J & N REALTY, INC.

Income Tax for Homeowners Associations  

HOAs for the most part are not tax exempt, (they do not qualify for 501C status) and therefore cannot file Form 990  

To qualify for tax exempt status, the HOA must serve the community—IRS deems that associations generally do not qualify for tax exempt status as they serve their members and NOT the community at large  

Originally, all HOAs had to file as a regular corporation - taxed on excess, if any, of income over expenses  

Section 277 of the Internal Revenue Code was added to require segregation of membership vs. non-membership income.  

·         To prevent offsetting membership loss against taxable non-membership income  

This was done to prevent offsetting membership loss against taxable non-membership income  

In 1976, IRC section 528 was added to provide HOAs with two benefits  

·         Simple method of filing  

·         Income considered as “exempt function” not be taxed  

Intent of Congress that the HOA receive no benefit or suffer no penalty as compared to individual homeowners  

·         Build reserves with no tax consequence  

·         Rate similar to individual homeowners  

File as regular corporation under Section 277  

·         Form 1120 - Standard federal form for corporations  

File as a condominium/homeowner association under Section 528  

·         Form 1120 H - Specifically for condominiums and homeowner associations  

Election made at the time of filing— based on the return filed  

Divide all sources of revenue as either membership or non-membership  

Membership income is monies received from Association members for 

·         Assessments  

·         Late Fees  

·         Membership Fees  

·         Clubhouse rental income  

Excess Membership income over expenses must be deferred to subsequent years so not subject to taxation  

Non-membership income is monies received from nonmember sources:  

·         Interest income from banks  

·         Rental income on an association owned unit  

Taxed on excess of non-membership income over related expenses  

Non-membership income cannot be deferred to the next year  

Excess membership income must be deferred to be used in future operating periods  

Approve a surplus resolution to defer membership income to be used in next year  

1120. General guidelines under IRC Section 277.  In order to not be taxed on excess membership income, must defer to future years.  

Prepare a surplus resolution to defer membership to be used in next year: 

·         Document  

·         Approve  

If not deferred, excess membership income may be subject to tax  

Guidelines to follow to exclude replacement fund contributions from membership income  

·         Contributions to replacement fund must be communicated to unit owners  

·         Contributions should be based on a plan  

·         Cash in replacement funds should be segregated from that of operating funds, and accounts labeled as such - Have banks/investment company specifically label account  

·         Expenditures of replacement funds should only be used for repair and replacement of common property  

1120. General guidelines under IRC Section 277 exclude replacement contributions from membership income  

Contributions to replacement fund must be communicated to unit owners  

·         Done via the budget process  

·         Contributions should be based on a plan  

·         Based on valid engineering study  

Expenditures of replacement funds should only be used for repair and replacement of common property.  

Do not use funds to pay for operating expenses  

May carry forward excess membership deductions for use in future years  

Divide all sources of revenue as either exempt function income or non-exempt function income  

Only taxed on non-exempt function income  

Exempt function income:  

·         from unit owners  

·         amounts must be solely as a result of membership in the association and assessed ratably to all unit owners  

·         Must be for qualified purposes  

·         Must meet gross income test  

Exempt function - must meet four tests  

Source — must be received from owners of units  

Nature-amounts must be paid solely as a result of membership in the association, and assessed ratably.  Fees paid for services and per use admission fees are not considered exempt function income  

Purpose—amounts must be for qualified purposes  

Gross income—excludes from exempt function any amounts that that the tax rules exclude from gross income (tax-exempt interest, excess assessments applied to future years, capital contributions  

Nonexempt function income-results primarily from three sources  

·         Revenue from non-association property  

·         Revenue from nonmembers for use of association property  

·         Amounts charged to association members for specific services.  (fees not assessed ratably to all members  

Nonexempt function income-results primarily from three sources  

Revenue from non-association property – Investment income earned on cash accounts  

Revenue from nonmembers for use of association property  

Amounts charged to association members for specific services.  (fees not assessed ratably to all members, laundry income, clubhouse rental income, pool income)  

IRC section 528  

 Must pass the following tests:  

·         Substantially residential test.  

·         60% gross income test  

·         90% of its expenditures are qualifying expenditures  

·         Lack of private benefit.  

Cannot carry forward net exempt function loss  

Tests defined:  

1. Substantially residential test.  85% of square footage of all units must be used for residential purposes (condominium association) or 85% of the lots must be zoned for residential purposes  

2. 60% gross income test—60% of association’s gross income must consist of exempt function income, received from owners in their capacity as association members  

3. 90% of its expenditures are qualifying expenditures.  Can be either current operating expenditures or capital expenditures made for the maintenance and care of the association property  

4. Lack of private benefit test—homeowners cannot receive distributions of earnings of the association  

Note: if utilities for units are submetered, then cannot file 1120H, as revenue and expenses would not be considered as exempt function in terms of meeting the 60 and 90 percent tests  

Can allocate expenses that are generated in the production of income  

Using 1120 then follow regular corporate tax rates starting at 15% and increasing when taxable income reaches levels of $50,000, $75,000, $100,000, $335,000, and $10,000,000  

Using 1120H, then use a standard deduction of $100 and then taxed at rate of 30% regardless of the amount of taxable income  

Using 1120 then follow regular corporate tax rates starting at 15% and increasing up to 39% when taxable income reaches levels of $50,000, $75,000, $100,000, $335,000, and $10,000,000.  

Using 1120H, then use a standard deduction of $100 and then taxed at rate of 30% regardless of the amount of taxable income  

At about $186,000, the straight 30% rate results in a lower tax liability  

Reasons for deciding which to file: 

·         Lowest tax  

·         High surplus carryover from year to year  

Not following guidelines to exclude replacement funding from membership income.  

Based on the existing tax rates, usually the 1120 will give the lowest tax.  However, you cannot look at this in a vacuum  

1. High accumulated surplus, not meeting the requirements of deferring revenues for one year.  Therefore, membership income could be taxed.  Better to file 1120H.  No surplus carryover concerns in 1120H and so can file.  

2. Not meeting guidelines to exclude replacement funding from membership income, better to file 1120H  

3. High amounts of income that are not assessed ratably, better to file 1120.  

Tax-exempt interest  

Capital losses  

Offsetting of non-membership gains/losses in different activities  

Tax-exempt interest is not considered taxable under either filing  

Capital Loss--A HOA may also have a capital loss.  That is more common now that many associations are investing in U.S. Treasury Notes and other investment vehicles to obtain a higher yield than on certificates of deposit.  Gains on investment sales are capital gains and are fully taxable.  Losses on investment sales, however, are considered capital losses and may only be offset against capital gains.  They are not deductible.  Capital losses may be carried back three years and carried forward five years.  

Offsetting of gains/losses--After segregating both income and expenses into membership and non-membership categories, HOAs will arrive at net membership income or loss and net non-membership income or loss.  In determining net non-membership income, income and losses from all non-membership activities may be aggregated.  Thus, interest income may be offset by losses from other non-membership activities, provided that the non­membership activities are profit motivated  

Federal tax payments must be made either using Electronic Funds Transfer System (EFTPS) or using Form 8109, Federal Tax Deposit Coupon  

IRS in process of changing these rules and many banks are no longer accepting Form 8109  

HOAs should register online at  

www.eftps.com  

Federal tax payments must be made either using Electronic Funds Transfer System (EFTPS) or using Form 8109, Federal Tax Deposit Coupon  

IRS strongly prefers EFTPS  

Many HOAs used Form 8109 due to small amount of tax due  

Processed at HOAs bank and direct debit from account to IRS  

IRS in process of changing these rules and many banks are no longer accepting Form 8109  

Possible penalties for paying tax-using paper check.  

IRS has not released new rules surrounding tax payments  

HOAs should register online at www.eftps.com and sign up  

Advance registration is required  

·         No returns to file and no tax to pay  

No 1099 required if payee is “Inc.” or “Corp.”  

Issue Form 1099 for payments to an individual or to an LLC  

Exception: always issue Form 1099 to attorney or law firm, even if incorporated  

Forms must be sent to recipient by January 31.  Due to IRS by February