Note: This weeks question was answered by my colleague, Gail Pizetoski, CPA.
Q: My husband is on the board of our HOA, and for the past two years our manager has said we have to file tax returns for the HOA. Our only income is from the assessments, plus a few dollars of interest from our savings account. Our expenses are for the managers fee and maintenance. Do we have to file income-tax returns?
All homeowners and condominium associations, residential and commercial, whether incorporated or not, must file annual federal and state income-tax returns. If a calendar-year association, the tax returns are due by March 15.
Community-association taxes are very complex. It is important that HOA boards select an accountant who knows the industry. Associations generally have two tax filing options available: Form 1120 or Form 1120-H.
Form 1120: This form is the regular corporation tax form and is required for commercial condominium associations. Although the tax rate is lower 15 percent on the first $50,000 of taxable income it is more difficult to prepare. This return requires the allocation of income and expenses between membership and nonmembership activities. Only its net nonmembership income is taxed. Filing this return may also subject the association to increased risk of tax audit.
Form 1120-H: This form was designed for homeowners associations. It applies to associations electing to be taxed under this method. This form requires the allocation of income and expenses between exempt-function income and non-exempt-function income.
Exempt-function income is the amount collected by the HOA from the dues paid by every homeowner. This income is not taxable.
Non-exempt-function income is income that comes from other sources (usually nonmembers), but it can also include income from members that is paid for the use of specific amenities. Some examples of non-exempt-function income are interest received on bank deposits, guest fees for the pool, laundry income, clubhouse-rental income, condemnation awards and income received from the rental of association property.
Interest income and other non-exempt-function income is taxed at a rate of 30 percent. Basically, associations elect tax-exempt status for that portion of the associations income that comes from assessments. Likewise, association income that does not fit the definition of exempt-function income is not tax-exempt.
Non-exempt-function income may be reduced by expenses directly connected to that income (such as state income taxes). In addition, other expenses may be allocated, such as management fees, tax-return preparation, insurance, bank fees, utilities, repairs and maintenance, and security and cleaning. Net non-exempt-function income is taxable, subject to a $100 deduction.
Under the IRS rules, the association must satisfy all of the following requirements to use Form 1120-H.
• The HOA must be organized and operated to provide for the acquisition, construction, management, maintenance, and care of association property;
• Substantially all (85 percent or more) of the units or property are used by individuals for residential and auxiliary residential purposes;
• At least 60 percent of its gross income is derived from the membership dues, fees, or assessments of owners in the association;
• At least 90 percent of its expenditures for the tax year are used for the acquisition, construction, management, maintenance and care of association property. This includes current expenses and reserve expenses;
• No part of its net earnings may benefit any shareholder, owner or individual.
If the above tests do not qualify your association to file Form 1120-H, which is a very safe filing method and is the easiest to prepare, the association will be required to file the more complicated (and risky) Form 1120. We recommend that the majority of associations file Form 1120-H to avoid the tax audit risks of Form 1120.
In summary, the majority of association returns are filed using Form 1120-H despite the higher tax rate. Form 1120-H is less complex to prepare (that is, less expensive), virtually risk-free, and most associations do not have taxable income, making the difference in tax rates a nonissue. The associations goal should be to minimize taxes and reduce risk.
Discuss your associations tax matters with your accountant before year end. Decide which tax form to file and evaluate the per-use charges (such as clubhouse rentals). Make any necessary changes. Tax planning may involve filing Form 1120-H in some years and Form 1120 in others. The key is knowing when to file which form.
Gail Pizetoski, CPA, AMS, CMCA, has prepared taxes for community associations for over 25 years and is very active in the industry. In addition to consulting with many management companies and over 250 HOAs, she is also a past owner of a management company. Her website is www.condohoacpa.com.