For decades, co-op boards and managers have had to walk a delicate line between generating revenue and obeying the law when it came to renting out space in their buildings to commercial tenants.

As of December 20, 2007, that has changed. On that date, President George W. Bush signed into law legislation dramatically liberalizing the so-called "80/20 Rule" restricting the amount of non-shareholder income co-ops are allowed to receive. Going forward, most co-op boards and management will be able to skip the "80/20 two-step" entirely, and charge fair-market rents for their commercial spaces.

A Little History

In order to better understand the significance of this latest development, it's helpful to know a little about the 80/20 rule itself.

According to a provision in Section 216 of the Internal Revenue Service (IRS) tax code, the amount of commercial revenue a co-op building can take in annually may not exceed 20 percent of the building's total cash inflow. At least 80 percent must come from shareholders' monthly fees, maintenance charges, or special assessments. If a building's outside income—sometimes even referred to as "bad income"—slides even one percent over 20, individual shareholders forfeit valuable tax write-offs and abatements.

But why is that, exactly? There's not really an ironclad answer to that question. The 80/20 rule came about when the federal government determined that people living in housing cooperatives were, in fact, homeowners—and then had to determine how they would be taxed.

"It's my conjecture," says Gerald Marsden, a partner with the Manhattan-based financial firm Eisner & Lubin LLP, "that somebody convinced Congress to push 80/20 through, saying, 'We'd like to get the tax benefits of home ownership —the deduction for real estate taxes, the deduction for mortgage interest, and the ability to get $250,000 or $500,000 in effect tax-free when we sell.' Making owning shares in a co-op more like outright home or condo ownership."

But legislators didn't want to give too many perks to homeowners who also happened to be shareholders in a residential cooperative corporation.

According to Mary Ann Rothman of the Council of New York Cooperatives and Condominiums (CNYC), "Section 216 of the IRS code was developed to enable [co-op owners] to get the same federal tax deductions as individual homeowners get on their real estate taxes and the interest on their mortgages. The intent was to extend these privileges to co-ops, but not give away the store. You can only pass on shareholders' proportional share of the interest paid on the building's underlying mortgage and the real estate tax paid if your building qualifies."

All this added up to one simple fact: co-op buildings could never charge too much rent for any commercial space they might want to lease out—no matter how much that space might actually be worth on the open market. If they charged fair-market rent, and that tipped the 80/20 ratio out of their favor, the co-op's residents would forfeit the aforementioned tax deductions.

"I'll assume that in 1942, [80 percent resident-generated versus 20 percent outside funds] was a fair ratio for the vast majority of co-op buildings, which there weren't a whole lot of anyway," says Rothman. "As time passed, and New York City became a very, very lucrative place to be, it would be possible to get very, very high rents in some of these stores."

The Law Itself

"80/20 goes back to the 1940s," says Marsden, "and it really hasn't been changed since, except for little things here and there."

Until now, that is. According to attorney Michael Manzi of Manhattan-based law firm Balber Pickard Maldonado & Van Der Tuin PC, the new legislation signed into law this past December changes pretty much everything.

"As a practical matter, this legislation will eliminate commercial income restrictions for most cooperatives," says Manzi.

That's a big deal—and it dramatically impacts how the original legislation can be interpreted on behalf of residential co-ops. According to Manzi, Section 216(b)(1) of the IRS code defined the term 'cooperative housing corporation' by the following criteria:

A.) Having one and only one class of stock outstanding

B.) Each of the stockholders of which is entitled, solely by reason of his ownership of stock in the corporation, to occupy for dwelling purposes a house, or an apartment in a building, owned or leased by such corporation

C.) No stockholder of which is entitled (either conditionally or unconditionally) to receive any distribution not out of earnings and profits of the corporation except on a complete or partial liquidation of the corporation, and

D.) 80 percent or more of the gross income of which for the taxable year in which the taxes and interest described in subsection (a) are paid or incurred is derived from tenant-stockholders (emphasis added).

Under this original legislation, shareholders living in co-op buildings were ineligible for the tax benefits extended to single-family homeowners if their building got more than 20 percent of its revenue from any non-shareholder source.

The potential challenge here is obvious to anyone at all familiar with the value of commercial rental property in New York City. Co-ops with attractive rental spaces were forced to cap rents in order to stay on the right side of 80/20. "Or," says Manzi, "[they had] to undertake elaborate restructurings designed to have the excess commercial income flow to an entity other than the cooperative corporation."

The Big Change

According to Manzi, the new amendment alters subsection (D) above and adds two new and different tests for qualification as a "cooperative housing corporation."

"Under the new legislation, a cooperative's shareholders will receive homeowners' tax benefits if any one of three following tests are met, in addition to complying with sections (A), (B) and (C) above," says Manzi.

"First: If 80 percent or more of the co-op's gross income is derived from shareholders—which is the pre-existing test. Second: If 80 percent or more of the total square footage of the co-op's property is used or available for use by shareholders for residential purposes. And third: If 90 percent or more of the co-op's total expenditures are for 'the acquisition, construction, management, maintenance, or care of the corporation's property' for the benefit of its shareholders."

"Under the new legislation, a cooperative's shareholders will receive homeowners' tax benefits if any one of three tests are met," Manzi continues. "First: If 80 percent or more of the co-op's gross income is derived from shareholders—which is the pre-existing test. Second: if 80 percent or more of the total square footage of the co-op's property is used or available for use by shareholders for residential purposes. And third: if 90 percent or more of the co-op's total expenditures are for 'the acquisition, construction, management, maintenance, or care of the corporation's property' for the benefit of its shareholders."

According to Manzi, most high-rise and mid-rise buildings will easily meet the second test of 80 percent or more of their building being used for residential purposes, regardless of how much income they're getting—or could potentially get—from commercial tenants. Manzi says that smaller buildings may well meet the criteria for the third test of 90 percent of expenditures being used solely for the benefit of the shareholder corporation as listed in the new legislation.

"The precise meaning of the third test is somewhat unclear," says Manzi, "but this expenditure test is virtually identical to the one for homeowners' associations under Section 528 of the Internal Revenue Code. Thus, we anticipate that the regulations and rulings under Section 528 will provide guidance in interpreting the new '90 Percent Rule' under Section 216."

Overall, this change spells good news for buildings forced to decide between commercial revenue and tax benefits. That said however, the tax code is a sprawling, Byzantine structure—and this new development impacting co-op communities throughout the country is more than can be exhaustively explained in a newspaper article. For questions about how the new law will affect your building and how you can take advantage of the change, contact your building's legal counsel and financial advisors.

Hannah Fons is an associate editor of The Cooperator.