Along with Section 121, the tax deferral provision of Section 1031 is among the most valuable opportunities available to taxpayers under the code. As we’ve covered previously, Section 1031 allows you and other taxpayers to defer recognition of capital gains when (real) property held for investment or business purposes is exchanged for other property of a like-kind. To effect an exchange, taxpayers must either engage in a direct swap with another party, or engage in a structured transaction involving an intermediary. In the most recent series of tax code revisions, personal property exchanges were eliminated, while real property exchanges, including those with a New York co-op, were preserved.
As the 1031 industry has grown over the years, one interesting phenomenon which has occurred alongside this growth has been the gradual expansion of the definition of “real property” to include 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 interpreted broadly, and so traditionally most 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, but this was not always the case. Now, the total number of investment properties available to choose from is quite large, and there’s plenty of reasons to suppose that this number will continue to increase into 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 go over the basics of New York co-ops and then discuss some of the legal authority which supports the use of co-ops as exchangeable real property under Section 1031.
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 which, in turn, owns the entire apartment complex. The individual owner of the co-op receives a proprietary lease which gives him or her access to a specific apartment on the property. The individual owner receives a monthly bill – referred to generally as “maintenance” – and this 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 property under 1031. Technically, when a person purchases a co-op, he or she purchases stock in a corporate entity, and 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, and so a New York co-op falls into a somewhat unusual situation in which their 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, with certain authorities treating them as intangible personal property and others treating 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, but this 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 the use of a New York co-op in 1031 exchanges is that these authorities leave some degree of uncertainty as to the classification of whether a New York co-op is either real or personal property. Many New York court opinions as well as many pieces of New York statutory authority hold that co-operative apartments are intangible personal property, given that ownership of such co-ops takes the form of stock. For instance, in State Tax Commission v. Shor (1977), the New York Court of Appeals ruled that an interest in a new York co-op was intangible personal property 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.
There are 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. In Private Letter Rulings (PLRs) 200137032 and 200631012, the IRS held that co-ops are exchangeable under Section 1031. In the former ruling, the co-op was exchanged for another co-op in the same complex, but 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 the classification of a New York co-op 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.
Although not every piece of authority holds that New York co-op apartments constitute real property for purposes of Section 1031, 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 from the state level. No matter what the specific facts of your case, you should definitely take the time to consult with an experienced tax attorney before initiating a 1031 exchange. The tax attorneys at Mackay, Caswell & Callahan, P.C. have lots of experience with Section 1031 and would be delighted to assist you with your case!