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Your New York Co-Op in a 1031 Exchange

Along with Section 121, the tax deferral provision of Section 1031 is among the most valuable.  Both provide unique opportunities to taxpayers under the tax code. As we’ve covered previously, Section 1031 allows taxpayers to defer recognition of capital gains.  It does so when real property held for investment or business purposes is exchanged for other like-kind property. To effect an exchange, taxpayers must follow either of two courses.  The taxpayer may either engage in a direct swap with another party. Or that same taxpayer can engage in a structured transaction involving an intermediary. In the most recent series of tax code revisions, personal property exchanges were eliminated.  Meanwhile, real property exchanges, including those with a New York co-op, were preserved.  

The Expansion of “Real Property”

As the 1031 industry has grown over the years, an interesting phenomenon has occurred.  Specifically, there has been a gradual expansion of the definition of “real property”.  Today, it includes new types of real estate investment vehicles. In the context of 1031, the property being acquired must be of “like-kind” to the original property. This like-kind requirement is being interpreted increasingly broadly.  Traditional properties classified as “real property” under local law will satisfy the like-kind requirement. The growth of 1031, however, has led to taxpayers attempting to use new types of investment properties to meet the requirement.

For example, today, mineral rights, water rights and other similar forms of real estate ownership are commonly used in 1031 exchanges.  This wasn’t always the the case, howver. Now, the total number of investment properties available to choose from is quite large.  Accordingly, there’s plenty of reasons to suppose that this number will continue to increase in the future. 

One type of property now used in 1031 transactions is the New York “co-operative apartment” (or “New York co-op”). In this article, we will review the basics of New York co-ops. We’ll then discuss some of the legal authority supporting the use of co-ops as Section 1031 exchangeable real property.  

New York Co-Op Basics

When a New Yorker owns a co-op apartment, he or she holds this ownership interest in the form of stock in a corporation.  The corporation, in turn, owns the entire apartment complex. The individual owner of the co-op receives a proprietary lease to a specific space in the building.  That lease gives him or her access to a specific apartment on the property. The individual owner receives a monthly bill, generally referred to as “maintenance”.  This maintenance fee, in turn, covers his or her share of the expenses for operating the whole complex.  

Upon casual inspection, you might be confused as to why there would be any confusion regarding the eligibility of co-op apartments as exchangeable 1031 property. Technically, when a person purchases a co-op, he or she purchases stock in a corporate entity.  Interestingly, Section 1031 specifically excludes stock as being like-kind to real estate. But the like-kind provision is typically satisfied as long as the property in question is classified as real property under local law.  Based on that fact, a New York co-op falls into a somewhat unusual situation in which eligibility may be uncertain in some cases.

As we will see, New York legal authorities (as well as various IRS rulings and publications) differ in their classification of a co-op.  Certain authorities treat them as intangible personal property.  Others treat them as real property for section 1031 purposes. In the end, a near consensus has emerged that a co-op can generally be included in an exchange.  This, however, doesn’t mean that taxpayers shouldn’t consult with a qualified New York tax attorney prior to attempting such a transaction.  

Legal Authority for Use in 1031 

The first thing to say about the legal authorities pertaining to a New York co-op in 1031 exchanges is that uncertainty remains. The uncertainty pertains to whether a New York co-op is either real or personal property. Many New York court opinions, together with New York statutory authority, hold that co-operative apartments are intangible personal property.  That’s based on the fact that ownership of such co-ops takes the form of stock.

The New York Court of Appeals State Tax Commission v. Shor (1977) is a case in point.  There the court ruled that an interest in a New York co-op was intangible personal property.  It did so for the purpose of the New York law pertaining to liens obtainable by judgment creditors.  Also, in Danforth v. McGoldrick (1951), the New York State Supreme Court likewise determined that co-ops constituted personal property. The New York State Department of Taxation and Finance has also regarded co-ops to be personal property for a variety of tax purposes.  

Specific Authority For Co-Ops As Realty

There are, though, a few critically important pieces of authority which hold that New York co-ops are in fact suitable as exchangeable real property under Section 1031. Two of them are IRS Private Letter Rulings (PLRs). In PLR 200137032 and 200631012, the IRS held that co-ops are exchangeable under Section 1031. The facts in the first of these rulings pertained to a co-op exchanged for another co-op in the same complex.  In the latter ruling, the co-op was exchanged for an entirely different type of replacement property.

In both of these rulings, the IRS highlighted the fact that co-ops are deemed “real property” under a number of different New York statutes. Additionally, the following pieces of authority further support classifying New York co-ops as real property.   N.Y. Civ. Prac. L & R § 5206, N.Y. Pub. Auth. Law § 2402(5), N.Y. Real Prop. Law § 254-b, N.Y. Real Prop. Law § 279(5), and IRS rulings 8810034, 8445010 and 8443054.  

Our New York City Tax Attorneys Can Help You

Not every piece of authority holds that New York co-op apartments constitute real property for purposes of Section 1031.  Nonetheless, it’s safe to say that taxpayers who use co-ops in their exchange are not likely to face a challenge by the IRS. If a taxpayer were to be challenged for such an exchange, the challenge would likely come at the state level. Fact patters differ.  Accordingly,  you should take the time to consult with an experienced tax attorney before initiating a 1031 exchange. A NYC tax attorney at Mackay, Caswell & Callahan, P.C. will have lots of experience with Section 1031.  Why not give us a call; we’re happy to assist you with your case!

Image credit: Joel Raskin