Reserve Loans and Interest Deductions

Reserve loan interest could become deductible under the right circumstances.

In recent years, loans have become more popular with homeowners’ associations as a means of smoothing out reserve funding plans for several reasons: (1) they avoid a huge, one-time special assessment that many members may not be able to afford; (2) they allow the Association to perform larger projects all at once when needed rather than spreading them out over years because of cash flow limitations; (3) they keep property values higher; (4) most importantly, they make more sense because newly-developed specialty industry banking services have created structured loan packages for homeowners’ associations. Unless a bank understands the industry, it probably wouldn’t know how to structure a loan within its own lending guidelines, simply because the HOA industry is so different from the commercial real estate market.

I receive frequent inquiries from board members asking how the interest expense on such loans is treated for income tax purposes on the Association’s tax return. Most people understand that real estate-related loan interest is deductible for individuals, and many know that it is also deductible for partnerships and corporations. So the question is, is HOA loan interest treated differently just because this corporation happens to be a homeowners’ association? And the answer is, maybe.

The general rule of the Internal Revenue Service (IRS) is that it is the use of funds, or the purpose of the borrowing, that determines the nature of the deduction. Personal interest expense is not deductible. For instance, the interest on your auto loan is not deductible unless the vehicle is held for business use. Applying this same concept to a loan for common area repairs in a homeowners’ association, the implied answer is that since the repairs are related to assets and are not held for business purposes, then any loan interest takes on that same characterization, and is not considered a deductible expense. That concept would apply whether the Association filed Form 1120 or Form 1120-H.

In a normal situation, the Association borrows money for specific, large projects because it does not have enough money otherwise to make the repairs. As an example, an Association may have only $100,000 in cash reserves, but needs $1,500,000 to replace roofs. The Association borrows and immediately (or at least in the very near future) spends the money it borrowed. Its $100,000 cash position is relatively unchanged, except on a very temporary basis. Given these circumstances, how is the matter treated on the tax returns?

IRC Section 528 (Form 1120-H)

If the Sec. 528 election is made, the interest on the loan to repair association property will not be deductible by the Association. The borrowed money was used to fund nondeductible personal expenses – repairs to common area residential property not held for business use. This interest is incurred with respect to repairs that would have otherwise been made from member assessments (exempt function income or capital contribution). Since these assessments would have been exempt function income, the loan presumably assumes the same status. IRC Sec. 528 (d) (1) (B) prohibits any deduction associated with exempt function income.

IRC Section 277 (Form 1120)

If the Sec. 528 election is NOT made, the Association is taxed as a regular corporation, subject to the limitations of IRC Section 277. The interest on the loan to repair association property will not be deductible by the Association. The borrowed money was used to fund nondeductible personal expenses – repairs to common area residential property not held for business use. The interest is incurred with respect to repairs that would have otherwise been made from member assessments, and the interest expense becomes part of “member deductions” (as opposed to “nonmember deductions”).

But, what if the circumstances are changed slightly, as I have seen occur on several occasions? Each situation needs to be looked at closely, as, under certain circumstances, the interest expense could be deductible. The key here lies in the very assertion by IRS that it is the purpose and use of the borrowing that determines deductibility.

Assume instead that the Association had $2,000,000 in reserves rather than $100,000 in the above example. That is more than enough to pay for the roofing project, but, because those funds are earmarked for other projects, the Association still decides to borrow $1,500,000 for the roofing project. What has just happened is that the purpose for the loan has just changed. Even though the borrowed money was used to pay for the roofing project, the actual purpose of the loan was to maintain existing cash balances. In other words, this became a economic decision rather than a financing decision.

The $2,000,000 in cash balances is generating taxable interest income that would not exist had the money been used to pay for the roofing project. Consequently, the interest deduction on the reserve loan simply reduces net interest income (interest income less interest deduction) back down to where taxable interest income would have been had no loan been used for the roofing project. However, the differential between the interest rate earned by the Association versus the interest rate paid may mean that there is no net interest income at all.

This basic concept applies no matter which of the two tax forms is filed. However, IRS bias will be against allowing such a deduction, because IRS agents generally look only at the use of the borrowed money, not the underlying reason (purpose) for borrowing the money. With respect to Form 1120, the relevant citation appears to be from the now withdrawn Treasury Regulations Section 1.277-1, certain paragraphs of which are reproduced below:

1.277-1 (d)(5) Total deductions. For purposes of this section, the total deductions a membership organization may take into account are the sum of its membership deductions and nonmembership deductions.

1.277-1 (d)(6) Membership deductions. Membership deductions are the expenses, depreciation and similar items of deduction attributable to membership activities. Such items of deduction may, however, be taken into account only to the extent that such items are otherwise allowable as deductions under Chapter 1 of the Code (applied without regard to whether the activity giving rise to such items was engaged in for profit).

1.277-1 (d)(7) Nonmembership deductions. Nonmembership deductions are the expenses, depreciation and similar items allowable as deductions under Chapter 1 of the Code other than those items described in subparagraph (6) of this paragraph.

1.277-1 (d)(8) Allocation of deductions. Items of deduction attributable in part to nonmembership activities and in part to membership activities shall be allocated between the two classes of activities on a reasonable and consistently applied basis.

Several years ago I fully discussed this issue while at a meeting at the national IRS office in Washington, D.C., specifically with the Special Industries and Pass-throughs Group, which is the particular group within IRS that considers tax law for this industry. These individuals are extremely well-versed in association tax law, and are the individuals who would either write the IRS’ position on such a matter in the form of a Letter Ruling or Revenue Ruling, or provide technical support for IRS lawyers in a tax litigation setting. For these reasons, I can feel comfortable with their response, even though it was informal. Their response, which is not documented in writing, was that the circumstances I set forth above would allow the interest expense to be deductible, unless the cash balances dropped below the loan balance. At that point, IRS contended, it was no longer an economic decision. So, any association contemplating taking this position must be careful to maintain reserve cash balances in excess of the loan balance for the full term of the loan.

The table below illustrates the difference in results depending on how the law is interpreted. I’m assuming an association with $1,000,000 invested earning 3% that elects to borrow $500,000 at 5% rather than lose the 3% rate it has locked in on long-term investments.

 

Position assuming no interest deduction allowed

 

Position assuming interest deduction allowed

Interest income

$30,000

$30,000

Deductions against interest income

(4,000)

(4,000)

Interest deduction

0

(25,000)

Net taxable income

$26,000

$1,000

Income tax at 15%

$3,900

$150

 

The deduction of loan interest saves $3,750 in taxes.

The above discussion is valuable because it points out two significant issues: (1) not all the tax law issues are written in stone – there is room for interpretation; and (2) not all tax practitioners agree on all issues, nor should they.

The deduction of interest expense for a homeowners’ association is an issue that, in my opinion, is not clearly delineated in existing tax law. Looking at the same citations as my colleagues, I can legitimately reach a different conclusion. The only way this issue will be finally resolved is through the issuance of guidance by the IRS or guidance from the courts (and even then, due to appeals and possible subsequent interpretations, it may not be finally resolved). As Yogi Berra said, “It ain’t over ’til it’s over!”

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