Community Associations Discover Old Development Rights Have Current Value

Published on: September 22, 2002

It is not exactly the equivalent of discovering oil in the back yard, but many homeowner associations in Massachusetts are finding that they are sitting on expired, and extremely valuable, development rights for planned but uncompleted phases of their communities. Developers, for their part, are making the far less happy discovery that they must buy back development rights they thought they still controlled.

The origins of this scenario date back to the real estate crash of the late 1980s that claimed, among its varied victims, large numbers of developers along with the residential projects they had begun but were unable to complete when funding, buyer demand, or both evaporated. Condominium communities caught in that downdraft remained only partly finished, as construction of later phases either stalled or was never begun.

Resuming work on those interrupted projects turned out to require more than an economic recovery. Fannie Mae guidelines, incorporated as a requirement in many condominium documents, specified that if developments were not substantially completed within seven years, the original development rights would expire. Community associations, thus, would have to grant new rights to the original developer or to a new developer in order to complete the project. But obtaining the required approval for the resumption of these projects was more difficult than the developers or the associations themselves anticipated.

Legal Roadblocks

The problem was, the Massachusetts courts had held that any change in a condominium’s percentage interest arrangement (which the addition of new units would produce) required the approval of 100 percent of the unit owners. On that basis, a single owner could, and in many cases did, block proposals to build out a development.

The state Legislature tried to address the problem by amending the condominium statute in 1994, but the new wording dealt only with the extension of existing development rights; it did not encompass the creation of new rights after the old ones had expired.

Lawmakers tried again in 1998 and this time, they got it right. Chapter 242 of the Acts of 1998 authorizes a condominium board to create new development rights with the approval of 75 percent of the unit owners and 51 percent of the lenders holding first mortgages on individual units who have specifically requested a say in these decisions. Most lenders don’t bother to exercise that right (the time for them to do so is at the loan closing), and those that do typically will consent as long as the condominium board and the requisite number of owners have approved the deal. But because Fannie Mae won’t approve an expansion plan unless all of the statutory requirements have been met, we typically include language in community association documents specifying that a lender’s failure to respond within 60 days will be considered a “yes” vote.

Something of Value

With this revised approval framework in place, many homeowner associations are now able to negotiate the terms under which they will allow developers to complete the long-delayed final phase, or final phases, of their communities. But a key question they must answer is how much to charge for the development rights they are now in a position to sell.

A general rule of thumb holds that land represents 20 percent to 25 percent of a completed development’s value. Using that formula, if a developer plans to build 50 new units at $400,000 each, the land the association is selling would be valued at around $5 million.

But most boards don’t approach this negotiation in the same way as a typical property owner looking to sell vacant land to a developer. For one thing, communities usually have a clear vested interest in seeing the development completed, and they often can negotiate other concessions—new common area amenities, necessary repairs to existing buildings, landscaping enhancements, etc.—that will enhance the community and further increase its value.

Still, it is important for boards to treat the sale of development rights as a business transaction and not as a fluke or a windfall. They don’t necessarily have to try to extract the last possible dollar from the developer, but they should demand a fair price sufficient to boost the condominium’s reserves, improve its overall finances, or achieve other community goals. The development rights are valuable and associations should not give them away nor sell them for substantially less than they are worth.

Getting Over It

Needless to say, this picture looks very different from the perspective of developers, who resent buying rights that were theirs to begin with. The operative word, of course, is “were.” The developers owned the rights at one time, but don’t own them any longer. Moreover, they have already realized a profit on their original rights, although, admittedly, that is not much consolation to developers who discover that they have missed the deadline for exercising their rights (without having to repurchase them) by a few weeks or even worse, a few days.

Their annoyance is so great that developers sometimes accuse associations of extortion, or worse, and even threaten to sue, especially if another developer has entered the picture with a new proposal for completing the project. Associations should be prepared for that response, but they shouldn’t be intimidated by it. Just because a developer threatens to fight is no reason for associations to roll over and give away something that belongs to them.

On the other hand, the association’s best deal is usually with the original developer, who knows the project and who is known by the community. Those memories are not always happy ones, however. Associations often feel (not always fairly) that the original developer let them down when the project stalled. In fact, the failure may have resulted from market forces beyond the developer’s control. Still, those hard feelings often linger. As a result, boards may have to overcome old resentments and the developer may have to overcome new ones in order to work together. But all parties share a strong interest in avoiding litigation and in completing the development. So what sometimes begins as a reluctant partnership usually evolves into a constructive relationship over time.

The developer and the community association are not the only beneficiaries. Completing these stalled condominium developments adds much-needed new residential units to the state’s housing stock. Although the new units aren’t likely to be inexpensive, condominiums are typically at the more affordable end of the home price spectrum. So from that perspective, the process of resurrecting old development rights turns out to be a public policy boon as well.

Other Issues

Resolving old tensions with the developer and negotiating a fair price for the land are not the only issues the association must address. Unit owners also have to consider the style and quality of the units the developer is going to add to the community. At a minimum, they will want to ensure that the architectural styles will be compatible and the construction quality comparable to the existing structures. Owners won’t want the equivalent of shanties added to a community of $500,000 town homes.

Existing owners also don’t want construction problems to become a drain on the association’s financial resources. By the same token, the purchasers of the new units won’t relish contributing to the upkeep of units that, necessarily, will be on a very different repair and replacement schedule than the newer structures.

One way to deal with these concerns is to have the developer create a second, separate condominium instead of simply adding to the existing one. This requires the same 75 percent approval but avoids many potential problems and thus may make the development plan more acceptable to some otherwise reluctant owners.

Tax Implications

The sale of the development rights will create tax planning issues that the association and unit owners must consider. Kenneth Bloom, a CPA with the Needham accounting firm of Friedman, Suvalle & Salomon, PC, who has handled many of these transactions, suggests structuring the sale as a transaction between the developer and the unit owners. He explains the process this way:

As a first step, the association establishes a nominee trust to handle the transaction on behalf of the unit owners, who own the land in common, as they own all other common areas of the community. The trust itself has no ownership interest; it is simply an administrative vehicle established to transfer ownership from the owners to the developer. The sale is closed in the name of the trust, which distributes the proceeds as directed by the condominium board and the unit owners. Sometimes all of the proceeds go to the association, but in most cases, the deal calls for some portion to go to the owners directly as an incentive to encourage them to approve the deal. The owners benefit in two ways:

  • The addition to the condominium reserves reduces the need for special unit owner assessments to finance necessary renovations or repairs, and;
  • The owners get a cash bonus that could amount to several thousand dollars, as well.

On the Sidelines

Structuring the transaction in this way makes the association an “innocent bystander” to the transaction, with no direct involvement in the sale and thus no tax consequences to manage. However, the sale does produce a taxable event for the unit owners, who must account for the portion of the sale proceeds they receive. Each unit owner’s share of the total sale price will be based on their percentage interest in the condominium trust. If the sale price is $1 million, an owner with a 2 percent interest would receive $20,000 and would have to pay taxes on a portion of that amount. But not all of it.

The original purchase price of each condominium unit includes the value of the land on which the community sits. Owners, thus, have a tax basis not just in their own units, but also in their share of the land the owners have sold collectively to the developer. To determine what that basis is, owners can look at the fair market value of the land they sold to the developer as a percentage of the fair market value of the entire condominium development, if all owners were to sell their units simultaneously. If the developer paid $1 million for the land and the sale of all the units would total $25 million, then the land cost represents 4 percent of each unit’s total value, and that amount is the owner’s tax basis in his/her share of the sale proceeds. Using the $1 million sale price, an owner who paid $300,000 for his/her unit, would have a tax basis in the land of $12,000 (4 percent of $300,000). If that owner’s share of the sale proceeds was $20,000, after deducting the tax basis, he/she would owe taxes on only $8,000 of that amount, effectively sheltering nearly two-thirds of the income.

Bloom cautions that this is relatively new tax planning ground. “It is something like the Wild West,” he acknowledges, with no formal opinions or test cases on which to rely. On the other hand, he says, many condominium owners have now used this strategy, and as far as he knows, the IRS has not challenged it.