IRS Revenue Ruling 70-604

It's actually a little complicated, but I will try to explain it as clearly as I can. First, let me say that I am not a CPA, although I am employed as a professional tax preparer for a CPA firm.

As a corporation, an HOA has the option of filing either a form 1120 or a form 1120-H. Form 1120-H is simpler, and usually provides the greater tax advantage for most associations. IRS ruling 70-604 does not apply to associations that elect to file form 1120-H. It only applies to associations that elect to file the standard corporate form 1120.

Form 1120-H:

This form provides a special status for homeowners associations. Using this form, the IRS considers 2 types of income: exempt function income and non-exempt income. Exempt function income is that income that comes from the regular, or special, assessments of the members (owners). Exempt function income means just what it says, the income is exempt from taxes, even if it is not all used for expenses during the current year. This means that an association can safely set aside a portion of their exempt function income as reserves to be used in the future without it being considered as profit and being taxed on the profit. Non-exempt income is income that is from other sources such as interest, special-use fees, or other sources. Rental fees for the use of a clubhouse are a good example. Non-exempt income is taxable, less a standard $100 deduction and deductions for expenses related to producing the non-exempt income. The net non-exempt income after allowable deductions is taxed at a flat rate of 30%.

There are requirements that must be met for an association to be eligible to file form 1120-H. Non-exempt function income must be at least 60% of the total income (exempt and non-exempt) received from all sources. Also, at least 90% of the association's budget must be to care for, manage, insure, repair, replace, or acquire the association's common property. Money that is set aside as reserves is not considered as an expense.

Form 1120:

Associations that are not eligible to file form 1120-H must file form 1120. Also, associations with significant non-exempt income may find it advantageous to file form 1120 because the corporate tax rate starts at 15% instead of the higher 30% rate when filing form 1120-H.

When filing form 1120 there is no exemption for income received through assessments. All income in excess of that needed to meet expenses necessary to maintain the association's common property is considered as "profit" and is fully taxable. This means that money placed into reserves could be subject to income tax.

However, the association may elect to exercise ruling 70-604. Note, however, that this ruling does not permit the association to put excess revenue into reserves. A couple of important issues about exercising this ruling:

1. The election to use the ruling must be made by a vote of the homeowners. It cannot be made by the board of directors.
2. The election must be documented.
3. The election must be made before the tax return is filed.
4. The left over money must either be returned to the homeowners, or it must be used to reduce assessments for the following year and it must be entirely used up in the following year. Any remaining money is taxed (this is what prevents associations from putting the excess into reserves).

Associations electing to exercise ruling 70-604 often will be under closer scrutiny by the IRS to prevent abuse.

1120-H vs 1120:

1120-H: Pros: all exempt function income (assessments) are exempt from income tax. Cons: taxable non-exempt income taxed at a flat rate of 30%; associations must meet certain income and expense ratios to be eligible to use this form.

1120: Pros: tax on excess income starts at a lower rate of 15%; no restrictions on sources of income. Cons: all income in excess of expenses is subject to income tax.

I have done a lot of research on the IRS Regulations for exempt/non-exempt income. What is your opinion about social event income which is deposited into the HOA account?

Thank you for your response. Just what I expected. The income is being included in the monthly Operating Statement as Maintenance Income, the expenses are listed in the Operating Income as a line item called Social Expenses . The amount is a credit.

This is a four-year old HOA and has not paid any Federal tax. The audited F/S say that we had adequate non-income expenses to offset the non-exempt income. The profit is in a Reserve account called Activities Fund.

This seems like a business within a business. I have suggested that the Social Committee charge return funds to the residents on those event where a profit was realized. The group wants to be able to have free parties in the future. I think that this is an improper practice and will present this to the F/C. I am a new member since January. I have the backing of two board members.

Any thoughts would be greatly appreciated. It won't be easy considering we the CPA firm preparing our 1120-H each year.