The Legal Structure Models for Equitable Housing page provided a long list of agreements and organizations that can be used to help people share the bundle of property ownership rights and responsibilities.  In crafting any arrangement for the allocation of such rights, there are certain challenges and considerations that people will frequently grapple with.  These include how the choice, structure, and tax status of an entity will affect the arrangement.  There are also a handful of other considerations that come up regardless of whether an entity is involved in the ownership or management of land:

Will the agreement endure even when the people do not?

Agreements are meant to create a framework for stability and predictability in what is otherwise a rather changeable world.  Property rights are often transferred at death, divorce, dissolution, or foreclosure; yet the remaining parties to an agreement about land will likely desire that the agreement be kept in place, to preserve the rights allocated to them.  Thus, a question to ask about any agreement is whether it is only personal to the parties or whether it will bind successors to the parties.
When it comes to real property, our legal framework leans in favor of the idea that a person taking title to land should receive the full bundle of property rights.  If they meet certain requirements, 1  agreements to re-allocate land rights can “run with the land” and thereby bind all future owners.  However, many of the agreements described in the above section will not meet either the common law or the state statutory requirements for the creation of a covenant that runs with the land, particularly those agreements that are not or cannot be recorded in property records.  Instead, if they meet the requirements, many agreements will be enforced as equitable servitudes, which courts will enforce by means of injunction.  Equitable servitudes generally require that successors have some notice that such an agreement exists, and that the original parties intended that successors be bound. 2  For example, an unrecorded Tenancy in Common (TIC) Agreement between two co-owners is unlikely to be deemed a covenant running with the land.  Most people do not record TIC Agreements for fear that doing so could subject the co-ownership arrangement to laws applicable to subdivisions.  But this leaves the question: will the agreement bind heirs if they inherit one co-owner’s interest?

Here are a few practices that people can use to improve the likelihood that an agreement about land will be enforceable as an equitable servitude:

  1. including clear language in the agreement that it is meant to bind successors,
  2. recording in public records a “Memorandum of Agreement” which is a brief statement to put the public on notice that such an agreement re-allocating property rights exists,
  3. advising parties to provide a copy or information about such an agreement to likely successors,
  4. ensuring that the terms of the agreement would be fair in the eyes of a “reasonable person,” (because courts have some discretion and will decline to enforce an agreement that appears unfair or inequitable), and
  5. crafting the agreement in a way that will not create an unreasonable restraint on alienation (described below).

Does the arrangement create unenforceable restrictions on transfer of the property?

This is only a slightly less lawyerly way of saying: does it create unreasonable restraints on alienation?  As a general and long-standing rule, courts will not enforce agreements that, without useful justification, prevent an owner from gifting, leasing, or selling the property in a reasonable and typical way.The way that courts decide what is an unreasonable restraint on alienation has important implications for many of the solutions proposed in this chapter, since many of the agreements people make to share use, management, and financing of land could also put some constraints on the way the land is transferred, and/or that detract from the marketability of the property.  Over time and case-by-case, courts have broadened the number of ways that people can lawfully create restraints on alienation, and hopefully this will continue to broaden in light of the land access crisis that society is facing.  Individuals facing these issues should become familiar with the ways that courts make this decision, 3 and also be prepared to make arguments that restraints are reasonable.  It is helpful here to quote directly from the Restatement Third on Property, regarding how courts generally determine the reasonableness of a restraint. 4 Italics have added emphasis in italics:

“Determining reasonableness. Determining reasonableness of a restraint on alienation requires balancing the utility of the purpose served by the restraint against the harm that is likely to flow from its enforcement. Restraints on alienation of land are used to accomplish a wide variety of purposes of differing utility. They are used to retain land in families and to preserve affordable housing. They are used to control entry into cooperative, condominium, and subsidized housing developments that require particular financial qualifications. They are also used to control entry into communities, like retirement communities, developed for specialized purposes. Entry controls may be used for legitimate purposes or for the purpose of effecting illegal discrimination. Restraints on alienation are used to further the conservation, preservation, and charitable purposes to which land is devoted. They are also imposed to facilitate land development and create investment opportunities. Restraints on renting or leasing property may also be imposed to ensure that a certain percentage of a development be owner occupied to meet requirements for financing imposed by institutional lenders.

The harmful effects that may flow from restraints on alienation include impediments to the operation of a free market in land, limiting the prospects for improvement, development, and redevelopment of land, and limiting the mobility of landowners and would-be purchasers. Other harmful consequences include the demoralization costs associated with subordinating the desires of current landowners to the desires of past owners, and frustrating the expectations that normally flow from land ownership. Harmful consequences also may flow from enforcement of restraints on alienation that place one person in a position to take unfair advantage of another’s need or desire to transfer property.In determining the injurious consequences likely to flow from enforcement of a restraint on alienation, the nature, extent, and duration of the restraint are important considerations.  The standard against which the impact of a restraint is to be measured is that of the property owner free to transfer property at his or her convenience at a price determined by the market. Common types of restraints include prohibitions on transfers without consent of another, rights of first refusal, requirements that transfers be made only to persons meeting certain eligibility requirements, and options that require transfer to a particular person at a time selected by that person. The restraint may extend to all types of transfers, or only to certain types, like leases and subleases. It may require transfer at a fixed price, a price determined by a formula, by an appraisal, or by an offer received from a third party. The duration may be a fixed period, long or short, it may be limited by the occurrence of some event, or it may be unlimited. The greater the practical interference with the owner’s ability to transfer, the stronger the purpose that is required to justify a direct restraint on alienation.”

The irony of the legal framework on unreasonable restraints on alienation is that it begins with the assumption that, ideally, we could all transfer land freely in the open market. 5  Yet, many restraints allowable by courts are designed for charitable or conservation purposes – in other words, to counteract the harmful impacts of a land marketplace left to its own devices.  Courts are empowered to perform a highly subjective balancing act, one that is subject to judges’ personal opinions about the needs of society, people, and the environment.  At the same time, empowering courts to perform this balancing act potentially turns the courtroom into a forum for the discussion of society’s land access crisis.  It should force courts to examine the harmful impact that the marketplace has had on people communities, and ecosystems, and to recognize that remedying those harms is, indeed, a “strong purpose” justifying the creation of restraints.

Courts have, in essence, already begun to do this, as demonstrated by their willingness to uphold restraints on the ways that subsidized affordable housing units are transferred or leased to tenants, 6 for example.  We can draw on this precedent if and when we are forced to argue that our agreements for managing shared property rights are reasonable and important.

To help preserve the enforceability of the restraint when drafting agreements, people should:

  1. explicitly describe the purpose and social/environmental/personal needs for such a restraint,
  2. describe the way in which the owners will benefit from or benefit “in consideration of” the restraint, and
  3. build in a sufficient number of exit options for property owners and co-owners, along with clear procedures and timelines for how to exercise them.

Building in exit options is what, for example, causes many co-ownership agreements to become quite lengthy.  Co-owners usually make agreements to waive their right to seek partition of the property, 7 but a court will only uphold this if it feels that the owners have sufficient other options for exit.  If a co-owner wants out, the remaining co-owners are often then given a specified period of time in which to exercise options to buy out the departing owner, to search for and choose new co-owners, or to decide to allow the co-owner to put his/her share on the open market. Thereafter, co-owners might still exercise a first right of refusal on an offer, they might refuse a prospective buyer on specified reasonable grounds, and the agreement will ultimately set the terms under which a departing co-owner could simply force a sale of the entire property.  People may go cross-eyed when given an agreement with pages of procedures for how an exit will play out; yet, such provisions protect co-owners and the enforceability of the agreement by giving them both a reasonable opportunity to stay and a reasonable opportunity to leave.

Note that, as a general rule, courts are less willing to enforce restraints on alienation as applied to condos, since those are legally divided interests that were designed to be easily transferred. Unlike in a TIC or cooperative, the units in a condo have been legally divided out from the total ownership of the building, which, in theory, makes them easier to transfer without affecting other units.  Some states may even have explicit rules prohibiting condo-owners associations from putting restraints on the transferability of a condo.

Ownership of land by means of an entity such as an LLC brings up another question with regard to the issue of restraints on alienation.  An ownership interest in an LLC may be considered ownership of personal property, not real property, which means that the entity may have greater freedom to impose restraints on alienation of the membership interests. 8

Individual Tax Implications of an Arrangement:

Property ownership, and particularly ownership of one’s primary residence, generally comes with tax benefits to the individual.  Reallocating property rights in some of the ways  described above may affect the availability of certain tax benefits, which include:

  1. The capital gains exclusion: The IRS currently allows homeowners to exclude from taxation the first $250,000 (or $500,000 for a married couple) of capital gains on the sale of a primary residence. 9  Unfortunately, individuals that own their property through an entity that does not meet the IRS definition of a “cooperative housing corporation” 10 or that is a disregarded entity, such as a single-member LLC, 11 will not be eligible to use this exclusion if they sell their share of a landholding entity and realize a gain.
  2. The mortgage interest tax deduction: Payment of interest on home mortgages is generally a tax deduction for an individual. 12  This is a substantial tax benefit, since a significant portion of mortgage payments consist of interest during the first years of payment, and the deduction could reduce an individual’s taxable income by tens of thousands of dollars. This tax deduction is available to tenant-shareholders of housing that meets the IRS’ definition of “cooperative housing corporation,” and it allows the tenant to deduct his/her share of the interest on the cooperative blanket mortgage. The availability of the mortgage interest tax deduction is a major consideration when a group of people is contemplating purchasing a multi-unit residential property together and choosing between ownership as tenants in common or a limited liability company.  Although the members of the LLC cannot claim the deduction in the same way direct homeowners may, an LLC passes the mortgage interest through to members as a business expense, which usually results in a business loss shown on the member’s K-1 (the statement of a member’s share of profits, losses, deductions, and credits in the LLC).
  3. The property tax deduction: Homeowners can generally deduct from income amounts paid toward local real property taxes.  This benefit is available to direct homeowners and tenant-shareholders of cooperatives, but must be passed through to members as a business expense in the case of ownership by an LLC that does not meet the IRS’ definition “cooperative housing corporation.”
  4. Sweat equity:  Another tax issue to consider is the effect of an agreement to grant a property interest to a person in exchange for work they do on a property.  People are frequently shocked when told that such a “sweat equity” arrangement generates taxable income to the person contributing work, as measured by the value of the land interest that they are granted.

Property Taxes

In California, where property tax assessors generally do not re-appraise a property unless there has been a change of ownership, a group of co-owners may want to find a way to prevent frequent changes of ownership.  For example, if a California property is owned by 8 people as a TIC, chances are that every several years an owner may wish to leave and relocate.  If that person sells his/her share, this could trigger partial re-appraisal of the property and, if the property value has risen, higher property taxes.  One way to avoid frequent re-appraisal is to own the property through an entity, such as a partnership, corporation, or LLC. Under California law, a change of ownership may not take place unless there is a transfer of more than 50% of the interests in the entity. 13

Here is a link to the full page on property taxes.

Implications for the financing of the property

Please see the Financing page.

Tiered Agreements

The creation of any of the legal configurations listed above could potentially entail multiple tiers of documents. Oftentimes, someone will draft an agreement to allocate property rights (such as lease, CC&Rs, TIC Agreement, etc), and work with people to create a second or third level of agreements of the sort that are likely to change more often in response to the evolving needs of the arrangement.
For example, in a cohousing community, in addition to deeds that confer ownership, CC&Rs that allocate property rights, and Bylaws that provide for the governance of the Community Association, the community may wish to adopt Policies and Procedures for various matters related to the operation of community, such as how maintenance or other projects are managed, how committees operate, how supplies purchases are made, how reimbursements are handled, and so on.   They may also wish to adopt Rules related to noise, pets, drugs, gatherings, and chemical use.  Some communities execute a document called Architectural Guidelines or something similar to set rules on how each unit owner can make exterior alterations to the unit, in order to ensure a common design scheme.  Many communities also have an extensive document detailing procedure for the management of meetings and consensus decision-making; sometimes this is included in the Bylaws and other times the Bylaws incorporate this document by reference.   Likewise, parties to a TIC Agreement in a co-owned property may wish to adopt a second-tier document called the “Community Agreement” or “House Policies,” to govern day-to-day matters such as maintenance, purchases, and chores.

Choosing and Structuring an Entity

There are three primary layers of considerations in the design of organizations for the ownership and management of land:

  • What entity we choose: The entity we choose and form at the state level comes with a set of built-in parameters for how the entity can operate, manage funds, make decisions, and engage in activities.
  • What tax status the entity chooses:  The choice of tax status adds another layer of parameters that guide how an entity can operate, and also affects the financial status of the entity and individuals involved.
  • How we structure the entity:   Once we have chosen and formed an entity, the next consideration is how to structure it, including how to manage governance, capitalization, allocation of profits/losses, etc.  This is done through the choices we make in drafting bylaws, operating agreements, and policies.

Sometimes multiple entities will be involved in the creation of a housing arrangement.  For example, there may be one for the ownership of land, one for the management of a development project, and one for management of shared activities.  Sometimes, holding title to land under a separate entity protects it from liability incurred by an entity that operates programs on and develops the property.  In addition, each entity may have different purposes or activities that mandate different legal structures and tax exemptions.

Entity Choice

Every state offers a large handful of entity types to choose from, and each entity comes with a set of legal requirements and constraints.  The rules governing entities vary from state to state, so it’s important to read the statute governing the entity types.  The most common entity types available at the state level and used for the ownership of land are:

  • Partnerships (General and Limited)
  • Limited Liability Companies
  • Low-Profit Limited Liability Companies 14
  • General Stock Corporations, 15 which include new corporation types, such as Benefit Corporations and Flexible Purpose Corporations 16
  • Cooperative Corporations
  • Nonprofit Public Benefit Corporations
  • Nonprofit Mutual Benefit Corporations
  • Nonprofit Religious Corporations

There are usually many considerations to weigh in the choice of entity; these are discussed generally in transactional law practice guides, and also in Chapter 4 of this book.  Here are some considerations relevant to the ownership and management of land:

  1. Does the choice of entity limit liability of individual members/shareholders?  If managed properly, limited liability companies and corporations of all kinds generally shield individual members/shareholders from liability for the entity’s debts, acts, and omissions.  If multiple people come together to purchase and develop land together, particularly if they plan to take out large loans, a entity with limited liability will likely be optimal to ensure that no one individual is left holding the bag if things go wrong.  All entities listed above, except partnerships, offer limited liability.  In many states, the primary reason that some groups may choose to form a partnership to own land is to save money on the costs otherwise required in forming and operating a limited liability entity.  In California, for example, partnerships are not required to pay the $800 annual minimum franchise tax required of LLCs and corporations.
  2. Does the choice of entity limit individuals’ abilities to derive profit from the entity?  The ability to profit from the equity or income of land offers a strong incentive for people to buy land, but this incentive also drives people to exploit land and buy/sell/own in ways that drive up prices for others.  Many people will want to limit individuals’ ability to profit from land, and will thus choose to form a nonprofit public benefit corporation or a nonprofit religious corporation.  While the exact name of the corporation type and the legal restrictions vary from state to state, such nonprofits are generally prohibited from distributing their profits and assets to individuals, and may only distribute profits and assets to other nonprofits.
    There are at least two other entity types that tend to impose some restrictions on the distribution of profits and assets.  A nonprofit mutual benefit corporation, under some state laws, is prohibited from distributing profits to members, but may purchase or redeem memberships from the members. 17  Thus, if a member buys a membership in a land-owning nonprofit mutual benefit corporation for $10,000, the corporation can pay that amount back to the member when he or she leaves.  Most likely, however, no dividend, interest, or appreciation could be paid along with the redemption.  Although they are prohibited from distributing profits, under some state laws, mutual benefit nonprofits may, upon dissolution only, distribute assets to members or to a person or entity of its choosing. 18  This means that individual members may have some incentive to cash out by selling the entire property and dissolving the entity.
    Often, cooperative corporations are limited by state laws in the ways that they can distribute profits to individuals. For example, in California, a cooperative cannot distribute more than a 15% return per year on individuals’ capital contributions. 19  Cooperatives are generally required to distribute earnings on the basis of patronage, rather than on the basis of capital contributed. 20  This means that earnings are distributed to individuals, but that one individual cannot make a large profit on his/her capital investment.
  3. Does the choice of entity mandate democratic or accountable governance?  If an entity mandates a certain type of governance structure, this can contribute to the protection of land, by helping to ensure that private interests cannot control an entity for their personal benefit.  Cooperative corporations, nonprofit mutual benefit corporations, and nonprofit public benefit corporations with members are typically mandated, by law, to have elections and major decisions be made on a one-member/one-vote basis.  This helps to ensure that an organization operates with its members’ interests or the original purpose of the organization in mind.  In addition, even when they do not obtain tax exemption under 501(c)(3), nonprofit public benefit corporations are often subject to certain rules that help to maintain the integrity of the board.  For example, state statutes may limit the number of financially interested directors that may serve on a board, and require that self-dealing transactions be approved by a disinterested panel of directors or by a government entity, such as the state Attorney General. 21
  4. Does choice of entity mandate a certain tax treatment? As described below, an entity can choose between two or more tax statuses or exemptions, but the IRS will also impose certain other rules on an entity depending on whether it is a corporation, LLC, or partnership.  Tax law is vast, and it’s impossible to summarize it all here. However, I’ll describe one major consideration briefly, which is that in the real estate context, most of the time it will be optimal to own land as an LLC (or partnership, if partners are willing to assume personal liability for debts).  People often choose to form an LLC over a corporation, because an LLC member’s adjusted basis in the LLC is raised by the member’s allocable share of the entity’s debt.  Because each member’s adjusted basis is much higher than the amount of cash the member has actually contributed to the entity, each member is able to deduct greater losses in an LLC than they would through a corporation (where the entity’s debt is not included in determination of a shareholder’s basis).  The loss deducted by an LLC member may, therefore, be greater than the amount of cash the individual member has actually contributed to the LLC.  Many LLCs formed for the purposes of holding real estate will be able to pass significant losses through to individual members, as a result of payment of mortgage interest, property taxes, insurance and other expenses, and by allocating a share of the property depreciation to members. 22  By passing through deductible losses to members in this way, LLCs are able to simulate some of the tax advantages of individual home ownership (such as tax deductions for mortgage interest and property tax payments).

Choice of Entity Tax Status

The question of an entity’s tax status is answered somewhat separately from the choice of entity formation at the state level.  Most entities, once formed, will then be able to choose from two or more tax statuses or exemptions.

  1. Entity-Level Taxation versus Pass-Through Taxation:  Some entities (C Corporations and LLCs that elect to be taxed like C Corporations) are subject to “double taxation” – the entity pays tax on its net earnings, and individual members/shareholders pay tax on those earnings when they are distributed to individuals.  By contrast, pass-through entities (S Corporations, most LLCs, and Partnerships) are not taxed until profits are distributed or allocated to members and shareholders.  Pass-through status is especially important in housing ownership, because, often more importantly, losses can be passed through to individuals to offset other sources of individual income. 
  2. Cooperative Taxation: As described in Chapter 4, entities that distribute income to members on a cooperative basis (on the basis of how much each “patronized” the cooperative) can be taxed under Subchapter T of the Internal Revenue Code, which provides for a type of pass-through taxation.  Under Subchapter T, cooperative earnings that are distributed as patronage dividends are taxable to individual, but not to the entity.
  3. Forms of Tax Exemption: Most nonprofit corporations will seek some form of tax exemption from the IRS.  The section of the Internal Revenue Code under which an entity obtains tax exemption may dictate many things about how the entity operates, for what purposes, how it is governed, what sources of income it may have, and how it may spend or distribute its funds.  Here is a brief summary of the categories of tax exemption land-owning organizations may contemplate:
    1. 501(c)(2) Title Holding Corporations: An entity “organized for the exclusive purpose of holding title to property, collecting income therefrom, and turning over the entire amount thereof, less expenses, to [another tax-exempt nonprofit]” may obtain exemption under section 501(c)(2) of the Internal Revenue Code. 23 There are a variety reasons that a nonprofit might want to create a separate entity to hold title to and manage income-producing properties, some of which are named by the IRS in one publication on 501(c)(2):
      “These factors would include limitation of liability from potential damage suits; enhancement of ability to borrow; limitations imposed in gifts and bequests to exempt organizations that effectively require such gifts to be kept in separate entities; clarity of title; accounting simplification; and limitations imposed by various state laws on organizations that would be recognized as exempt under the federal revenue laws.” 24
      In addition to the benefits listed by the IRS, 501(c)(2) title holding corporations create an avenue for 501(c)(3) nonprofits to benefit from rental income from properties.  Rental income is not considered taxable unrelated business income to a 501(c)(2), but such income may be subject to unrelated business income tax under a 501(c)(3). 25  If a 501(c)(3) organization plans to hold title to land that serves its tax exempt purposes, but which will also have a good amount of rental income, it may be helpful to hold title to the land in a 501(c)(2) to avoid tax on the rental income.
    2. 501(c)(3) Charitable, Religious, Educational, and Scientific Organizations: Unless it is in furtherance of a recognized charitable, educational, religious, or scientific purpose, developing and providing housing, alone, is generally not considered a purpose that is tax exempt under 501(c)(3).  Providing housing to people that are poor, distressed, or underprivileged is considered a charitable purpose. 26  Through various rulings and guidance documents, the IRS has provided guidance on the circumstances under which provision of housing to low income individuals, 27 people with disabilities, 28 and the elderly 29 will be tax exempt.  Providing housing in furtherance of another tax exempt purpose can also, itself, be a tax exempt activity.  For example, providing housing to students (whether or not students are part of an underprivileged group) may be tax exempt, because provision of housing advances the school’s educational purpose.  Housing provided in connection with a religious center or other educational center will also likely be found to be a tax exempt purpose, if the provision of such housing is necessary to achieving the religious or educational purposes. Organizations formed to preserve ecologically significant land 30 or, in some cases, historically significant buildings 31 may also obtain tax exemption under 501(c)(3).
      Many people that form groups with the intent of developing housing for themselves consider the possibility of obtaining 501(c)(3) status and using grant money or tax-deductible donations in the purchase or development of their housing. Unfortunately, many of these groups would fail to meet the requirements necessary to 501(c)(3) tax exemption, primarily because their organization is designed to meet the housing needs of a fixed and defined group of people, and not necessarily formed for the purpose of creating broader public benefit.  However, such groups may benefit from creating a separate 501(c)(3) corporation for the operation of specific activities that are tax exempt, such as educational or charitable programs provided on the property.  Groups may also sell or give title, a conservation easement, or other rights to a 501(c)(3) organization to empower that organization to enforce the preservation of ecosystems on the land or the affordability of some of the housing on the land.
    3. 501(c)(4) Social Welfare Organizations: 501(c)(4) tax exemption is generally available to organizations engaging in activities that benefit the public or a broad sector of the community. 32  Many activities can fall under 501(c)(4) tax exemption, so long as they don’t look a good deal like commercial activities and so long as they are not designed to benefit only a fixed group of people.  A group that wants to develop housing for itself will likely fail to meet the requirements of 501(c)(4) for some of the same reasons that it might fail under 501(c)(3), since the group’s efforts are often aimed primarily to benefit the group, as opposed to a broad community.  Some homeowner’s associations, however, obtain 501(c)(4) status if they operate primarily to provide facilities to the public 33 or if they operate to provide benefit to a large community (as opposed to a small geographic area). 34  If the organization works to improve individually-owned properties, it will likely fail to qualify for exemption under 501(c)(4). 35  Donations to 501(c)(4)s are not tax deductible to donors and most foundations do not make grants to 501(c)(4)s; this means that 501(c)(4) status generally does not help an organization to fundraise.
    4. 501(c)(7) Social and Recreational Organizations:  In contrast to (c)(3) and (c)(4) organizations, which are required to provide benefits to the public, 501(c)(7) tax exemption is designed specifically for groups that provide a private benefit to themselves.  In that respect, 501(c)(7)s may be fitting for groups seeking to provide certain housing amenities to themselves, like a country club, swimming pool, or possibly a cohousing common house.  501(c)(7) is a category of exemption designed for social, recreational, and “other nonprofitable purposes.” 36  A question for further inquiry is: what kinds of activities can be included under 501(c)(7)’s “other nonprofitable purposes” category?  It is not a perfect “catch-all,” because the IRS has already said that maintaining roads in a neighborhood is not a proper activity for a 501(c)(7) because is not related to social or pleasurable purposes. 37  Apparently the IRS has appointed itself the arbiter of “pleasure,” in deciding what does and does not further social and pleasurable purposes.  Maintaining roads, to the IRS, must sound like all work and no play.  501(c)(7) may be a fine tax category for a group that wants to share a private vacation home or campground (which sounds like fun), but it will not likely work for a group that simply wants to provide itself with primary residences (which sounds too normal and boring). 38
      Note that 501(c)(7)s may not receive more than 35% of their income from non-member sources, and no more than 15% of the income may come from the use of the club’s facilities by the general public.  This rule requires that the organization provide only for a limited group of people.  The income derived from members must also be of a sort “traditionally” associated with “normal and usual” activities of a social club (member fees, entrance fees, and so on). 39  The IRS seems to have also appointed itself arbiter of “tradition,” in deciding what groups can provide for themselves and on what terms.  A cohousing community could likely own a common house as a 501(c)(7) and could charge members dues and fees for involvement in community meals and social activities.  But could that entity also operate a grocery buying club for the members, an equipment rental service, a shared internet service, a guest house, or other amenity that the members must pay for?  This is an area for further inquiry, and it may require that we seek guidance from the U.S. Department of Pleasure and Tradition (the IRS).
    5. 501(d) Apostolic Associations: A group of people that wishes to develop and own housing communally may want to consider seeking tax exemption under 501(d) 40 if that group is bound together by a set of common beliefs and values.  To obtain exemption under this section, a group must meet requirements of the statute, which are summarized by the 9th Circuit as follows: “that there be a common treasury, that the members of the organization include pro-rata shares when reporting taxable income, and implicitly, that the organization have a religious or apostolic character.” 41  The phrase “common treasury” generally means that members share income and property.
      Twin Oaks is an intentional community in Virginia that has tax exemption under 501(d).  Twin Oaks was also the subject of a Tax Court decision that held that members of a 501(d) community need not surrender their personal property and take a vow of poverty upon joining. 42  In determining what is a proper religious or apostolic “character,” 501(d) organizations appear to be subject to far less scrutiny than are churches that seek tax exemption under 501(c)(3).  501(d) organization need not hold religious services or engage in activities characteristic of traditional religions, such as songs, adoption symbols, or rituals.  The community may simply create “an environment for the daily practice of its beliefs,” as the Tax Court observed in the Twin Oaks case. 43
    6. Section 528 “Homeowners Associations”:  A “homeowners association” (HOA) may sound like something you’d find managing common areas and property use in a run-of-the mill subdivision, but the tax category that the IRS has created for HOAs could also be used to purchase, develop, and own entire properties for the creation of intentional communities.  Earthhaven Ecovillage in North Carolina, for example, owns a 320-acre property as a homeowners association and files taxes under Section 528. 44  Earthhaven leases plots of land to members, who construct residences on those plots.  Homeowners associations are defined by the IRS to include condominium management associations, residential real estate management associations, and timeshare associations. 45  Such organizations are usually formed under state law as mutual benefit nonprofits.  To qualify for tax status under Section 528, 90% of the entity’s expenditures must be made to acquire, construct, manage, and maintain property. 46  In addition, 60% of the organization’s income must be derived from member fees, dues, and assessments. 47  Income from other sources is generally taxable.  An organization need not apply for tax exemption under 528, but need only meet the requirements of the statute and file its tax return using form 1120 or 1120-H.

Structure and Governance Considerations

Choice of entity and tax status are important considerations in designing an organization to own and manage land; however, the real “teeth” of an organization can sometimes be found in the choices the members/owners make in designing its structure, governance, and financial terms.  These terms can greatly influence an organization’s accountability to its members and to the purposes it was designed to serve.

Some entities, like LLCs, afford a vast amount of flexibility to members to structure and manage the entity however they wish.  Even in corporations, which, by statute, require specific structural and procedural formalities, there is flexibility to build in the structural “teeth” to sustain the organization’s purposes and ensure accountability.  Chapter 4 discusses some of these choices, but here are some of the important considerations to be made in structuring an entity to own land:

  1. Composition of membership: Who may join and/or buy in to the entity?
  2. Voting rights: Do members receive one vote each, or are voting rights allocated in proportion to a member’s investment, share of land ownership, or on some other basis?
  3. Governing body:  Will there be a governing board of directors or will members manage the entity directly?
  4. Election and appointment procedures: If the entity has a governing body, how will members of the governing body be elected or appointed?  How will officers be elected or appointed?
  5. Composition of governing body: Will the governing body be comprised of people that live on the property, people that do not live there, or some balance?  (For example, many community land trusts require that 1/3 of the board be comprised of residents of the trust’s housing, that 1/3 be comprised of experts, professionals, and public officials helpful to the trust, and that 1/3 be comprised of concerned and committed community members.)
  6. Spheres of decision-making, management, and operations:  What decisions must be put to all members of the entity and what are decisions that will be made by governing bodies?  Are some decisions allocated to certain committees within the organization?  Will certain officers of the organization be empowered to make some decisions?  How will the activities of the organization be managed?
  7. Procedures for meetings and decision-making: What procedures will be used to hold meetings?  What procedures are used to consider and decide on proposals?
  8. Financial provisions: How will members buy in and sell out?  How will profits and losses of the entity be allocated and distributed to members, if applicable?  What fees may members be required to pay regularly?
  9. Conflict of interest policies:  How will the organization preserve the integrity of its governing body and ensure that it is not steered to serve the interest of certain individuals or certain profit interests?  Under what circumstances might a member or director be deemed financially interested in a transaction or issue, and how will the organization handle this?
  10. Procedures for amending governing documents: If governing documents can be amended simply (such as by a majority vote of the board), this means that many of the safeguards built into legal structure could be easily undermined.  Many organizations may want to build in greater safeguards, such as by requiring approval by a super-majority of the board or members, unanimous approval, or approval by a third party (such as a designated nonprofit) to change certain key provisions of the governing documents.
  11. Dissolution of the entity: Under what circumstances might the entity dissolve and sell its assets?  How will the proceeds be distributed?  To a nonprofit, to current members, or to both current and past members?

 

Coming soon: Governance Models, Conflict Resolution

Footnotes:

  1. One case that has helpfully summarized the common law and statutory requirements for a covenant that burdens a property to run with the land is In re Snow, 201 BR 968, 972-973 (Bankr. Court, CD California 1996), which explained:

    “Under the traditional United States law of covenants running with the land, the following requirements must be met for the burden of a covenant to run with the land: (1) intent by the contracting parties that the burden bind subsequent owners of the servient estate; (2) horizontal privity (mutual interest in the same land) at the time of creation; (3) vertical privity (the successor to the servient estate holds the same interest as that held by the original promisor); (4) a promise that “touches and concerns” the land; and (5) notice, usually given by the recordation of the covenant.” For the running of the benefit with the dominant estate, the elements of intent, vertical privity and touch and concern must be met. See generally 1 ARTHUR R. GAUDIO, THE AMERICAN LAW OF REAL PROPERTY § 6.04 (1994).

    California law on covenants is slightly different. The California statute, as amended in 1968 and 1969, requires the following elements for a covenant to run with the land: (1) the instrument containing the covenant must describe both the dominant estate and the servient estate; (2) the instrument must expressly provide that all successive owners of the servient estate are to be bound by the covenant, and the deed must refer to the recorded restrictions to show the intent of the parties that the covenant run with the land; (3) each act required by the covenant must relate to the use, repair, maintenance, or improvement of, or payment of taxes and assessments on, the land described; (4) the instrument containing the covenant must be recorded in the office of the county recorder of the county where the land is situated. CAL.CIV.CODE § 1468 (West 1996).”

  2. In re Snow, also provides a helpful explanation of the legal requirements for the creation of an equitable servitude:
    “An equitable servitude arises where one or more of the requirements of a covenant running with the land are not met, but the following conditions are met: (1) the subsequent owner of the servient estate has notice of the covenant; (2) the holder of the servitude is seeking equitable relief only (as opposed to a remedy at law); and (3) it is inequitable to deny the enforcement of the servitude. See, e.g., RESTATEMENT OF PROPERTY § 539 cmt. b (1944); 7 HARRY D. MILLER & MARVIN B. STARR, CURRENT LAW OF CALIFORNIA REAL ESTATE §§ 22:5-22:26 (2d ed. 1990).

    “The California Supreme Court has recently described equitable servitudes as follows:
    ‘Under the law of equitable servitudes, courts may enforce a promise about the use of land even though the person who made the promise has transferred the land to another. . . . (E)quitable servitudes permit courts to enforce promises restricting land use when there is no privity of contract between the party seeking to enforce the promise and the party resisting enforcement.’

    Nahrstedt v. Lakeside Village Condominium Association, 8 Cal.4th 361, 33 Cal.Rptr.2d 63, 73-74, 878 P.2d 1275, 1285-86 (1994) (citations omitted).”

  3. An article containing a helpful summary of courts’ approaches is Lefcoe, George. “Should We Ban or Welcome “Spec” Home Buyers?” USC Legal Studies Research Paper No. 09-33, 36 J. LEGIS. 1 (2010).
  4. Restatement Third of Property, § 3.4 Direct Restraints on Alienation, Comment C at 442 (2000).
  5. See also Alby v. Banc One Financial, 128 P. 3d 81 – Wash: Supreme Court (2006), where a dissenting judge argues that a restraint on the ability to mortgage a property should be deemed unreasonable, since this has become the primary way in which people effect transfers of property.
  6. The City of Oceanside v. McKenna, 264 Cal. Rptr. 275, 279  (Cal. Ct. App. 1989), where the court upheld a restriction preventing owners of subsidized affordable condo units from moving out and renting to a tenant of the owner’s choice.
  7. Although the word partition connotes the physical division of land parcels, the vast majority of partitions actually involve the sale of the property and division of the proceeds among co-owners.
  8. Business interests are also sometimes found by courts to be subject to unreasonable restraints on alienation.  See this article summarizing case law on this issue: “Beware Unreasonable Restraints on Alienation When Drafting Shareholder and Operating Agreements,” by Peter A. Mahler, November 23, 2009, posted on New York Business Divorce (http://www.nybusinessdivorce.com).
  9. See IRS Publication 523, “Selling Your Home.” available at http://www.irs.gov/pub/irs-pdf/p523.pdf
  10. See Internal Revenue Code Section 216(b), the text of which is included in a footnote above.
  11. See IRS Publication 3402, “Taxation of Limited Liability Companies,” (March 2010), page 3, for when a single-member LLC may be considered a disregarded entity.
  12. See IRS Publication 530, “Tax Information for Homeowners,” available at http://www.irs.gov/pub/irs-pdf/p530.pdf
  13. California Revenue and Taxation Code Section 64
  14. These are only available in a handful of states. See Chapter 4 for more information.
  15. We use the phrase “general stock corporations” to refer to run-of-the mill for-profit corporations, to differentiate between those corporations and cooperatives and nonprofits.
  16. These are only available in a small handful of states. See Chapter 4 for more information.
  17. See, for example, Cal. Corp. Code Section 7411.
  18. See, for example, Cal. Corp. Code Section 8717.
  19. Cal. Corp. Code Section 12451
  20. See Cal. Corp. Code Section 12201, and Chapter 4 of this book for a description of patronage in cooperatives.
  21. See, for example, Cal. Corp. Code Section 5233.
  22. For more information, see IRS Publications 541 and 925.
  23. See 1986 IRS EO CPE Text, “C. IRC 501(c)(2) – Title Holding Corporations” available at http://www.irs.gov/pub/irs-tege/eotopicc86.pdf
  24. See 1986 IRS EO CPE Text, “C. IRC 501(c)(2) – Title Holding Corporations,” page 2, available at http://www.irs.gov/pub/irs-tege/eotopicc86.pdf
  25. See A. Allen Butcher, “Legal Incorporation for Intentional Community,” published by Fourth World Services, page 9, available at http://www.culturemagic.org/PDF/c1Legal%20Inc.pdf.
  26. See IRS Publication 557 (October 2011), page 30.
  27. See IRS Exempt Organization Continuing Professional Education Text, 1992, “Low-Income Housing as a Charitable Activity,” by Robert Louthian and Marvin Friedlander, available at http://www.irs.gov/pub/irs-tege/eotopicd92.pdf.  See also Rev. Rul. 70–585, 1970–2 C.B. 115, Rev. Rul. 67–138, 1967–1 C.B. 129, IRS Low Income Housing Guidelines Revenue Procedure, Rev. Proc. 96-32, 1996-1 C.B. 717, 1996-20 I.R.B. 14, available at http://www.irs.gov/pub/irs-tege/rp_1996-32.pdf
  28. See Rev. Rul. 79–19, 1979–1 C.B. 195.
  29. IRS Exempt Organization Continuing Professional Education Text, 1979, “Rental Housing for the Elderly Under IRC 501(c)(3)” available at http://www.irs.gov/pub/irs-tege/eotopich79.pdf. See also Rev. Ruls. 72–124, 1972–1 C.B. 145; 79–18, 1979–1 C.B. 194; and 79–18, 1979–2 C.B. 194.
  30. Rev. Rul. 76-204, 1976-2 C.B. 15
  31. See the following IRS Revenue Rulings: Rev. Rul. 75-470, 1975-2 C.B. 207, Rev. Rul. 67-6, 1967-1 C.B. 135, and Rev. Rul. 76-147, 1976-1 C.B. 151
  32. See Exempt Organizations-Technical Instruction Program for FY 2003, “IRC 501(c)(4) Organizations,” by John Francis Reilly, Carter C. Hull, and Barbara A. Braig Allen, available at http://www.irs.gov/pub/irs-tege/eotopici03.pdf
  33. See Rev. Rul. 80–63, 1980–1 C.B. 116.
  34. See Rev. Rul. 74–99, 1974–1 C.B. 131.
  35. See Rev. Rul. 74–17, 1974–1 C.B. 130.
  36. See Exempt Organizations-Technical Instruction Program 1996, “C. SOCIAL CLUBS – IRC 501(c)(7),” by Jim Langley and Conrad Rosenberg, available at http://www.irs.gov/pub/irs-tege/eotopicc96.pdf
  37. See Rev. Rul. 75-494, 1975-2 C.B. 214.
  38. See Rev. Rul. 75-494, 1975-2 C.B. 214.
  39. See Exempt Organizations-Technical Instruction Program 1996, “C. SOCIAL CLUBS – IRC 501(c)(7),” by Jim Langley and Conrad Rosenberg, available at http://www.irs.gov/pub/irs-tege/eotopicc96.pdf
  40. See Internal Revenue Manual Section 4.76.29 (June 4, 2010).
  41. Kleinsasser v. United States, 707 F. 2d 1024 (9th Cir. 1983).
  42. Twin Oaks Community, Inc. v. Commissioner, 87 T.C. 1233 (1986).
  43. Twin Oaks Community, Inc. v. Commissioner, 87 T.C. 1233 (1986).
  44. Diana Leafe Christian, Creating a Life Together: Practical Tools to Grow Ecovillages and Intentional Communities (New Society 2003), page 179.
  45. IRC Section 528(c)(1).
  46. IRC Section 528(c)(1)(C).
  47. IRC Section 528(c)(1)(B).