Tax Day: What Your Board Must Know about Homeowners Association Taxes

Tax Day: What Your Board Must Know about Homeowners Association Taxes

April 2010

"A lot of people aren't aware that associations do have to file income taxes," says Robert Galvin, a partner at Davis, Malm & D'Agostine PC in Boston who specializes in representing condos and co-ops.

That's right. Homeowners associations have to file tax returns like the rest of the corporations in the United States. Here's a primer on the rules associations must follow when they file and advice on minimizing the stress of tax day for your HOA.

Follow Corporate Rules

Associations are like any other corporation, even if they're not for profit. That means they must file tax returns with the rest of the corporations in the country. If your association hasn't filed a 2009 federal tax return yet, you'd better get cracking.

Corporations that follow a calendar-year accounting method are required to file returns by March 15 of every year, and associations must follow that rule, too. If your association doesn't follow calendar-year accounting, its taxes are due on the 15th day after the third month of your taxable year. So if your calendar year ends on July 31, your tax return is due on Dec. 15.

"Here's the problem in our industry," explains James Donnelly, president and CEO of Castle Group, a property management company in Plantation, Fla., that manages 55,000 association units. "Almost all associations operate their finances on a calendar-year basis. The CPAs who specialize in corporations and associations have to do all their work in the first 60 days of the year. It may be hard to get your association's taxes done by March 15. So we tell associations to file for an automatic extension using IRS Form 7004. That gives you six additional months to file."

There's good news and bad news when you file an extension. The bad news is that just as you have to pay interest if you personally file for an extension and end up owing the government money, your association is also on the hook for interest for that period after the March 15 deadline that its taxes weren't paid.

The good news is that most associations typically don't owe the government. They don't make much, if any, money. "That's by far the minority of associations," says Donnelly.

Choose Your Poison

Why don't most associations have much, if any, of a tax liability? In general, most take in only funds to operate their facilities; they don't conduct income-generating activities.

You have two options when you file your association's tax returns. "One is to file as a corporation, and the other is to file under Section 528 of the Internal Revenue Code," explains Bob Tankel, principal at Robert L. Tankel PA in Dunedin, Fla., a law firm that advises associations. "Section 528 is specifically for homeowners associations. It has a higher marginal tax rate, but it eliminates all exempt-function income and expenses. Assessments wouldn't even be counted as income."

Whether to file a straight corporate return or a return under IRC 528 is a judgment call. "Your accountant will advise you," says Tankel. "It's not a legal issue; it's more of a dollars-and-cents issue."

"Most associations elect to be taxed under Section 528 of the IRC," explains Galvin. "It's very useful because before this was enacted, there was a lot of ambiguity about how associations should report and pay taxes. Under IRC 528, your association has to be a homeowners association and properly legally organized for that purpose. Then, if almost all your income is from association assessments and almost all of your outgo is spent on maintaining the property, you don't have to pay taxes on that money."

To qualify to file Form 1120-H under IRC 528, your association must meet the following requirements:

  1. The substantial majority of units, 85 percent, must be used as residences.
  2. More than half, 60 percent, of the association's gross income must be exempt, which means it's received from owners in their capacity as association members, rather than from them as customers for goods or services.
  3. At least 90 percent of the association's expenses must be exempt, which means they're operating and capital expenses that directly affect association property.
  4. Residual income can't be used to benefit members.

"Most associations won't have any problem meeting these requirements," says Galvin.

Defining Taxable Income

As the IRC's test indicates, your association will have to pay taxes on interest income it earns on bank and reserve accounts and on nonexempt income. Income from for-profit activities, such as clubhouse rentals or golf-course fees, isn't exempt and is taxed at a flat rate of 30 percent.

"If you generate income from something that isn't a simple association expense—you rent out your clubhouse or have a cell tower lease—you need to pay taxes on that income," explains Galvin. "Let's say one of the owners wants to rent your clubhouse for a wedding. That rental would be counted as taxable income because the unit owner has now reserved the clubhouse for an afternoon to the exclusion of all the other unit owners. In addition, in some condo associations, there are actually apartments that are part of the common areas and are rented out. That's rental income."

Like any corporation, your association can offset income with money spent to generate that income. "Any expenses directed to the production of the rental income can be deducted," says Galvin. "If you have maintenance staff cleaning up after the wedding in your clubhouse, that's deductible. If you spend money to advertise the clubhouse rental, that's deductible."

Do A Rollover?

If you happen to have had a great income-generating year, consider rolling over some of that income so you can delay or avoid paying taxes on it altogether. "If an association has money leftover at the end of the year, the board can vote to roll it over to the next year," says Tankel. "Under Ruling 70-604, the Internal Revenue Service will treat that as a constructive return of capital to members."

If you later have a year when your association has lost money—as many associations have done in the past several years—your association can declare that rolled over income and offset it against losses. "You could roll the income over forever," says Tankel. "Five years ago, associations were flush; now they're flushed down the toilet. If they had carryovers, they could have rolled them over and used them these past few years. There'd be less tax liability. All associations should roll over income because it never hurts."

States May Want Their Cut, Too

Check with your accountant to determine whether and when you need to file a state tax return. "State taxes vary from state to state," says Galvin. "In Massachusetts, you do have a file a form and pay tax."

Though many people delay filing taxes because they consider them a painful hassle, with associations they're typically not. "Most associations really don't have a lot of taxable income," says Galvin. "The tax isn't a great burden, but you do have to file a return."

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