1031 Exchange for a Co-op Apartment

Co-op shares and the proprietary lease are real property for a 1031 exchange by regulation

Reg. section 1.1031(a)-3(a)(5)(i) lists stock in a cooperative housing corporation among the intangible interests that are real property for section 1031, while other stock, bonds and notes are not, whatever state law says. The Treasury preamble explains that a commenter pointed to the REIT regulations treating a tenant-stockholder's stock as an interest in real property, and that Treasury added co-op stock because it has historically been characterized as real property.

That makes co-op shares like-kind to every other kind of U.S. real property held for investment. A rented co-op can be exchanged for a condo, a single-family rental, a mixed-use building or a traditional DST, and a condo or house can be exchanged into a co-op.

The regulation does not cross-reference the Code's definition, but section 216(b) is where the Code defines a cooperative housing corporation: one class of stock, each stockholder entitled by that ownership to occupy a dwelling, and in each year at least one of three tests met, 80% of gross income from tenant-stockholders, 80% of square footage available to them for residential use, or 90% of spending for their benefit. Ask the managing agent which test the corporation meets.

Depreciation on a rented co-op runs through the stock, and the exchange defers its recapture

Under section 216(c), the part of a tenant-stockholder's stock allocable to a proprietary lease in depreciable property is treated as depreciable when the unit is used to produce income, and the deduction cannot exceed your adjusted basis in the stock. Publication 527 says you depreciate the stock, not the apartment, and if you bought after the first offering you start from your cost per share times the outstanding shares, add the corporation's mortgage debt, remove the part not for depreciable property such as land, and take your share of the result.

Publication 527 also lets you deduct the maintenance fees on a rented unit as a rental expense and adds assessments charged to the corporation's capital account, such as a new roof or mortgage principal, to the basis of your stock. Keep the corporation's letters showing the capital portion each year, because they set your basis at sale.

Hypothetical: shares bought for $600,000, $40,000 of capital assessments, $90,000 of depreciation taken, sold for $850,000 after costs. The adjusted basis is $550,000 and the gain is $300,000, of which $90,000 reflects depreciation. A complete exchange defers both layers; on a cash sale, ask your CPA how the stock depreciation is characterized for the 25% rate, and run your own numbers with your CPA.

Board approval, sublet rules and share-loan limits decide who can buy and how long it takes

Your buyer needs the board's approval, and in New York the Court of Appeals held in Levandusky v. One Fifth Avenue Apartment Corp. that courts will not substitute their judgment for a co-op board acting for the cooperative's purposes, within its authority and in good faith. Build the application and interview into the contract timeline, because your 45-day and 180-day periods start when your sale closes, not when the board decides.

Financing narrows the investor market. Fannie Mae's Selling Guide B4-2.3-04 buys co-op share loans only where the borrower occupies the unit as a principal residence or second home and prohibits investment properties, so most buyers of a rented co-op will live in it or pay cash. The same section recognizes flip taxes owed on transfer under a building's documents; a seller-paid flip tax is a closing cost, and how it is reported on Form 8824 is a question for your CPA.

Sublet approvals, leases and rent receipts are your evidence that the unit was held for investment. In New York City, transfer taxes on co-op share sales are covered on our New York City transfer taxes page.

Replacement options when a building's rules make renting harder

Many co-op landlords exchange because sublet limits, board turnover or assessments make the unit a poor rental. Any real property held for investment works, and the choice is mostly about how much control you want.

• A condominium rental: you own real property directly and leasing is governed by the declaration rather than a board's consent.
• A rental house or small multifamily: no board, full control of leasing and financing.
• A DST or cash-out DST: fractional ownership with no tenants or board to manage, exchangeable under Rev. Rul. 2004-86.

Buying a co-op as replacement property: sublet policy, financing and board timing before day 45

Start with the sublet policy, in writing. Ask for the proprietary lease, house rules and any sublet policy, including how long you can sublet, whether there is a minimum period of owner occupancy first, and the sublet fees. A unit you cannot rent is not a workable investment replacement, so confirm the board will approve an investor purchaser before you identify it.

Plan the money without a Fannie Mae share loan, since investment units are prohibited from that program; that usually means cash or a portfolio lender, which matters if you have to replace debt from the property you sold. Read the corporation's financial statements, its underlying mortgage and reserves, because under section 216(a) your maintenance carries your proportionate share of the building's real estate taxes and mortgage interest.

Board packages and interviews take time, and the purchase must close within 180 days. Reg. section 1.1031(k)-1 lets you identify three properties of any value or more within 200% of what you sold, so list a second unit or a DST as a backup in case the board declines you after day 45.