This site provides information regarding homeowner association taxation on forms 1120 and 1120-H.  For information on tax exempt homeowners associations, go to our site specifically dedicated to tax exempt associations.  We hope you find this information helpful in understanding the complexities of the various Internal Revenue Code (IRC) Sections and other rulings that affect homeowner associations.  The one thing we can promise you is that this area of taxation is far more complex than it appears on the surface. 

This site is maintained by Porter & Lasiewicz, CPAs, a firm nationally recognized for expertise in homeowner association taxation.  Gary Porter, CPA has the rather dubious distinction of having either directly handled or been retained to consult with other CPAs, tax attorneys, or associations on more than 70 IRS audits.  That’s more than any other tax practitioner in the industry and gives Porter & Lasiewicz a much broader viewpoint on tax issues and how IRS generally deals with association on IRS audits.

Overview of filing methods

While most CPAs in the community association industry talk about taxations, they refer only to the two most common methods, Forms 1120 and 1120-H.  But there are actually many more methods than that, although they may apply to specialized associations only.  This site discusses ALL methods and provides the most comprehensive information available.

• Form 1120 as nonexempt membership organization
• Form 1120-C as nonexempt cooperative organization
• Form 1120-H as homeowners association
• Form 990 - exempt under IRC 501(c)(3)
• Form 990 - exempt under IRC 501(c)(4)
• Form 990 - exempt under IRC 501(c)(7)
• Form 990 - exempt under IRC 501(c)(12)

Form 1120

Associations that are not exempt under any other section of the code are required to file Form 1120 as a nonexempt membership organization.   This is the mandatory application of Internal Revenue Code (IRC) Section 277.  Form 1120 carries the highest tax risk of any of the filing options for associations, and generally should be avoided where possible to mitigate tax risk.  Too many tax preparers themselves underestimate the tax risk of Form 1120 due to lack of knowledge of all of the rules related to this tax filing method.

There is no codified body of law related to Form 1120 for associations.  Also, there is a common misunderstanding that the concept of “homeowners association” applies to association that file Form 1120.  The term “homeowners association” is defined in IRC Section 528 and applies only to organizations that file on Form 1120-H.  An association that files on Form 1120 is simply a nonexempt membership organization, no different from a card club, an auto club, a sports club, or any other type of organization that is a nonexempt membership organization. 

What makes association filing Form 1120 so different from other organizations is the concept of reserves, and this is where the greatest risk lies for associations filing Form 1120.  Associations filing Form 1120 are required to report all monies received as gross income under IRC 61 unless any amounts are excluded from income by another section of the Code.  Associations normally exclude reserve assessments from gross income by claiming they are capital contributions under IRC Section 118.  However, the rules for exclusion from gross income under IRC 118 are murky, as they have been modified and refined by various revenue rulings, court cases, and General Counsel Memoranda (GCM).  See article attached on reserves as capital contributions.  Also see revenue rulings 75-370 and 75-371 which provide additional guidance on what items regularly included in reserves may be considered noncapital in nature.  One of the biggest tax risks results from confusion within the community association industry which applies the concepts of operating versus reserve funds as compared to the IRS which applies the concepts of noncapital versus capital transactions – they are two completely separate concepts.

After eliminating capital contributions and related capital expenditures, the association must then separate member versus nonmember transactions.  Nonmember transactions are considered taxable at the corporate income tax rate of 21%.  One of the huge drawbacks of filing Form 1120 is that any excess of member income over member expenses is also considered taxable income. 

IRS issued Revenue Ruling 70-604 which provides an administrative technique that allows an association to make an election to avoid taxation of that excess member income in a given tax year.  There is considerable controversy over how to interpret this very brief two paragraph ruling and this in one of the most commonly raised issues in tax audits of associations filing Form 1120.

Excess membership deductions may NOT be used to offset nonmember income but may be carried over indefinitely to future years.  Excess membership deductions may not be carried back to prior years.

Form 1120-C

Associations that qualify as cooperative organizations are required to file Form 1120-C.  Cooperative organizations are taxed under a completely different scheme of taxations as set forth in Subchapter T of the Code, which is Code sections 1381 through 1388.  While income and expenses are defined as member and nonmember activities on Form 1120, the concepts applied to cooperative organizations are patronage and nonpatronage activities on Form 1120-C.  The definitions are different, but similar.  Also the concept of taxing nonpatronage activities is similar to taxing nonmember activities and the fact is that excess patronage income may be subject to taxation.  There are several very significant advantages that cooperative associations typically enjoy compared to associations that file Form 1120:

• Because cooperative organizations own the real estate, they are entitled to a depreciation deduction that is not available to other forms of associations. This depreciation deduction often generates large losses that offset patronage income and create large patronage loss carryovers to offset future patronage income.  Unlike the net operating loss, patronage loss carryovers do not expire, but may be carried over indefinitely.
• Interest income earned on reserves is considered patronage income and generally avoids taxation. See trump Village Section III v. Commissioner
• Cooperative may declare patronage dividends the eliminate much of net patronage income
• Cooperative housing corporations that meet the requirements of IRC Section 216 may pass through deductions of mortgage interest and property taxes to the members (patrons) of the association.

The Puget Sound Plywood v. commissioner case established principles of operating on a cooperative basis

• Subordination of capital
• Democratic control
• Sharing of fruits and increases

Form 1120-H

Associations that meet the qualifying tests of IRC Section 528 may elect annually to file Form 1120-H as a homeowners association.  Financial activities are characterized as exempt and nonexempt activities, and are defined differently than member and nonmember activities on Form 1120 or patronage and nonpatronage activities on Form 1120-C.

The qualifying tests under IRC Section 528 are:

• 60% of income must derive from exempt function sources.
• 90% of expenditures must derive from exempt function sources
• The association must be residential in nature – 85% of square footage in the case of condominium associations must be used for residences, and 85% of lots in the case or property owners associations.
• No private inurement

Net operating losses are not allowed.

Net nonexempt income is taxed at a flat rate of 30%.

There is virtually no tax risk associated with Form 1120-H.

The election to file under IRC Section 528 as made simply by timely filing Form 1120-H.

Form 990

501(c)(3) - Associations qualifying for exemption under IRC Section 501(c)(3) are extremely rare.  The authors are aware of only three in the entire country, although more may exist.  In order to qualify under this section as a charitable organization the three existing associations all qualify by providing housing to low income or disadvantaged groups or people.

501(c)(12) - Associations qualifying for exemption under IRC Section 501(c)(12) are extremely rare.  The authors have personally worked with only one such association and are aware of only two others by virtue of discussions with other tax practitioners.  These associations all qualify buy operating as a mutual water company and providing domestic water to the residents of the association.

501(c)(7) - Associations qualifying for exemption under IRC Section 501(c)(7) are more plentiful, but still rare because the very nature of associations generally will cause them to not qualify for this exempt section.  IRC Section 501(c)(7) organizations must provide recreational services to their members and have strict limitations on nonmember activity.  The two factors that generally prevent associations from qualifying are:

• Associations that have architectural control activities are considered to be performing activities that are not recreational in nature.
• Associations that have roads that serve residences in addition to recreational facilities are considered to be involved in activities not recreational in nature.

501(c)(4) - The majority of associations that qualify to file Form 990 are exempt under IRC Section 501(c)(4) as social welfare organizations.  To qualify the associations must be providing services that benefit a community and must not be conducting activities where its members receive any significant private benefit.

See IRC Section 501 for primary qualifying requirements.  Revenue rulings 74-99 and 80-63 provide further guidance for associations seeking exemption under this section.  The primary court cases affecting this section are Rancho Santa Fe Association v. US and Flat Top Lake Association v. USA. 

 

Tax Citations Relevant to Associations

Internal Revenue Code

IRC 61 – Gross Income

IRC 118 - Contributions to Capital of a Corporation

IRC 277 – Certain Membership Organizations

IRC 501 – Exempt Organizations

IRC 528 – Certain Homeowner Associations

IRC – Subchapter T – Cooperative Organizations

Treasury Regulations

1.118-1 - Contributions to the Capital of a Corporation

1.528-1 through 10 - Homeowners Associations

Revenue Rulings

70-604

74-99

75-370

75-371

80-63

Court Cases

Flat Top Lake Association

Puget Sound Plywood

Rancho Santa Fe Association

Trump Village Section 3

Articles

Reserves as Capital Contributions