Condominium and other forms of community associations are entities that must account for their taxable income. Even if no tax is owed, there is still a filing requirement.
Today's column provides brief and general information regarding the alternatives and filing requirements related to the taxation of community associations. When I use the term "community association," it includes condominium, townhouse and master associations, but does not include cooperative housing corporations.
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A community association will generally not qualify for tax-exempt status under Section 501(c) of the Internal Revenue Code. Nonetheless, Section 528 of the code permits a qualifying community association to make an election to receive certain tax benefits that, in effect, permits the exclusion of certain income (referred to as "exempt-function income") from its gross income, thereby reducing (if not eliminating) its income tax liability.
If such an election is made, the community association is not taxed on its exempt-function income. However, the community association is taxed at the rate of 30 percent of the "homeowners association taxable income." This rate applies to both ordinary income and capital gains.
"Homeowners association taxable income" for any taxable year is an amount equal to the excess, if any, of the gross income for the taxable year (excluding exempt-function income) over the allowed deductions. "Exempt-function income" means any amount received as membership dues, fees or other assessments from owners of condominium housing units in the case of a condominium management association, or owners of real property in the case of a residential real estate management association.
Exempt-function income includes, but is not limited to, assessments made for the purpose of paying the principal and interest on debts incurred for the acquisition of association property; paying real estate taxes on association property; maintaining association property; removing snow from public areas; and removing trash.
Exempt-function income does not, for example, include amounts that are not includable in the organization's gross income other than by reason of Section 528 of the code (e.g. tax-exempt interest); amounts received from persons who are not members of the association for use of association facilities such as tennis courts, swimming pool, clubhouse; amounts received from members for special use of the association's facilities, the use of which is not available to all members as a result of having paid the dues, fees or assessments required to be paid by all members; interest earned on amounts set aside in a reserve fund for replacement of common elements; amounts received for work done on privately owned property that is not association property; or amounts received from members in return for their transportation to and from shopping areas, or other locations.
The election to be treated as a homeowners association, and thus to exclude exempt-function income from gross income, is made each year by filing a properly completed Form 1120-H (U.S. Income Tax Return for Homeowners Associations). Once made, the election is binding for the particular tax year only and cannot be revoked without the consent of the Internal Revenue Service.
A community association will not always receive a tax benefit by making the election to be treated as a homeowners association. After computing its tax liability on Form 1120H, the community association should consider figuring the tax using Form 1120 (U.S. Corporation Income Tax Return) or Form 1120-A (U.S. Corporation Short Form Income Tax Return). For example, when the community association imposes substantial assessments for the purpose of creating reserves, it may be useful to make the election since those assessments would be nontaxable exempt income. In years when expenditures and income are more closely in balance, using Form 1120 or Form 1120-A to avoid the 30 percent tax rate on nonexempt income may reduce tax liability. Forms 1120 and 1120-A have lower tax rates that may result in less tax than figured on Form 1120-H.
In addition, the type of form the community association selects to file will determine if it must make estimated tax payments. A community association that expects to file on Form 1120-H is generally not required to make estimated tax payments.
If the election to exclude exempt-function income is not made, or if the community association does not meet the requirements of a homeowners association, the community association must file tax returns in the same manner as other corporations (Form 1120 or Form 1120-A), even if it is an unincorporated association.
The laws concerning income taxation are complex. Careful tax planning, and input of an accountant, is required of each community association in order to receive the greatest income tax benefit.
• David M. Bendoff is an attorney with Kovitz Shifrin Nesbit in Buffalo Grove. Send questions for the column to him at CondoTalk@ksnlaw.com. The firm provides legal service to condominium, townhouse, homeowner associations and housing cooperatives. This column is not a substitute for consultation with legal counsel.