The tax issues causing this perceived problem arose in 1993 when the IRS audited approximately 15 associations in San Diego, California. IRS proposed to add back as taxable income all the painting reserve assessments that had been excluded from income in calculating taxable income on the Form 1120 tax returns. This created a national furor within the HOA industry on the concept of the inclusion of painting in reserves, but only because of the misunderstanding that occurred related to this issue. The difference lies in definitions and perceptions, not in any differences of facts.
HOA Industry Positions
These are general statements only, and like all general statements, there will always be exceptions.
1. The HOA industry has generally always considered reserves as “capital contributions” for tax purposes
2. The HOA industry has generally excluded reserve assessments from taxable income for tax purposes. If the association is filing Form 1120, this is a major factor in eliminating taxable MEMBER income.
3. Many tax preparers recommend Form 1120 so that the association can take advantage of the lower 15% tax rates of Form 1120, versus the 30% tax rates of Form 1120-H
It is also necessary to state certain tax facts
1. Form 1120 carries a 15% tax rate for the first $50,000 of taxable income
2. Form 1120 requires the association to delineate between capital and noncapital transactions
3. Form 1120 requires noncapital transactions to be separated between member and nonmember activities
4. Form 1120 considers all nonmember activities to be taxable
5. Form 1120 considers member activities to be taxable only if there is a net member income
6. Form 1120-H does not tax ANY exempt function activities
7. Form 1120-H taxes all nonexempt function activities at a flat 30% tax rate
It is important to note that member activities on Form 1120 are generally similar to exempt function activities on Form 1120-H, but with critical differences that can affect certain tax returns.
1. The IRS has its own rules
2. The IRS doesn’t care what the HOA industry thinks
3. Internal Revenue Code (IRC) Section 277 requires separation of member and nonmember activities on Form 1120
4. IRC Section 263 defines capital activities – painting is not considered a capital activity (in most circumstances)
5. IRC Section 118 (with numerous interpretations in Rulings and Tax Court cases) defines contributions to the capital of a corporation
6. Revenue Ruling 75-370 specifically states that painting does not qualify as a capital activity that may be excluded from the income of a homeowners association as a contribution to capital. Painting is considered to be a non annual maintenance expense.
The crux of the issue is that the HOA industry refers to expenditures as being either operating or reserve in nature, and considers all reserves to be “capital” expenditures. The IRS refers to expenditures as being either noncapital or capital in nature. These two definitions are not the same, and the major area of difference is painting expense. The simplest way to look at this is to realize that painting is simply a noncapital reserve component.
OK. So now what?
Let me state for the record that I, as a reserve preparer, am of the opinion that the components to be included in any reserve study should be determined by the maintenance plan, budget policies, and economic considerations. Tax considerations should NOT be a determining factor in what components are included in a reserve study. Certain conclusions can be drawn from the above discussion of tax issues related to painting as a reserve component.
- It’s acceptable to include painting in the reserve study
- Painting reserve assessments cause potential tax issues on Form 1120
- Careful tax planning can allow you to minimize tax risks of painting reserve assessments on Form 1120
- Painting reserve assessments cause NO potential tax issues on Form 1120‐H
Gary Porter, RS, PRA
Gary Porter is the President of Facilities Advisors, Inc., a company that provides reserve study services
nationwide. He is also a CPA, familiar with the tax issues related to the HOA industry