Chapter 502

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Kshowalter
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41635
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Chapter 502
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2010-10-17 10:37:32
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CIRA
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1120H
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  1. 502.1 IRC Section 528 applies to homeowners' associations as that
    term is defined by the IRS. (See PPC's Homeowners' Association Tax Library,
    Appendix 2K, for the complete text of IRC Section 528 and its related
    regulations, with added emphasis and annotations.) According to the IRS, there
    are three kinds of homeowners' associations:
    • • Condominium management
    • associations organized and operated to acquire, build, manage, and care for the
    • property in a condominium project substantially all of whose units are homes
    • for individuals.



    • • Residential real estate
    • management associations organized and operated to acquire, build, manage, and
    • care for a subdivision, development, or similar area substantially all of whose
    • lots or buildings are homes for individuals.



    • • Timeshare associations in
    • which the members hold rights to use or ownership interests in real property of
    • the association.
  2. 502.2 Thus, the IRS definition of homeowners' associations includes
    • residential condominium associations, homeowners' associations, and
    • timeshare associations, but it excludes cooperative housing corporations.
    • Incorporated homeowners' associations and unincorporated associations that
    • elect to be taxed as corporations may elect to file Form 1120-H. Based on IRS
    • statistics, Form 1120-H is the form most commonly used.
  3. 502.3 IRC Section 528 specifies the following additional provisions
    under which those associations must qualify before they may file Form 1120-H.
    If a CIRA qualifies, Form 1120-H is the simplest tax alternative, although
    generally it may be considered less favorable because net nonexempt function
    income is taxed at the rate
    • 30% for condominium and homeowners' associations and 32% for timeshare
    • associations
  4. The tests
    • • Substantially Residential
    • Test. Substantially all of the units must be held for residential purposes
    • (except in the case of timeshare associations). (See discussion beginning at
    • paragraph 502.6.)



    • • 60% Income Test. At
    • least 60% of the association's gross income for the tax year must consist of
    • exempt function income. (See discussion beginning at paragraph 502.11.)



    • • 90% Expenditure Test.
    • At least 90% of the association's expenses for the tax year must be for the
    • purpose of carrying on one or more of the exempt functions of a condominium or
    • homeowners' association. Timeshare associations must spend at least 90% during
    • the taxable year for activities provided to or on behalf of their
    • members. (See discussion beginning at paragraph 502.12.)



    • • Lack of Private Benefit
    • Test. No member may profit from the association's net earnings. (See
    • discussion beginning at paragraph 502.19.)
  5. 502.4 If a condominium or homeowners' association meets the
    “substantially residential test,” it will also generally meet the 60% income
    test and the lack of benefit test. However, a condominium or homeowners'
    association with significant commercial operations or recreational or
    nonmembership activities may not meet the 90% expenditure test. (See beginning
    in paragraph 502.12 for additional discussion of the 90% expenditure test.) If
    the association does not meet all of the tests listed in paragraph 502.3, it
    will be taxed under
    IRC Section 277 and must file Form 1120. (See section 503.)
  6. 502.5 If a condominium association, homeowners' association, or
    timeshare association meets the preceding tests, it may elect to have IRC
    Section 528 apply. Treasury Regulation 1.528-8 (HTL—Appendix 5N) requires that
    the election, which must be made annually, be made simply by
    • filing Form 1120-H for the tax
    • year on a timely basis, including extensions.
  7. However, if the tax preparer has not determined whether to file Form
    1120-H or Form 1120 by the filing date, Form
    • 1120 should be specified. It is the authors' opinion that it is not the
    • filing of an extension, but the actual filing of Form 1120-H that constitutes
    • making an election under IRC Section 528.
  8. 502.6 Substantially
    Residential Test As noted in paragraph 502.3, the substantially residential test does
    not apply to timeshare associations. For a condominium or homeowners'
    association to be considered residential, at least
    • 85% of the units in the association must be used as residences on the
    • last day of the association's taxable year.
  9. The 85% test is applied to a condominium and a homeowners' association
    as follows:
    • • Condominium Associations.
    • 85% of the square footage of all of the units must be used for residential
    • purposes.



    • • Homeowners' Associations.
    • 85% of the lots must be zoned for residential use.
  10. 502.7 Some associations are mixed use in nature. An example is a
    high-rise association in the downtown area of a major city that has office or
    retail space on lower floors, with parking and residential space on upper
    floors. In such a case, the square footage for each
    • different type of usage must be determined to properly calculate the 85%
    • test. In the above example, parking space may also require an allocation
    • between residential and nonresidential use. Each situation is unique and must
    • be examined individually.
  11. 502.8 In making the 85% calculation, IRS regulations allow certain
    property to be considered as residential even though it is not occupied as
    dwelling units. For example,
    • condominium associations may consider unoccupied units as residences if
    • they were constructed for use as residences (in the case of new units) or if
    • they were both constructed and used as residences (in the case of used units).
    • Property that is not part of the units, such as swimming pools, tennis courts,
    • storage rooms, and areas used by maintenance personnel, also is considered as residential.
    • Similarly, in the case of homeowners' associations, lots zoned for residential
    • purposes are included in the 85% calculation even if the lots are actually used
    • for purposes such as parking areas, tennis courts, and swimming pools. However,
    • commercial shopping areas and their parking lots are excluded from the
    • calculation.
  12. 502.10 The substantially residential test (which does not apply to timeshare
    associations) actually is a two-part test. Although a unit may be occupied as a
    residence at the end of the association's taxable year, a special provision
    applies if it is occupied for transient purposes
    • In that case, units are not considered as residential for purposes of
    • the 85% test if, for more than one-half of the days in the year, each of the
    • persons living in the unit occupies it for less than 30 days.
  13. 502.11 60%
    Income Test To qualify for taxation under IRC Section 528, at least 60% of the
    association's
    • gross income for the year must consist of exempt function income; that
    • is, it must be received from owners in their capacity as association members,
    • rather than in their capacity as customers for goods or services. Amounts, such
    • as qualifying contributions to capital reserves, that are excluded from the
    • association's gross income are not considered in determining whether the
    • association meets the 60% test, however. Consequently, the authors caution
    • against transferring operating funds to reserve funds if that transfer would
    • make the association fail the 60% test
  14. 502.12 90%
    Expenditure Test An association (other than a timeshare association) cannot qualify
    under IRC Section 528 unless at least
    • 90% of its expenditures are qualifying expenditures. For
    • condominium and homeowners' associations, qualifying expenditures are either
    • current operating expenditures or capital expenditures that are made for the
    • acquisition, construction, management, maintenance, and care of association
    • property.
  15. As defined for tax purposes,
    association property includes the following:
    • a. Real and personal property
    • owned by the association or by the members in common that benefits all of the
    • members and enhances the enjoyment of their units. (Property in this category
    • is the same as common property for financial reporting purposes as described in
    • section 304.)



    • b. Certain property within the
    • development that is owned privately by association members.



    • c. Property owned by a
    • governmental unit that benefits all of the members, such as roads, sidewalks,
    • and streetlights.



    • d. In the case of a timeshare
    • association, property in which the timeshare association or its members have
    • rights arising out of recorded easements, covenants, or other recorded
    • instruments to use property related to the timeshare project.
  16. 502.15
    Qualifying expenses include any expenditures 1
    for association property, even if the property may result in nonexempt function
    income. Thus, for example
    • qualifying expenses include expenditures for recreational facilities
    • that guests may use for a fee, provided that the recreational facilities are
    • reserved for use primarily by members
  17. IRS regulations also stipulate that the following amounts are not
    treated as expenditures for purposes of the 90% test:
    • • Excess assessments that are
    • refunded to members or applied against the following year's assessments.



    • • Transfers of funds to be held
    • to meet future costs, such as roof replacement, even if the roof meets the
    • definition of association property.
  18. 502.18 Most associations qualify under the 90% expenditure test if they
    have only interest income
    • and no commercial facilities or significant sources of nonexempt
    • function income.
  19. 502.21 Determining
    Exempt Function Income As explained in paragraph 502.11, exempt function
    income basically consists of amounts received from association members solely
    as a function of their membership in the association. To qualify as exempt
    function income, income must meet the following four tests:
    • • Source Test.
    • Generally, exempt function income must be received as membership dues, fees, or
    • assessments from owners of residential units (in the case of a condominium
    • association), residential lots (in the case of a homeowners' association), or
    • rights to use or ownership interests in association property (in the case of a
    • timeshare association). Amounts paid by a developer on unsold units or lots
    • also are considered exempt function income even though the developer does not
    • actually use the units or lots. Likewise, a litigation settlement with the
    • developer for prior under-assessments is considered exempt function income.
    • Income on membership assessments, such as interest, however, is not exempt
    • function income.



    • • Nature Test. Amounts
    • received from members must be paid solely as a result of membership in the
    • association. As a general rule, they must be assessed ratably to all members.
    • Amounts assessed based on the value or size of the property meet the nature
    • test, but fees paid for services and per use admission fees do not, even though
    • the amounts are paid by members and the facilities are restricted to members'
    • use.

    • IRS regulations provide an exception to the preceding provisions
    • by allowing special use fees to be classified as exempt function income if—



    • •• Amounts are paid by members
    • not more than once in any 12-month period.



    • •• The privilege obtained from
    • the payment of those amounts lasts for the entire 12-month period (or other
    • period if the facility is not used for the entire 12-month period).



    • Thus, for example, yearly fees for use of recreational facilities
    • are exempt function income.



    • • Purpose Test. Amounts
    • received must be used for qualified purposes. Generally, a qualified purpose
    • for this test is the same as for the 90% expenditure test. (See discussion
    • beginning in paragraph 502.12.)



    • • Gross Income Test. The
    • gross income test excludes from exempt function income any amounts that the tax
    • rules exclude from gross income. For example, the following amounts are not
    • includable in an association's gross income and, therefore, are not exempt
    • function income. (Thus, they should not be included on Line A of Form 1120-H.)

    •• Tax-exempt interest. 2



    • •• Excess assessments that are
    • refunded to members or are applied against future years. (However, excess
    • assessments applied against a future year will be considered exempt function
    • income for that year. 3 )



    • ••
    • Assessments for capital improvements that are treated as capital contributions
    • for tax purposes. The concept of capital contributions or capital improvements
    • is identical to the concept of “contributions to capital” discussed beginning
    • in
  20. One of the most common errors
    made by tax preparers in filing Form 1120-H is in calculating the 60% test
    based
    • test based on total member assessments. The test should be based
    • on operating assessments only; that is, total assessments less capital
    • assessments.
  21. 502.23 As explained in paragraph 502.20, under IRC Section 528,
    associations are not taxed on their exempt function activities. Instead, they
    are taxed only
    • on their nonexempt function activities. The tax is calculated on
    • nonexempt function income less expenses appropriately charged to nonexempt
    • function income. That amount, which is similar in concept to the unrelated
    • business income of nonprofit organizations, equals “homeowners' association
    • taxable income.”
  22. 502.24 Nonexempt Function Income Nonexempt function
    income results primarily from three principal sources
    • : (a) revenue from nonassociation property, (b) revenue from nonmembers
    • for use of association property, and (c) amounts charged to association members
    • for specific services.
  23. Under IRC Section 277, member assessments for major repairs and
    replacements are nontaxable contributions of capital if they meet certain
    criteria. (See discussion beginning in paragraph 501.15.) Under IRC Section
    528, even member assessments for future major repairs and replacements that are
    considered to be noncapital in nature (for example, painting) are
    • nontaxable because they relate to
    • the CIRA's exempt function activities.
  24. 502.25 Charging
    Expenses to Nonexempt Function Income In calculating homeowners'
    association taxable income, nonexempt function income may be reduced by (a)
    expenses attributable solely to
    • that income (such as state income taxes) and (b) other expenses that are
    • “directly connected” to the nonexempt function income.
  25. 502.27 IRS regulations state that expenses with elements of both exempt
    and nonexempt activities should be allocated between them on
    a “reasonable basis
  26. .” Although the regulations do not explain what constitutes a reasonable
    basis, the authors believe that estimates of employee time devoted to specific
    activities, asset usage, or consumption would constitute a reasonable basis.
    The authors also recommend that the basis for the allocations be documented
    • in the accountants' tax working papers, although they need not be filed
    • with the tax return itself.
  27. 502.33 Regulations Section 1.528-9(d) (HTL—Appendix 5N) provides that,
    if billing and payment for services provided by an association are made just
    once during a tax year
    • for the entire tax year, the
    • payment is considered exempt function income. That exception may allow
    • associations to bill annually for cable television or utility services to avoid
    • unfavorable treatment as nonexempt income.
  28. 502.35 Borrowing money is often the least costly financing alternative
    available to CIRAs; it is often less expensive to pay interest on borrowed
    funds than to pay penalties on early withdrawals from long-term investments
    • Under other circumstances, if a CIRA is unable to raise sufficient funds
    • through regular or special assessments to make necessary repairs, borrowing
    • funds will allow necessary repairs to be made. Reserve studies now frequently
    • include loans as part of the funding plan.
  29. 502.36 The Internal Revenue Service holds the position that interest on
    loans of a CIRA is
    • not deductible. This is based on the reasoning that the interest paid is
    • directly related to the underlying purpose of the loan, generally to make
    • repairs to the association's common areas. Since repairs to the association's
    • common areas are exempt function expenditures under IRC Section 528, and
    • membership deductions under IRC Section 277, the related interest payments are
    • also exempt function or membership expenditures, and therefore nondeductible
  30. 502.37 The authors believe that the same concept and language in tax law
    upon which the IRS is relying can also lead to a different conclusion under the
    right circumstances. Although the IRS has not issued a ruling on this subject,
    the IRS has informally stated that if the interest deduction is directly
    connected to the production of gross income, then it will be deductible. When
    an association can document that a loan is taken out solely as a financing
    decision—meaning it has more reserve funds on hand than the amount
    borrowed—then it can be established that the primary purpose of the loan is to
    preserve working capital, not to make repairs
    • (as the repairs could clearly
    • have been made from existing funds on hand). Accordingly, the interest
    • deduction is directly connected to the production of interest income, and is
    • therefore deductible. Such an assertion cannot be justified if the funds on
    • hand are less than the amount of the loan.
  31. Advantages of Filing Form 1120-H
    • 1. Form 1120-H is a one-page
    • form. It is easier to complete than Form 1120.




    • 2. Less risk is associated
    • with filing Form 1120-H.







    • 3. Exempt function income is
    • not taxable.





    • 4. Large associations are not
    • subject to the alternative minimum tax on Form 1120-H. (Small associations
    • are not subject to AMT, as discussed beginning in paragraph 503.35.)





    • 5. Some states exempt
    • associations that file Form 1120-H from state income taxes.
  32. Disadvantages of Filing Form 1120-H
    • 1. Taxable income is taxed at
    • a 30% (or 32% for timeshare associations) rate versus the regular corporate
    • rates available when filing Form 1120.




    • 2. Associations are not
    • entitled to net operating loss deductions. The association may not claim a
    • net operating loss generated during the year if a Form 1120-H is filed for
    • that year, nor can the association carry the NOL forward. (However, while a
    • net operating loss generated in a prior year when the association filed a
    • Form 1120 may not be deducted in a year the association files a Form 1120-H,
    • it can be carried forward and deducted in subsequent years on Form 1120
    • returns.)





    • 3. Associations are not
    • entitled to write off organizational costs.





    • 4. Associations are not
    • entitled to the deductions allowed under Part VIII of Subchapter B of the
    • Code.
  33. 502.40 Authors' Recommendations The authors encourage
    accountants to consider whether the income tax liability of their CIRA clients
    may be reduced through tax planning and filing Form 1120.
    • If the financial affairs of a qualifying homeowners' association are
    • properly structured, Form 1120-H, although simpler, rarely yields a lower tax
    • than Form 1120. Even so, the additional risk associated with filing Form 1120
    • may not outweigh the tax savings (see paragraph 502.41). To compare the results
    • of filing Forms 1120 and 1120-H, Appendix 5A presents sample Forms 1120-H and
    • 1120 that are completed using the same facts. (Tax-planning opportunities for Form
    • 1120 are discussed beginning in paragraph 503.43.)
  34. 502.41
    The authors believe that filing Form 1120-H generally should be considered in
    the following circumstances:
    • • The difference between the
    • tax calculated on Form 1120 and Form 1120-H does not warrant the additional
    • risk assumed by filing Form 1120.



    • • The risk of filing Form 1120
    • is too great due to a lack of compliance with IRS regulations and rulings.



    • • Cost-benefit considerations
    • make filing the simpler return the better alternative.



    • • The association's taxable
    • income is either (a) $100 or less or (b) approximately $186,200 or
    • greater. In those circumstances, the 30% tax rate for condominium and
    • homeowners' associations on Form 1120-H yields a lower tax than the
    • regular corporate rates on Form 1120. 6 (The breakeven point
    • for timeshare associations, which are taxed at a 32% rate, would be different.)



    • • Form 1120-H may be preferable
    • because of the effect of the alternative minimum tax on large associations when
    • Form 1120 is filed. (See paragraph 503.35.)



    • • The association's total tax
    • liability is lower because it can avoid state income taxes.
  35. 502.43 Tax-planning
    Opportunities When Form 1120-H Is Filed If the association
    decides it is preferable to file Form 1120-H, tax-planning opportunities should
    be considered to minimize the association's tax liability. The main
    tax-planning objective is to convert nonexempt income into exempt income.
    Generally, that is accomplished by the following methods:
    • Eliminating user fees for
    • facilities and increasing member assessments to compensate for the loss of
    • income.



    • • Reducing user fee income to
    • the point that the activity breaks even.



    • • Charging special-use fees
    • only once during a 12-month period rather than on a per use basis.
  36. 502.44 The procedures for filing Form 1120-H are as follows:
    • a. Determine that the
    • association is qualified to file Form 1120-H. (See beginning at paragraph
    • 502.1.)



    • b. Segregate exempt function
    • income from nonexempt function income. (See beginning at
    • paragraph 502.20.)



    • c. Allocate expenses to
    • nonexempt function income. (See beginning at paragraph 502.25.)



    • d. Determine taxable income;
    • i.e., nonexempt function income as determined in step b, less expenses
    • allocated to nonexempt function income as determined in step c, less a specific
    • deduction of $100.



    • e. Determine the association's
    • tax liability. (See paragraph 502.47.)



    • f. Compare the tax liability to
    • that obtained by filing Form 1120 to see which tax return results in the lowest
    • tax. Even if Form 1120 results in a lower tax, the circumstances in paragraph
    • 502.41 (particularly the risk of filing Form 1120) should be considered when
    • determining which form to file.
  37. 502.47 As explained in paragraph 500.2, association taxable income less
    a specific
    • deduction
    • of $100 (which is preprinted on Form 1120-H) is taxed at a flat rate of 30% for
    • condominium and homeowners' associations and 32% for timeshare associations.
    • Additional considerations in determining the association's tax liability are as
    • follows:

    • • Associations may qualify for
    • the following tax credits:

    •• Foreign tax credit.



    • •• Credit for fuels produced
    • from nonconventional sources.



    • •• Qualified electric vehicle
    • credit.



    • •• General business credit, but
    • not the investment credit, the Indian employment credit, the work opportunity
    • credit, the welfare-to-work credit, or the empowerment zone employment credit.





    • • Associations are not entitled
    • to a net operating loss deduction.



    • • Associations are not entitled
    • to the dividends received deduction or to write off organizational costs.



    • • Associations are subject to
    • the capital loss limitation rules.



    • • Associations are not subject
    • to the alternative minimum tax.
  38. 502.49 Similar to other corporate returns, Form 1120-H is due on
    • the fifteenth day of the third
    • month after the end of the association's taxable year. Associations may file
    • Form 7004 to receive an automatic six-month extension for filing the return.
    • (Form 7004 must indicate that the extended return is a Form 1120-H for that
    • election to remain valid. However, if the tax preparer has not determined
    • whether to file Form 1120-H or Form 1120 by the filing date, both returns
    • may be specified on the extension form.) Although associations are not required
    • to pay estimated taxes if they file Form 1120-H, it often is preferable for
    • them to do so to avoid penalties if they ultimately decide to file Form 1120
    • instead (which requires estimates to be made).
  39. Revoking the 1120-H Election

    502.50
    Once an association has elected IRC Section 528 treatment for a tax year by
    filing Form 1120-H, it is considered binding; the election for a previously
    filed 1120-H may not
    • Form 1120-H, it is considered binding; the election for a previously
    • filed 1120-H may not be revoked without the consent of the IRS except under the
    • provisions of Treasury Regulation 301.9100-3, if the revocation occurs within a
    • 12-month period from the original due date of the return. In Revenue Ruling
    • 83-74 (HTL—Appendix 6AE), the IRS ruled that, under certain circumstances, it
    • will allow revocation of the election because of inadequate tax advice provided
    • by a professional tax advisor. However, in Revenue Ruling 82-203 (HTL—Appendix
    • 6AD), a homeowners' association was not allowed to revoke IRC Section 528
    • elections made in previous tax years in order to obtain the benefit of a net
    • operating loss incurred in a subsequent year. The IRS stated that would be
    • taking advantage of hindsight at the government's expense.
  40. 502.51
    Although the regulations clearly state that consent must be obtained from the
    commissioner to revoke an election, practitioners nationwide report that
    associations have successfully revoked their elections by simply filing amended
    returns changing from Form 1120-H to Form 1120 and attaching an explanation of
    the facts and a statement such as the following:
    • The amendment is made pursuant to the provisions of Revenue Ruling 83-74, which
    • provide that an amendment may be made if the association originally filed Form
    • 1120-H (copy attached) based upon erroneous advice from the tax preparer.

    • The attached Form 1120 represents an amendment to the Form 1120-H
    • as originally filed.
  41. 502.52 The authors believe that practice to be risky. An informal
    amendment changing from one form to the other (1120 to 1120-H or 1120-H to
    1120) may be accepted by the IRS, but it still does not represent a valid
    revocation of election.
    • Revenue Ruling 83-74 provides
    • very specific guidance on obtaining relief from an inadvertent election.
    • Failure to comply with specific formal procedures will be viewed by the IRS as
    • the equivalent of having done nothing. If substantial tax is at risk, the
    • authors believe that the appropriate procedure for revocation of election
    • should be followed.
  42. The term qualifying expenses refers to
    • actual expenditures made; merely holding funds in reserve to meet future
    • expenditures does not qualify. “Any expenditures” specifically includes
    • expenditures from the reserve or replacement fund but does not include
    • transfers to that fund.

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