All Homeowners and Condominium associations, residential and commercial (whether incorporated or not) must file an annual Federal and NC income tax return. If a calendar year association, the tax returns are due March 15th.
Community association taxes are very complex. It’s important that the Board selects an accountant who knows the industry and will make the best choices and recommendations for your association.
Associations generally have two tax filing options available: Form 1120 or Form 1120-H.
Form 1120: This form is the regular corporation tax form and is required for commercial condominium associations. Although the tax rate is lower (15% on the first $50,000 of taxable income), it is more difficult to prepare. This return requires the allocation of income and expenses between membership and nonmembership activities. Only its net nonmembership income is taxed. Filing this return may also subject the association to increased tax audit risk.
Form 1120-H: This form was specifically designed for homeowners associations. It applies to associations electing to be taxed under this method. This form requires the allocation of income and expenses between exempt function activities and non-exempt function activities. These associations pay tax on interest income and other non-exempt function income at a rate of 30%. Exempt-function income is not taxed. There are several tests that an association must pass in order to be able to “elect” to use this form. Basically, associations elect tax-exempt status for that portion of the association’s income which comes from assessments. This income is called “exempt-function income”. Under this method, the income of associations which does not fit the definition of exempt-function income is not tax-exempt. This is a very safe filing method, virtually risk free and is the easiest to prepare. We recommend that the majority of associations file Form 1120-H to avoid the tax audit risks of Form 1120.
Under the IRS rules, to qualify for the favored tax status of a homeowners association (File Form 1120-H), the following must apply:
- It is organized and operated to provide for the acquisition, construction, management, maintenance and care of association property; and,
- substantially all (85%) of the units or property (square footage) are used by individuals for residential and auxiliary residential purposes; and,
- at least 60% of its gross income is derived from the membership dues, fees or assessments of owners in the association; and,
- at least 90% of its expenditures for the tax year are used for the acquisition, construction, management, maintenance and care of association property. This includes current expenses and reserve expenses; and,
- no part of its net earnings benefits any shareholder, owner or individual.
If the above tests do not qualify your association to file Form 1120-H, you will be required to file the more complicated (and risky) Form 1120.
“Exempt-Function Income” – the association dues paid by every homeowner. This income is not taxable.
“Non-exempt function income” – income that comes from other sources, usually non-members, but can also include income from members that is paid for the use of specific amenities.
Examples of Non-Exempt Function Income include:
- interest received on bank deposits
- rental of association property (such as from foreclosed units)
- guest fees for pool
- lease payments on association property – in exchange for an easement
- gain on the sale of a foreclosed home
- laundry income
- clubhouse rental income
- rental of RV parking spaces
- condemnation awards
- annexation income
- newsletter advertising (special expense allocation rules apply)
Non-exempt function income may be reduced by expenses directly connected to that income (such as state income taxes) . In addition, other expenses may be allocated: management fees, tax return prep, insurance, bank fees, utilities, repairs & maintenance, security and cleaning.
Net Non-exempt function income is taxable, subject to a $100 deduction.
In summary, the majority of association returns are filed using Form 1120-H despite the higher tax rate. Form 1120-H is less complex to prepare (less expensive), virtually risk-free and most associations don’t have taxable income, making the difference in tax rates a non-issue. The association’s goal should be to minimize taxes and reduce risk.
Discuss your association tax matters with your accountant before year-end. Decide which tax form to file and evaluate the “per-use” charges (such as clubhouse rentals). Make any necessary changes. Tax planning may involve filing Form 1120-H in some years and Form 1120 in others. The key is knowing when to file which form.
Contact us today to get the accuracy and insight that comes with a trusted CPA firm. We would love to discuss how we can help your association save both time and money.Share