Tax/Profit Status?

We're a small condo association with a modest budget (<25 units, ~$5k annual budget). We're roughly 10 years since transfer.

We have no facilities other than open common areas, so no pool, no courts, or other things that are generally for members only.

I've been reading IRS publications and rules and I'm rather stumped at which classification we qualify for. It seems like some pubs suggest that we're a 501(c)(4), and depending on the size of our annual budget that we might not even need to file with the IRS annually.

Any experience with similar sized developments?

Thx
Dave

A little bit more info from that report:

Stat. 1525, provides an elective exemption for certain homeowners associations that are described in IRC 528(c). This Code provision was enacted because many homeowners associations found it difficult to meet the requirements for exemption under IRC 501(c)(4).

IRC 528 exempts from income tax any dues and assessments received by a qualified homeowners' association that are paid by property owners who are members of the association, where the assessments are used for the maintenance and improvement of association property. Thus, all homeowners' associations described therein may be granted a sort of quasi-exempt status by virtue of their own election.

IRC 528 defines a "homeowners' association" as an organization which is a condominium management association or a residential real estate management association if:

It is organized and operated to provide for the acquisition, construction, management, maintenance, and care of association property,

It elects to have the section apply for the taxable year,

No part of the net earnings of the association inures to any private shareholder or individual,

60 percent or more of the association's gross income consists solely of amounts received as membership dues, fees, assessments from owners of residential units or residences or residential lots (exempt function income), and

90 percent or more of the association's expenditures for the taxable year are expenditures for the acquisition, construction, management, maintenance, and care of association property.

If qualified, an association makes the election by timely filing a Form 1120-H, U.S. Income Tax Return for Homeowners' Associations, according to the instructions for that return

A number of years ago I was on the board of a hobby club. Because of changes in local tax laws, it appeared that we could avoid some serious property taxes if we could get 501(c)(3) status. Our attorney advised us to incorporate a new association and apply to the IRS for charitable status then dissolve the old corporation. He said that it is fairly easy for a new association to obtain charitable status but if you try to convert an existing association the IRS will want to know what has changed, why did you not seek this status before this?

Dave,

To obtain tax-exempt status under Section 501 an organization must apply for it by filing an application, either IRS Form 1023 or 1024, with the IRS. Which form you use depends upon which part of Section 501 you claim tax-exempt status. After reviewing and processing your application the IRS will send the organization a determination letter either approving or denying the tax-exempt status sought on the application. Negative IRS determinations can be appealed.

IRS Publication 557, "Tax-Exempt Status For Your Organization," describes the types of organizations that can qualify for tax-exempt status and which part of Section 501 applies in each case. For example, a Social and Recreational Club (like a golf club) can apply for tax-exempt status under 501(c)(7). A cooperative hospital service organization would apply under 501(e). Publication 557 also describes the restrictions that apply in each case and also provides application instructions. Organizations granted tax-exempt status under Section 501 must file information returns each year.

But for HOAs, all that is unnecessary.

It is far simpler for an HOA to elect to file for the preferred tax status of an HOA by filing IRS Form 1120-H each year. There is no need for a formal advance application and determination letter from the IRS. Also, the election of whether to file Form 1120-H or Form 1120 can be made each year and can change from one year to the next without requiring advance approval from the IRS. Form 1120-H is just a simple variation of the corporate tax form (1120). In fact, I think it is simpler than the individual Form 1040 with its standard schedules. As long as the HOA meets certain income and expenditure tests, the HOA can qualify to use 1120-H. If all of the HOA's income comes from dues and assessments, and if all of the income is used for HOA expenses to care for its property, it will be exempt from income tax. If the HOA receives income from outside sources (such as interest on deposits or other types of non-exempt function income), only a portion of that income will be subject to tax, as long as the HOA is qualified to file Form 1120-H. All of this is figured out for you when you fill out the information required on Form 1120-H.

My advice - forget Section 501; it's likely not for you. File Form 1120-H instead.

DaveD3,

An HOA does not qualify for tax-exempt status under 501(c)(4).

"To qualify for exemption under 501(c)(4), the organization's net earnings must be devoted only to charitable, educational, or recreational purposes."

Typically, a 501(c)(4) organization is a local organization whose purpose is to promote the social welfare of its community. One example would be an organization that is formed for the purpose conducting fundraisers to raise money which will be given as scholarships to area high school graduates.

Thanks Bruce,
I guess a follow up question would be if 501 would benefit us in any way, or if it would be completely unnecessary? If we get taxed only on a portion of the $13 we earn in interest per year (gotta love savings rates!) I think we can manage.
Dave

Dave maybe this will also help. Under U.S. tax law, homeowners associations are considered corporations. As such, they have to file a federal tax return every year, regardless of whether they make a profit or owe any tax. The typical HOA can file Internal Revenue Service Form 1120, which is the standard corporate income tax return, or a simplified version designed specifically for homeowners associations, Form 1120-H. You may also have to file with your State. Form 1120-H was suggested in another message so this appears to be the right form.

Being a 501-c doesn't suggest being a charity. It's a tax exempt non-profit, which I would think we certainly qualify as.

Yes, we're incorporated.

Dave,

Then submit the paperwork to see if the IRS will grant you 501-c status.

Since Assessments are exempt from taxes using the 1120H form, I'll stick with that as it's fairly simple to do and doesn't require additional approvals from a government agency.

BTW - since your Association hasn't filed taxes for a few years, you likely need to get that caught up with. You may also want to check to see if the State Corporation Annual reports have been filed and paid (since you said you were incorporated) along with any State Income tax filing requirements.

After reading the penalty for failure to file in the 1120H instructions, I see the reason why you are trying for that status and trying to justify the need of not filing past year returns.

Most IRS penalties are based on the amount of taxed owed, so if no taxes are owed for prior years, there most likely will be no penalty, even for failure to file. Even so, the IRS has been known to waive penalties in some cases if it can be shown that failure to file was not because of an intent to avoid the payment of tax.

By the way, whether filing as a Section 501 tax-exempt organization or as an HOA using Form 1120-H, it will be necessary for the HOA to obtain an EIN from the IRS. State tax returns will also be required.

As far as prior years go, either way, yes, the organization will have to file returns for those years.

Also, by the way Dave, Form 1120-H is a single-page form. What could be simpler?

Bruce,
We do have an EIN (needed one to transfer our finances into a proper business account from the former treasurer who had it in a personal account)

Our common areas are, for all intents and purposes, open for anyone to use.

I thought there was a postcard-return that would be even simpler than a one page form

You've got me convinced, Bruce. Thanks for the help!

Dave

Instructions?? Who has time for instructions? :-)

So as long as we're using the assessments for allowed things and not going over $100/year in interest, we're tax free. I assume net income (assessments - expenses) is also not taxed, suggesting that we don't have to spend every dime every year to avoid the tax.

Getting a little off the original topic, but we want to have some amount of "slush" in our operations fund, right? (2x monthly expenses is a good rule of thumb as I understand) That has to come from being under budget at some point, doesn't it?

And what of the case where we're under budget one year, but want to spend a little more the next year? For example, Emerald Ash Borer has continued to take a lot of our trees and we've budgeted annualy for new trees in our common areas. If we decide we're going to hold off this year and spend more next year, that puts us effectively under budget one year and over budget the next. I wouldn't think we would refund the under from this year only to increase dues next year. Or is there an accounting trick to expense this year bus spend next year?

So you essentially maintain three accounts: reserve for capital items, contingency reserve, and the normal every-day checkbook that pays for budgeted expenses?

I was looking at it as if the latter two would be one and the same. Wondering if there's any harm in that. Heck, thus far, we've had all THREE combined, which I'm trying to fix.

This is incorrect with regard to entering association expenses on Form 1120-H.

The instructions for entering expenditures on Form 1120-H state, in part:

"Also, do not include investments or transfers of funds held to meet future costs."

So, does that mean the money set aside in reserves or a contingency fund represents profit and is taxable? No. None of the money that is exempt function income (usually, assessments) is taxable, whether it is all spent for current expenses or whether some of it is set aside for future expenses. All the IRS is saying is that to qualify to use Form 1120-H, at least 90% of the association's current expenses must be to maintain association property. Let's look at a couple of examples:

Example 1:
Exempt function income: $5000
Association expenses for property: $4250
Unqualified expenditures: $250
Total expenses: $4500
Amount placed in Reserve: $500
Total expenditures + amount transferred to Reserve: $5000 (cash in = cash out)

Form 1120-H:
Line B: $5000
Line C: $4250
Line D: $4500

To qualify to use 1120-H, Line C divided by Line D must be equal to or greater than 0.9. In this case the result is 0.9444. The association qualifies to use 1120-H and none of the %5000 is taxable.

Example 2:
Exempt function income: $5000
Association expenses for property: $4000
Unqualified expenditures: $500
Total expenses: $4500
Amount placed in Reserve: $500
Total expenditures + amount transferred to Reserve: $5000 (cash in = cash out)

Form 1120-H:
Line B: $5000
Line C: $4000
Line D: $4500

This time the ratio of Line C to Line D is 0.8888 and the association does not qualify to file Form 1120-H and must file Form 1120 instead. A portion of the $5000 may be taxable. If you incorrectly included the $500 transferred to Reserves as an expense you would wrongly conclude that the association was qualified to File Form 1120-H. In other words, you are inflating your current expenses by including an amount you are setting aside to meet future expenses (put bluntly, you are cheating). You will get to claim that amount as an expense (or a portion of it) in the future when you transfer it back into the operating account to meet some capital or unplanned expenditure in that future year.

The important thing to remember is that when calculating expenses, the IRS wants to know what your current expenses are for that year. They do not want you to include money set aside to meet future expenses. You claim it when you actually spend it.

Yup.

And as long as 90% or more of your total expenses are related to the management and care of association property (maintenance, repairs, replacement, insurance, management fees, legal and accounting fees, etc.), which I believe is true for most associations, you can file 1120-H and none of your exempt function income (assessments) is taxable, even if you are saving some of it for the future.

The only reason the IRS wants to know what your exempt function income is, is so that they can compare it to your non-exempt function income to make sure you meet the 60%/40% income test to qualify to use 1120-H, which again, most associations do.