By Kim Hithcock, McNurlin, Hitchcock & Associates PC
Did you know there are two different tax provisions benefiting Homeowner Associations aka Common Interest Realty Associations or CIRAs? With the correct knowledge of these provisions, income can be treated as tax exempt. Don’t miss out on this opportunity to save money!
Most of the time, we think tax-exempt only applies to non-profit organizations like the Red Cross or the Better Business Bureau. The Homeowner Association is not a charitable organization, so how does this work?
The Internal Revenue Code (IRC) has two provisions, or tax codes, written especially for Associations. One provision is for the Association to file their annual tax return as a Homeowner Association under Internal Revenue Code §528. If the Association elects to file Form 1120-H, it is not taxed on “exempt function income.” Exempt function income includes membership dues, fees, and assessments received from owners who are members of the Association. Under this provision, Homeowner Associations avoid paying tax on most of their income.
To qualify for exempt treatment and file form 1120H, the Association must meet the following requirements:
- At least 60% of the Association's gross income must consist of membership dues, fees, or assessments from the owners of the timeshare units;
- At least 90% of the Association's annual expenditures must be to acquire, construct, manage, maintain, and care for Association property;
- No part of the net earnings of the Association can directly benefit any one member or individual; however, a rebate to all members of excess assessments would generally be allowed; and
- At least 85% of the units within the Association (using a square footage test) must be for residential, non-commercial use.
These requirements can be difficult to meet for Associations that are mixed-use so there is a second provision. If the Association does not qualify for exempt treatment under IRC §528, they can file their annual tax return as a C-Corporation using Form 1120. This provision follows Internal Revenue Code §277 which allows for Deductions Incurred by Certain Membership Organizations in Transactions with Members. Although it uses the same tax form as other corporate businesses, it has a special tax rule which permits net membership income to be excluded from the tax calculation.
If the Association collects too little (or spends too much), it has Excess Membership Expenses which is not a problem because the excess will carry forward and offset future assessments.
The trouble comes when the Association has collected more than it spent. This is called Excess Membership Income. This excess can also be carried forward to offset the next year’s budget, but this doesn’t happen automatically. The Association is required to make an election under Revenue Ruling 70-604 to agree to carryforward any excess or repay it to the members. This election must be agreed to by the full membership, so we recommend having the election addressed at the annual meeting. All Associations should make this election annually just in case they have to file Form 1120 and report excess membership income for that year.
Now that you understand what income is tax exempt under IRC §528 or IRC §277, we can move on to non-exempt income. If an Association collects rents, interest, vending machine revenue, easement contracts, or certain other income, that income is not tax free. When an Association has this type of income, it gets specially classified and reported as taxable on either Form 1120 or Form 1120H. Fortunately, the Association also writes off related costs before calculating the tax. The deductions can be any expenditure associated with the specific type of income, such as tax preparation fees, cash management costs, maybe even utilities or repairs.
Once the Association has calculated the net taxable income, it then calculates the tax. If the Association is filing Form 1120H, it takes a $100 standard deduction and then pays Federal Income tax of 30% of the net taxable income.
If the Association is filing Form 1120, it pays Federal Income tax of 21% of the net taxable income.
In every case, the Association will also file a State income tax return and pay tax to the proper taxing authority. In Colorado, we pay a State income tax of 4.63% of the net taxable income.
This area of the law is technical. The bottom line is that the opportunity to benefit from tax-exempt treatment is an option all Associations will want to consider.
If you would like to pursue this matter further, particularly with regard to the determination of tax return form, or to discuss specific tax ramifications of either option, please do not hesitate to email me at email@example.com or call our office to speak to one of our professionals at (303) 988-5648.
Kim Hitchcock and her team at McNurlin, Hitchcock & Associates PC have been working with Homeowner Associations for more than 24 years. Call them to benefit from their extensive experience with accounting, payroll, audited and reviewed financial statements, and income tax preparation!