financing a painting project

I believe that it is prudent to have a contingency fund for both the Reserves and the Operational expenses.

As far as the budget goes, an operational contingency fund would be considered an expense.

To set one up, you need to adopt a resolution that establishes an amount that would be it's maximum and what it would be used for (operating budget shortfalls) and the typical amount to be set aside each year for the fund (until it reaches it's maximum).

I've heard that a good number for an operational contingency fund is 1/12 of the annual assessments or the amount the insurance deductible. (we use 1/12 of the annual assessments).

Here are a couple of articles about operational contingency funds:

Article titled: You Have a Replacement Reserve… Now How About an Operating Reserve?

Article titled: Know Your Community’s Financial Position

How you treat it internally for structuring your budget is your business. As far as the IRS is concerned, money that is set aside to meet future expenses is not an "expense" and should not be reported as such on Form 1120-H. The instructions are very clear on this. A simple way to view this is money that is spent on something (goods or services) and is no longer available for use for something else is an expense. Money that is set aside is still available to purchase goods or services at some future time is not an expense.

Glad you clarified that, Bruce. I thought hat perhaps CT was different than others states. We have two twin towers that get quite a combo of sun, salt air, fog and wind. You can bet we're setting funds aside in a specific line item in reserves to paint them!

Bruce and Tim

I am most appreciative of all your comments and suggestions.

Bruce, you asked "Who told you that"? re:IRS taxing all of the reserves if any of it is used for painting. Well, I thought I read it on this site so did a quick browse and and under Reserve Studies/Funds 101 I came accross a posting from a CPA(so he said) SteveJ8(Florida)dated 7/21/2011. If you can find it and have the time would you kindly interpret that for me.

Your explanation was really what I wanted to hear!

Thanks for all your past post.

H

Tim,

I did, and here's my (lengthy) explanation which I hope Helene and others will find informative:

I think I see where the confusion might be coming from.

The thread Helene is referring to, was started by you (Tim)in 2010. The first mention of painting as being cosmetic was made by David from Virginia, who does not claim to be a CPA. The CPA was someone named Steve, from Florida, who, it appears, has posted only five times. Steve also refers to painting as cosmetic. Steve refers to three IRS rulings: 74-563, 75-370 and 75-371. None of these mention painting. The first, 74-563, refers to special assessments. The conclusion was that special assessments are not taxable to corporations for which Section 528 applies; namely, homeowners associations that qualify to file Form 1120-H per Section 528. Rulings 75-370 and 75-371 deal with the issue of whether excess assessments (collecting more than is needed to meet expenses) represents taxable income. Again, these two rulings apply to special assessments only.

If you own rental or commercial property, painting that property is considered to be a repair, or maintenance expense, and is taken as a deduction in the year you pay for the painting. Similarly, if you have an office in your home that you use for business, and you take a home office deduction, you may include the cost of painting that office as part of the home office deduction. What you normally cannot do is treat the painting expense as a capital improvement and include it in the cost basis when you dispose of (sell) that property and you determine the capital gain (or loss) on that property. However, if you make an improvement, such as adding a garage to your rental property, the painting of the garage may then be treated as an improvement and added to the cost basis.

Publication 527, which deals with Rental Property, specifically refers to painting as a repair expense on page 5.

Now, here’s where the confusion comes in.

There is a 3% “Domestic Production Activity” deduction that may be taken against the net income of certain qualified small businesses whose manufacturing activities are in the U.S. To qualify, the business must be engaged in some type of manufacturing or production. Business activities that are considered to be “cosmetic” in nature are not considered as manufacturing and do not qualify for the Domestic Production Activity deduction. For the purposes of this deduction, painting is considered to be a cosmetic business activity. In other words, a small company that provides painting services for homes, businesses, etc., does not qualify for the Domestic Production Activity deduction because its business activity is considered cosmetic. So, that's where I think the "cosmetic" part of the confusion is coming from.

Now, for the other part. The IRS does not recognize painting as a legitimate expense to be paid from reserves. But, it’s not because the IRS considers painting to be “cosmetic,” it’s because the IRS considers painting to be maintenance. Here’s the thinking: HOAs like to think in terms of Operating Accounts and Reserve Accounts. The IRS thinks in terms of Operating Accounts and Capital Accounts. As I previously stated, the IRS does not consider painting to be a capital expense; it is a non-annual maintenance expense. So, the conclusion is that if painting is paid for out of the Reserve Account it could result in a big tax issue.

Form 1120-H to the rescue. As long as an HOA files Form 1120-H, there should be no tax issue. For most HOAs, who generally have only a little non-exempt function income, such as interest, they generally would file Form 1120-H and should have no tax issue if they pay for painting from their reserves. Why? Because all of this is generally invisible on Form 1120-H because of the preferential tax treatment given to HOAs. The downside of Form 1120-H is that all net non-exempt function income, if any, is taxed at a flat 30% rate. For HOAs with significant non-exempt function income, this could be a large tax burden. Those HOAs would benefit from filing the regular corporate Form 1120, where the tax rate for the first $50,000 of taxable income is only 15%. But then, paying for painting out of reserves becomes an enormous tax issue because the money (reserves) represents excess income (profit) and becomes taxable. So more careful tax planning is needed.

So, the short answer? If you file Form 1120-H, don’t worry about paying your painting expense from reserves. But, be sure to include the expense in with all your other expenses when you file your Form 1120-H the following year.

There are several good articles on the internet on the subject of HOA reserves, taxation, and paying for painting from reserves in particular; far too many for me to list here. But, searching for topics such as "HOA reserves and taxes", "painting and HOA reserves", and similar constructions should turn up a number of them for those that are interested.

I hope this helps to clarify the confusion.

Bruce.

Part of what you said:

Why? Because all of this is generally invisible on Form 1120-H because of the preferential tax treatment given to HOAs. The downside of Form 1120-H is that all net non-exempt function income, if any, is taxed at a flat 30% rate. For HOAs with significant non-exempt function income, this could be a large tax burden. Those HOAs would benefit from filing the regular corporate Form 1120, where the tax rate for the first $50,000 of taxable income is only 15%.

Without a calculator and on my 2nd drink, I assume you are saying that without more then $XX function income (rent clubhouse, rent pool, rent retail space, ski passes, greens fees, etc) then they should always file 1120-H?

15% of $50K is $7,500.00. 30% of $25K is $7,500.00. 100% of zero, is still zero....LOL

Not trying to overly simplify....but....

Thanks

Like the Beano TV commercial, "Now I get it!"

Thanks Bruce.

Gosh, what about me?

According to our audit report the Assoc. has elected, under 528(c)(1)(E) of the Internal revenue Code, to be treated as a tax-exempt homeowners assoc. Is that o.k.
to take funds out of the reserves to paint?

I think I'll have a drink now!

Cheers!

This is a great question. I don't have time to read all the responses tonight. It is 11:30 P.M. and I have to work tomorrow. I am responding so that This will go to my forums and I can read the responses later. It is budget time for us also.