up. Condos have higher real estate taxes than identical buildings that are cooperatives because the sum of all the condo unit taxes is more than the single tax on the cooperative building.
  2. It is easier to finance repairs in a cooperative. Condos can get short term financing at commercial rates in some markets. Condo associations often finance repairs by hitting owners with special assessments of a few thousand dollars per unit. Cooperatives can get long term financing at rates closer to residential mortgage rates.
  3. When a cooperative borrows, the shareholder gets a personal income tax deduction for the mortgage interest paid by the cooperative on your behalf. When a condo association borrows, the owners get no deduction.
  4. It is easier to build up reserves in a cooperative. IRS taxes the interest on condo reserves at a rate as high as 30%. So in condos, you have to make greater reserve contributions toward the same roof replacement, because reserve earnings are taxed. Housing cooperatives just finished a successful 9-year battle to be treated like all other cooperatives and have reserve earnings be counted as patronage income, which can usually be offset with depreciation and not taxed at all.
  5. Cooperatives can not only take a depreciation expense to shelter otherwise taxable income, but cooperatives can also use the patronage refund to credit any surplus back to members. IRS Revenue Rulings for condo associations restrict the ability of condo associations to give a patronage refund. Condo associations cannot take a depreciation expense, and so have to pay income taxes on any outside income.
  6. Cooperatives have an easier and surer collection process for carrying charges through eviction. In all but one state, condo associations have to go through a lengthy judgment and foreclosure process to collect overdue monthly charges, and even if they are successful, the foreclosure sale may not produce enough money to pay off the owner’s mortgage and the overdue charges. In the few years of a condo association’s existence, the association often has to write off thousands of dollars in uncollectable charges.

What really happens as a result of conversion to condo?

  1. When a cooperative building converts to condo, the cooperative will owe corporate income tax on the gain from the sale—the difference between the depreciated value of the building and the sales price to a third party converter. Your share of the proceeds will be “after tax.”
  2. You will pay substantially more to live in the same place. The conversion process adds costs, such as engineering studies, land surveys, appraisal fees, recording taxes, fees lenders charge (points and loan fees), marketing costs, title insurance, converter’s profit, and attorney’s fees, all of which are added into prices of units.
  3. You will pay more property taxes. The higher sales prices bring higher real estate tax assessments.
  4. Forced displacement. Some members of the cooperative will not be able to qualify for financing the purchase of a cooperative unit converted to condo. They will have to leave and cope with high rents elsewhere in town.
  5. Catch 22. Those who were beneficiaries of Section 8 assistance will no longer qualify for Section 8 because of the payment received for their shares. More displacement.
  6. From displacement and the fact that some residents will take the proceeds and walk away, there will be units still to be sold. The converter will have to sell those units in the marketplace. If you want to sell in the first year or two, you may find yourself competing for buyers with the converter. There is no guarantee that you will get your price. In fact you may find that the converter is cutting prices in order to get out.
  7. It may not work. There is no guarantee that all units will be sold. At the Carlyle in Arlington, Virginia, unsold units were auctioned off, and even then not all were sold. At Woodward Heights in Michigan, the converter went bankrupt before he could meet the pre-sale requirement; then the lender took over the building, and everyone became renters.
  8. If you plan on selling within a few years, you should know that financing will be difficult for your buyer. Lenders will evaluate the condo under strict secondary mortgage market guidelines for condo associations which are new and where the converter has not been gone for at least years.

Questions to ask

  1. Is the market what you think it is? A 40-year old cooperative is not the same as a 3 year old condo. Be sure you are comparing apples to apples. When were your kitchens and baths last upgraded? Do you have central air and energy efficient appliances and buildings? Will your unit accommodate an in unit washer/dryer? What will it cost to install and operate a swimming pool, and if that is a desired amenity, why not do it and remain a cooperative?
  2. Who really benefits? The consultants, financers, and real estate professionals. There will be two closings (cooperative to straw man developer, straw man to condo buyer) with surveys, engineering, appraisals, loan fees, legal documents, commissions, meeting state consumer protection disclosure requirements, etc. A conversion will produce fees equal to 30% or more of the price of the condo units.
  3. Who really benefits? Those who leave! A major argument for condos is higher prices for resale of the apartments or townhouses. But that hurts those who stay (higher real estate taxes and higher mortgage payments) and only benefits those who cash out. Isn’t cooperative living for living, not speculating, profiting, and moving out?

Get independent professional help

  1. Income tax advice. The transactions are tricky. Some aspects have not been ruled on by IRS. A promise of tax avoidance is just a promise until seven years have gone by, or in the case of fraud, forever.
  2. Get a good zoning attorney. The conversion may require rezoning and waivers. There likely are new building codes to comply with or seek exemption from.
  3. Get a corporate attorney who can advise whether the statute that your cooperative is incorporated under permits distribution of assets to members. Most state non-profit corporation laws say that the cooperative has to distribute assets to another non-profit corporation, not the members. In addition, if your cooperative was originally intended to provide housing for low and moderate income families, that purpose was probably stated in your corporate charter or articles of incorporation. If that clause is not removed by amendment (which may take a high percentage of members to vote “yes”), the cooperative can be sued for taking actions that are not in keeping with its purpose.
  4. Get an independent appraiser and market assessment professional to study the value of the cooperative and the value of the proposed condo units.
  5. Get experienced help—but wait–there have been so few conversions that it is hard to find experience. Does that make you feel like a guinea pig?