-
500.1 All CIRAs generally are taxed as
- corporations, but the available tax
- options depend, in part, on the specific type of CIRA—condominium
- association, homeowners' association, cooperative housing corporation,
- or timeshare association
-
• Residential condominium associations, homeowners' associations, and timeshare associations may be taxed either
under IRC Section 277, which applies to certain membership organizations, or may elect to be taxed under IRC Section 528, which applies specifically to homeowners' associations as that term is defined for tax purposes. (See paragraph 502.1.) Qualified CIRAs that elect to be taxed under IRC Section 528 file Form 1120-H, U.S. Income Tax Return for Homeowners Associations. CIRAs that are taxed under IRC Section 277 file the standard Form 1120 (or 1120-A).
-
500.2 If a condominium or homeowners' association elects to be taxed under IRC Section 528, it must allocate
- its income and expenses between its exempt function activities and its activities for the production of gross income
- (or nonexempt function activities). It is not taxed on its exempt
- function activities but is taxed at the rate of 30% on its net nonexempt
- function income (referred to as its homeowners' association taxable income.)
-
500.3 The taxation of condominium
associations, homeowners' associations, and timeshare associations
presents an option that is not available in any other area of taxation:
the ability
to choose which tax form to file and, therefore, which tax rate applies.
-
IRC Section 528Applies to:Qualified electing condominium associations, homeowners' associations, and timeshare associations only.
Net ExemptFunctionIncomeNot taxed. Net NonexemptFunctionIncomeTaxed at 30% rate for condominium and homeowners' associations.Taxed at 32% rate for timeshare associations. Net ExemptFunctionLossNo exempt function loss carryover or carryback allowed. Net NonexemptFunctionLossNo net operating loss deduction allowed. May not be carried forward or back.
-
500.4 It is important to know the purpose of the enactment of IRC Section 528 in order to understand its intent and to contrast it with the application of IRC Section 277. IRC Section 528 was added to the Internal Revenue Code in 1976 to provide CIRAs two benefits
- They were given a simple method of filing their tax returns, and exempt
- function income that was inadvertently being taxed on Form 1120 was
- exempted from taxation.
-
500.5 The other filing option
available to the majority of CIRAs is to file Form 1120. When Form 1120
is filed, the CIRA may be subject
subject to the provisions of IRC Section 277,
-
500.6 The tax posture adopted by
the authors in this chapter is generally a conservative one in which the
recommendations do not vary significantly from known positions of the
IRS. In most cases, it is less expensive to comply with a law or
regulation than
- to adopt a more aggressive posture.
- In the authors' opinion, an aggressive tax posture that is known to be
- at variance with laws, regulations, rules, or guidelines is usually
- unsuccessful when it is challenged during an audit.
-
500.11 IRS Notice 2007-54,
issued June 11, 2007, raised the bar on penalties for tax preparers.
Prior to issuance of this notice, for preparer penalties under IRC Section 6694,
the penalty applied to understatement of tax liability due to a
position for which there was not a realistic possibility of being
sustained on its merits, and—
500.12 IRC Section 6694 has been amended so that the penalty would apply if—td dl { margin-top: 0px; margin-bottom: 0px; }a. the tax preparer knew, or reasonably should have known, of such position, andb. there was not a reasonable belief that the position would more likely than not be sustained on its merits, andc. the position was not disclosed as provided in Section 6662(d)(2)(B)(ii), ord. there was no reasonable basis for the position.
-
501.1 Many tax law principles apply to all CIRAs, regardless of
the tax option selected when filing returns. Those principles are:
- • The definition of gross
- income under IRC Section 61.
• Prepaid assessments.
• Agency relationships.
- • Contributions to the capital
- of a corporation under IRC Section 118.
• Litigation settlements.
- • The basis in assets received
- from a developer/sponsor or others under IRC Sections 351 and 362.
- • Capital expenditures under
- IRC Section 263.
-
501.2 IRC Section 61 defines gross income by
- “Except as otherwise provided in this subtitle, gross income means all
- income from whatever source derived. . . .” IRC Section 61 (HTL— Appendix 2A)
- should be considered in conjunction with IRC Sections 118 (HTL—Appendix 2C),
- 277 (HTL—Appendix 2F), and 528 (HTL—Appendix 2K) in determining taxable income
- for a CIRA. Types of gross income may be treated differently depending upon the
- tax filing option selected.
-
501.3
The receipts of a typical condominium or homeowners' association may generally
be categorized as follows:
- Member operating assessments
- (IRC Sections 277 and 528).
- • Member replacement fund
- (reserve) assessments (IRC Section 118 if capital in nature; IRC
- Section 277 if noncapital in nature).
- • Member fees for services (IRC
- Sections 277 and 528).
- • Nonmember fees for services
- (IRC Sections 277 and 528).
- • Litigation settlements (IRC
- Sections 61 and 118).
- • Passive income, such as
- interest income (IRC Sections 277 and 528).
-
501.4 While most of those categories of receipts are treated as gross
income for tax purposes, IRC Section 118 excludes
- (a) assessments for specific capital improvements or the replacement of
- personal property and (b) litigation proceeds from income and treats them as
- contributions to capital (as discussed beginning in paragraph 501.11).
-
Prepaid Assessments
501.5
As mentioned in Chapter 3, member assessments received in advance should be
treated as deferred revenue for financial reporting purposes. However, the tax
treatment of prepaid assessments may depend on the nature of the amounts
received.
- . Revenue Procedure 71-21 (HTL—Appendix 9A) allows deferral of income
- for only 12 months, from one tax year to the next succeeding tax year.
-
Contributions to the Capital of
a Corporation
501.11 Contributions to the capital of a CIRA generally arise
from:
- • Monthly replacement fund
- assessments.
- • Special replacement fund
- assessments.
- • Capital improvements
- assessments.
• Litigation settlements.
- • Insurance proceeds
- settlements.
-
501.12 IRC Section 118 states that “In the case of a corporation, gross
income does not
include any contribution to the capital of the taxpayer.”
-
IRC 118
- All contributions to capital (reserves) are excluded from gross income
- under IRC Section 118.
-
IRC 263
- No deduction may be taken for capital expenditures. Amounts paid or
- incurred for restoring property (such as painting) are not capital
- expenditures.
-
501.13 For a CIRA that files Form 1120-H, there are no tax consequences
associated with misclassifying
- receipts as contributions to
- capital that should be reported as exempt function income.
- However, if the CIRA classifies receipts as exempt function income that
- should have been capital contributions, the CIRA would not properly calculate
- the 60% income test to determine whether the CIRA qualifies to file Form
- 1120-H.
-
501.16 Purpose of Assessment IRC
Section 263 (HTL—Appendix 2E) is not an elective section. It is a mandatory,
anti-abuse section intended to prevent a taxpayer from claiming a current
deduction for “capital” expenditures that the taxpayer is required to
capitalize and depreciate. IRC Section 263(a), under its general rule, states
“No deduction shall be allowed for—
- (1) Any amount paid out for new
- buildings or for permanent improvements or betterments made to increase the
- value of any property or estate.
- (2) Any amount expended in
- restoring property or in making good the exhaustion thereof for which an
- allowance [for depreciation] has been made.”
-
501.17 The principal decision to charge the replacement fund for certain
expenses is governed by the CIRA's members when they adopt the budget. (Further
explanation of this decision-making process can be found at the “Accounting for
Assessments and Expenses” discussion in section 306.) Thus, the replacement
fund may include expenditures
- for items other than capital improvements, such as painting, pest
- control, landscape maintenance, insurance, and fees for studies to estimate the
- costs of future major repairs and replacements. Since the revenue rulings
- discussed in Exhibit 5-2 indicate that only assessments for specific capital
- expenditures qualify as contributed capital, most associations will report a
- portion of the assessments for future major repairs and replacements as
- contributed capital for tax purposes and the remainder as membership income.
-
501.18 Many accountants argue that major expenditures for painting the
common elements should qualify as capital in nature because normally they are
being “reserved” for in the replacement fund. However, it is
- the nature of the activity that is controlling. Painting does not meet
- the criteria for capitalization under IRC Section 263, and several court cases
- hold that painting is a deductible expense.
- Also, Revenue Ruling 75-370 (HTL—Appendix 6P) explicitly states that
- funds collected “to provide the services for which [The
- Association] was formed such as maintenance of the common elements”
- are not considered as contributions of capital but are includable in the association's
- gross income.
-
501.22 Each of the citations in Exhibit 5-3 lends weight to the IRS
position that painting is
not capital in nature.
-
501.25 Accounted
for as a Capital Contribution The CIRA's general ledger
and financial statements should clearly delineate
- capital assessments from operating assessments. The budget and reserve
- study should support the amount collected for capital assessments. Also, there
- should be a clear tax return reconciliation (on Schedule M-1 or Schedule M-3)
- separating capital transactions from operating transactions
-
501.30 Funds
Held for That Purpose The CIRA can demonstrate to the IRS that the
funds were held for a capital purpose by segregating the funds for future major
repairs and replacements from
operating funds
-
501.32 Separate
Bank Accounts The proper segregation of funds is a crucial procedure in demonstrating
the CIRA's intent to classify some assessments as
contributions of capital.
-
Failure to segregate cash may taint the entire replacement fund with
respect to the capital versus operating issue. There is a difference between
the terminology used in IRS rulings and that commonly used by CIRAs
- CIRAs
- generally refer to operating cash and reserves (or the replacement fund).
- “Membership activity” and “operating” are comparable terms. However, “capital”
- as used by the IRS is not comparable to “reserves,” which may contain both
- capital and noncapital items (such as painting reserves). For tax purposes, the
- authors recommend that the CIRA have the following three categories of cash accounts:
• Operating bank account(s).
- • Noncapital replacement fund
- bank account(s) for items such as painting, tree trimming, and contingencies.
- • Capital replacement fund bank
- account(s) for items that are clearly capital in nature.
-
501.33 Expended
for Intended Purpose The CIRA can show this factor by actually
spending the capital contribution for its intended purpose. There is some
flexibility
- in showing that funds are
- expended for their intended purpose, as the IRS will lump all capital items
- together. This means that if the CIRA assessed the funds for roof reserve
- funds, but spent them on streets, another capital component, the CIRA will not
- be out of compliance. This is because both are capital items in the eyes of the
- IRS.
-
501.34 Increase
Capital Account Increases in the reserve accounts automatically increase the capital
accounts of the members. While some people attribute little value to reserves
when buying into a common interest development, the reserves have significant
value.
- A unit in a CIRA with fully
- funded reserves should command a higher price than an equivalent unit in a CIRA
- with no reserves.
-
501.41 Amending
Tax Returns Due to Significant Exposure If a CIRA determines it
has significant exposure because of an impermissible accounting method, it may,
prior to being selected for audit, amend
amend prior year returns from Form 1120 to Form 1120-H
-
501.42 Treasury Regulation Section 301.9100-2 provides an automatic
12-month extension for
- amending
- a return and no reason must be specified. For periods of time beyond the
- automatic 12-month extension period, the CIRA must request permission from the
- Commissioner to change from one form to the other. The regulations provide
- guidance on when the CIRA will be allowed to amend the returns. The generally
- applicable provisions are:
- • The CIRA acted reasonably and
- in good faith.
- • The IRS will not prejudice
- the interests of the government in allowing the change.
-
501.43 Treasury Regulation Section 301.9100-3 gives examples of applying
the provisions of the regulations. Example 2, “Reliance on a qualified tax
professional,” will generally be the most commonly used provision for relief by
the CIRA industry. The example indicates that, if the CIRA was not advised that
an election under IRC Section 528 was available, it may seek relief
- under the regulation. However, the authors warn that, if the CIRA has
- ever previously filed a Form 1120-H, the IRS will probably not allow the
- change. Their reasoning is that the CIRA, by having previously filed the Form
- 1120-H, had knowledge of the benefits of IRC Section 528 and may not attempt to
- use the excuse that it later received inadequate advice, causing it to file
- Form 1120 in a subsequent year.
-
501.44 Under Revenue Procedure 92-20, an association that is not
presently under examination may amend prior year Form 1120 tax returns (rather
than filing an amended Form 1120-H) to correct the impermissible method of
accounting by recognizing
- the appropriate adjustment and reporting the income over a three-year
- period. An association under examination may also do so within 90 days after
- being contacted for examination.
-
The tax effect of interfund transfers varies depending on whether
operating funds are transferred to reserves or reserves are transferred to
operating funds. (See also the discussion beginning at paragraph 501.46
regarding the disagreement among accountants as to the treatment of such
transfers.) This exhibit presents the tax effects of various scenarios when
different actions are taken by the CIRA.
1. Operating Funds Are Moved
to Reserves—An association discovers during the year that it has $50,000 in
excess reserve funds.
Action
The association transfers the
$50,000 from its operating to its reserve bank account during the current
year without following the guidance described beginning in paragraph 501.13.
Effect on Form 1120-H
- The $50,000 represents exempt function income since the rules
- for making a capital contribution were not complied with.
Effect on Form 1120
- The $50,000 represents membership operating income since the
- rules for making a capital contribution were not complied with.
-
The association republishes the
budget for the remainder of the year to decrease operating dues revenue by
$50,000 and increase reserve assessments by $50,000, keeping overall dues
assessments the same. At the same time, the reserve study is revised to reflect
the additional $50,000 funding in the current year. The association clearly
earmarks the funds for a specific capital purpose. No transfer of money between
funds occurs, as that will be accomplished by normal, recurring transactions
during the remainder of the year.
- 1120H
- The $50,000 has been successfully (and safely) converted from exempt
- function income to a capital contribution. The association must still meet the
- 60% income test to qualify to file Form 1120-H.
1120
- The $50,000 has been successfully (and safely) converted from membership
- operating income to a capital contribution.
-
At its annual membership
meeting, the association makes an election under Revenue Ruling 70-604 to carry
over the $50,000 in excess operating funds to the next tax year. The
association publishes a budget for the next year (Year 2) decreasing operating
dues revenue by $50,000 and increasing reserve assessments by $50,000, keeping
overall dues assessments the same. At the same time, the reserve study for Year
2 is revised to reflect the additional $50,000 funding. The association clearly
earmarks the funds for a specific capital purpose. No transfer of money occurs
during the current year (Year 1).
1120H
- The $50,000 is excluded from exempt function income in Year 1 under the
- provisions of Regulation 1.528-9.
- The $50,000 is included in exempt function income in Year 2 under the
- provisions of Regulation 1.528-9.
- 1120
- The $50,000 has effectively been removed from membership income for the
- current year (Year 1). It becomes an excess income carryover to the next tax
- year (Year 2), when it must be reconsidered. The association must incur a
- $50,000 operating loss in Year 2 (exclusive of the carryover) to offset the
- $50,000 membership income carryover. If it does not, any excess membership
- income in Year 2 will be taxed along with net nonmembership income. Assuming
- the $50,000 operating loss is achieved in Year 2, the association will have
- successfully converted the excess $50,000 from membership operating income to a
- capital contribution by spreading it over a two-year period.
-
. Reserves Are Moved to Operating Funds—An association discovers
during the year that its operating fund has a $50,000 deficiency.
The association transfers the
$50,000 from its reserve bank account to its operating bank account during the
current year.
1120H
- The $50,000 is converted from a contribution to capital to exempt
- function income.
- 1120
- The $50,000 is converted from a contribution to capital to membership
- operating income. (In addition, the IRS may view such an arrangement as
- endangering the entire reserve fund since the funds have clearly not
- been held or spent for the specific capital purpose for which they were
- originally assessed
-
501.51
Since a transfer from the reserve fund to the operating fund generally would
only be done if the association was in a deficit position in the operating fund,
the following steps could be taken to nullify any tax effect:
- • The members could vote to
- refund money equalling the amount of the deficit from reserves to themselves.
- • The members could then vote
- to contribute the same amount of money as operating assessments.
-
501.52 A CIRA may also attempt to mitigate any negative tax impact of
interfund transfers by treating them as temporary loans rather than as permanent
transfers. While
- there is no official (or unofficial) guidance on that matter, IRS
- officials have verbally conceded that such a position may be valid. For an
- interfund transfer to be considered a loan, that intent must be well
- documented. The CIRA should document the loan in its minutes, create a written
- note, charge interest, arrive at a reasonable repayment plan, and repay the
- loan as scheduled.
-
Litigation Settlements
501.53 Litigation Proceeds from Developers
CIRAs may receive construction defects litigation settlements, many times on a
pre-trial basis within 10 years after their formation. (It takes some time for
the defect to be discovered and corrected and to complete negotiations with the
developer.) As stated in the discussion of legal settlements in section 303,
litigation proceeds are typically
recorded as income in the financial statements of the association.
-
501.55 Who gets taxed is a function of the mechanics of the
lawsuit
- If the association is merely acting as an agent for the members for
- purposes of filing the legal action, the members may be considered to be the
- taxpayers. Private Letter Ruling 9238021 (HTL—Appendix 7AI) states that a
- construction defect award paid to an association acting as an agent for the
- condominium owners is not income or return of capital to the association. Since
- the association retained the funds to repair or replace the damaged property,
- the retained funds are treated the same as a capital assessment against the
- unit owners. Legal advice should be obtained if there is any question about
- whether the members or the association is the taxpayer
-
501.58 Generally, damage awards are consumed by the repairs that are the
subject of the award. Sometimes, however, there may be excess award funds
remaining because members may previously have been assessed to perform the
corrective work, repairs were made at lower than estimated costs, or for other
reasons. Any such excess funds are potentially subject to taxation
- If the excess funds are retained by the association for any capital
- purpose, such as capital reserve additions to more fully fund reserves or to
- make a capital improvement or addition to the association (even if it was not
- included in the reserve study or mentioned in the settlement), the authors
- believe no taxable event should occur.
-
501.60 Damages Settlement
Illustration A condominium association
receives a settlement from an insurance company related to a damage claim in
the amount of $1,500,000. The association's law firm that negotiated the claim
receives $500,000. Since repairs have already been made and paid for by a special
assessment to all members, no additional repairs expenditures are required from
the settlement proceeds. The association retains $350,000 of the proceeds for
the association's reserve fund, and $50,000 for the association's operating
fund. The remaining $600,000 is disbursed to the members.
- 501.61
- GAAP requires that this transaction be included in the association's financial
- statements for financial reporting purposes. However, for tax purposes, the
- association has only acted as an agent on behalf of the members. The settlement
- proceeds are not taxable to the association, because it is not the taxpayer in
- this instance; the members are the taxpayers. However, since the association
- has received all the settlement proceeds, it must determine the tax impact of
- the transaction and communicate that information to its members. The authors
- determine the tax impact of this illustrative transaction as follows:
- • The $1,500,000 gross
- settlement proceeds would generally represent compensatory damages to the members,
- and accordingly, would not generally be taxable. Revenue Ruling 81-152
- (HTL—Appendix 6AA) indicates that such proceeds would reduce each member's
- basis to the extent of their basis, and any excess would be taxable.
- • The $500,000 legal fees are
- treated as a reduction of the settlement proceeds, and may not otherwise be
- deducted currently.
- • The $350,000 retained for the
- association's reserves would generally qualify as an IRC Section 118 capital
- contribution (assuming the purpose was for a specific capital expenditure) from
- the association's perspective. From the members' perspective, this amount would
- represent a capital contribution that increases their tax basis in the
- association, which is not separable from their real property interest.
- • The $50,000 retained for the
- association's operating fund would represent either member income on Form 1120,
- or exempt function income on Form 1120-H from the association's perspective. To
- the members, the $50,000 would represent a regular operating assessment that is
- nondeductible, unless connected to a business activity of the member.
- • The $600,000 disbursed to
- members represents a capital distribution from the association's perspective.
- To the members, the $600,000 is a nontaxable recovery of capital, unless such
- amount exceeds the member's basis in their property.
-
501.62 Structured
Settlements Structured settlements are a relatively new concept sometimes
applied to CIRAs in cases of construction defects litigation. In those
circumstances, the payout of the construction defects settlement is
- structured to help reduce the tax burden of the association while at the same time
- making it less expensive for the developer to settle the claim.
-
501.71 Earnings
on Investment of Proceeds Earnings (i.e., interest
or dividends) from the investment of the proceeds of a settlement or award can
often be significant. Unless the proceeds are invested in tax free securities,
the earnings will always
- represent taxable income, regardless of the nature of the underlying
- award
-
501.87 As discussed throughout this chapter, some transactions may be
treated differently for financial reporting and tax purposes. For example,
initial contributions required by new members upon purchase of their units to
provide the CIRA with additional working capital are treated as
- contributed capital for financial reporting purposes but are generally
- treated as revenue for tax purposes
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