Taxes: Impact of roll over to reserves on Form 1120-H

I'd like to file a 1120-H this year for the neighborhood, but I am confounded by this ridiculous "90% expenditure test."

Virtually all of our income is exempt - the only exception being some nominal bank account interest.

We had about $237,000 in exempt (dues) income this year, but we're only going to spend about $175,000 (all on maintenance, etc.) For the remainder, we planned to roll it over to our reserve account to pay for upcoming capital improvements.

To qualify to use Form 1120-H, you have to pass the "90% expenditure test", which means that "at least 90% of the association's
expenditures for the tax year must consist of expenses to acquire, build, manage, maintain, and care for property." Ok, well that should be fine, since we spent all $175k on maintenance items. The problem is, the instructions for the test also says "do not include investments or transfers of funds held to meet future costs. An example would be transfers to a sinking fund to replace a roof, even if the roof is association property."

So that seems to indicate that our roll over to reserves is also an expense, but not a maintenance-related expense, which effectively means that if we roll over the excess to reserves, then only 74% of our expenses (175k / 237k) were maintenance-related, right?

So what do we do? Just leave the excess sitting in our operating account?! Going forward, if we earmark a portion of our assessments as reserve-funding, then we wouldn't have to treat this as an "expense" on the operating budget, right?

I am a little frustrated, if I'm understanding these rules correctly, that we are being penalized and having to jump through extra hoops just for being good stewards of our neighbors' money!

Right. So does this mean we don't qualify to use Form 1120-H? What do we do?

Reserve Fund Deposits are - and can be - expenses on your annual budget. If you're leaving more than 10% of your budget revenue in a state of non-appropriation, I'd think you'd run afoul. Very few of us will know Texas HOA laws, however, and especially the interpretation of state forms.

BM5,

For the expenditure test, you don't count the reserves. Perhaps it's best to use an example:

You had $ 100,050 in income. $100,000 from assessments, $50 from taxable interest earned.
Your expenses totaled $95,000 with $5,000 of that being deposits into Reserves and $100 being donated to the local fire department.

Exempt Income Test: 100,000 divided by 100,050 = .9995 multiplied by 100 = 99.95%
Income test passes

90% expenditure test: (95,000 minus 5,000 minus 100) divided by (95,000 minus 5,000) = .998
or 99.8 percent. Expenditure test passes.

1120-H Item A = $100,000
1120-H Item B = $ 89,900 (total expenses minus deposits to reserves minus non-hoa expenses)
1120-H Item C = $ 90,000 (total expenses minus deposits to reserves)
1120-H Item D = $ 0

I hope this helped,

Tim

BruceF1 seems to be the best reference on this site for tax questions. Here is an earlier thread where Bruce explained Form 1120-H and when an Association should use it.

http://www.hoatalk.com/Search/ForumSearch/tabid/87/view/topic/postid/152924/Default.aspx

Yes, that is correct.

There are a few points to remember:

1. The 1120-H form has 2 parts: an information return and a tax return. The first part of the form (lines A through E) are an information return. None of these entries are used in calculating any tax you may owe. These entries are only used to determine if you qualify to file Form 1120-H. The second part (lines 1 through 26) is the actual tax return. The entries here are used to calculate any tax, overpayment, or balance due, just as on your personal return.

2. The 60%/40% income test is separate from, and in no way related to the 90%/10% expenditure test.

3. When filing Form 1120-H, ALL exempt function income is tax free, no matter how you spend or use it. If you don't qualify to use Form 1120-H then you must file the standard corporate Form 1120. Exempt function income means just what it says: it is exempt from taxes. So, the fact that you put part of it aside for future capital expenditures, (even if it's as much as 20%) doesn't matter. However, if you were required to file the standard Form 1120, then the amount you transfer into reserves would be considered as profit and would be taxable. So, when and where does it show up? It shows up when you withdraw it and spend it on something. Now, if you withdraw it and spend it on your property (to replace a roof, repave your roads and parking areas, etc.) then it is considered as a qualifying expense. But, if you withdraw funds to have an enormous wild party, or to donate to some charity, or to help out some burned-out family replace or repair their home, then it could cause you to fail to meet the expenditure test during the year you withdraw it.

4. The fact that at some time in the future you withdraw funds from your reserves to repair or replace something on your property so that your expenditures for the year exceeds your exempt function income is irrelevant. As I said, the two tests are unrelated.

I've got a question.

Are the following exempt function income?
1. Late Fees
2. Transfer Fees (assessed when property changes hands)
3. Lien Filing and Lien Release Fees
4. Legal fees (charged to members and then paid by members)
5. Fines for CCR violations

As Bruce concurred, it is that simple.

Yes, yes, yes subject to the conditions Tim noted), yes and yes.

Here's the rule:

"For the purposes of section 528 exempt function income consists solely of income which is attributable to membership dues, fees, or assessments of owners of residential units or residential lots. It is not necessary that the source of income be labeled as membership dues, fees, or assessments. What is important is that such income be derived from owners of residential units or residential lots in their capacity as owner-members rather than in some other capacity such as customers for services. Generally, for the membership dues, fees, or assessments with respect to a residential unit or lot to be exempt function income, the unit must be used for (or the unit or lot must be expected to be used) for residential purposes."

The above is taken from Section 1.528. As noted, the important thing is that the income is a result of the the homeowner being a member (owner) of the association. It is not the result of the owner acting as a "customer" of the association. For example, if an owner rented the clubhouse for a private activity (birthday party, baby or bridal shower, merchandise demonstration party, etc.) That would be taxable income because in that case the owner is acting as a customer of the association.

As for the question in your other post, management, accounting and legal fees are included as part of the expenditures you report on line C. Also, any wages you pay employees for work such as lawn care or other work related to the maintenance of association property are included in the amount on line C.

Lines 1 through 26 of Form 1120-H are used ONLY to compute the taxes you may owe on non-exempt (taxable) income.

You are allowed to deduct from your taxable income a flat $100 (line 18) and any other expenses that are directly related to the production of that taxable income (lines 1 through 15). Any wages you report on line 9 are the wages you pay that are directly related to the production of your taxable income. Most associations probably never have a need to enter anything on lines 1 through 15, but I'll give you an example:

Suppose you rent your clubhouse for private use to your homeowners. The rents you collect during the year are taxable income and would be entered on line 3. (Line 11, rents, is used to enter rents you pay, not rents that are paid to you.) Now, the cost of repairs and maintenance, utilities, etc. associated with the clubhouse can be split between the normal association use and the use as a rental in proportion to the times for such use. In other words, you would take the total costs for the year and multiply that by the ratio of the number of hours the clubhouse is rented during the year divided by the total number of hours in the year and enter that amount on line 10. Note that if you do this you must reduce the amount that you included for clubhouse repair and maintenance in your total expenditures on line C by the amount you put on line 10. As with any other deduction in IRS-land, you can't use the same deduction twice. However, it would still remain as part of the total on line D.

Sorry, I may have caused some confusion. Lines 1 through 8 are for entering non-exempt (taxable) income and lines 9 through 15 are for entering the expenses directly related to the production of the income reported on lines 1 through 8. In my post above I stated that expenses were entered on lines 1 through 15.

Based on what you posted here that sounds correct to me.

Unfortunately, once you make an election to file either Form 1120-H or Form 1120, I think you're stuck with it. Usually, you cannot revoke your election for a particular tax year unless the IRS consents. I would suggest you contact the IRS and explain the situation. They can provide you with the appropriate paperwork to file to ask for a ruling and permission to re-file using form 1120-H. Not guaranteeing you will get permission to re-file, but there's no harm in asking.

Happens all the time. Obviously your previous CPA is not familiar with Form 1120-H or Section 1.528.

Just last month I did an amended return for 2011 for one of our firm's new clients because the CPA who did the original 2011 return mishandled the HSA contribution and 1099-SSA distribution. Between federal and state taxes that mistake cost the client over $1500 in taxes. Earlier this year I reviewed my granddaughter's 2011 return and discovered that the firm that prepared her 2011 return used an itemized deduction (Schedule A) instead of the standard deduction which would have resulted in the greater deduction and the larger refund. That mistake not only cost my granddaughter $40 on her 2011 return, but an additional $400 on the 2012 return because she itemized in 2011 and had to claim her state tax refund as income for 2012.

People are human. They make mistakes.

Our tax preparer provides a side by side comparison of the tax due under both 1120 and 1120-H. We can then clearly see why he recommends a filing method. In all recent years we have filed 1120-H due to large end of year surpluses that have been transferred to replacement reserve fund and/or a capital improvement fund. Unless the subsequent year's assessments are reduced by an equivalent amount these would be taxable under 1120 (see IRS revenue ruling 70-604).

Our accountant NEVER got back with us on filing 1120-H.