Operating Reserve (HOA in Virginia)

Donna,

If the amount of operating funds that are left (caused by expenses being less then budgeted for) are transferred to the Reserves, there is no tax implication.

If the amount of operating funds that are left are used to offset the following years assessments, then there is no tax implication.

What we do, instead of having an operating fund contingency, is maintain a Reserve fund contingency that is utilized to cover budget shortfalls for reserve items and pay for extra heavy snow fall (we consider that maintenance of the roads, which is a common element). Any left over funds in the operational account is transferred to this contingency line item at the end of every year.

Description and sample at:

http://www.hoamco.com/assets/irs_revenue_ruling.pdf

70-604 only applies if you are filing form 1120 to take advantage of the 15% tax rate on non-exempt income. If you file 1120-H instead, you're non-exempt income is taxed at 30% but you don't have to make a special election.

Tim, the idea of snow removal being a capital reserves item is surprising to me. I thought this fund was for replacement and repair.

Per VA § 55-514.1, Reserves are repair, replace and restore the capital components.

Per Merriam-Webster, to restore is to return (something) to an earlier or original condition by repairing it, cleaning it, etc.

Per Merriam-Webster, repair is to restore by replacing a part or putting together what is torn or broken; to restore to a sound or healthy state.

We consider removing the snow is akin to performing preventative maintenance. It restores the roadway to it's earlier condition and aids in keeping the road in a sound and healthy state (to utilize the definitions above).

I've been astonished at the amount of misinformation out there on these tax issues. Some of it posted by tax professionals who claim great expertise and write extensively about HOA taxation, making it difficult for someone without training in this area to know what to believe. Relevant to the OP, here are the most important things to understand:

1. If your HOA qualifies to file as exempt (filing Form 1120-H), do so, and ignore talk about the potential advantage of filing as a taxable corporation (Form 1120), which rarely saves more than a trivial amount of tax and entails complexities and risks that make it foolhardy in all but the rarest cases.

2. Now that you know you're filing Form 1120-H you can ignore everything you see about Rev. Rul. 70-604, as it doesn't apply when filing this form. (And you should probably ignore everything you see about that ruling anyway, as almost everything written about it on the internet is incorrect.)

3. Better still, when you file Form 1120-H, the IRS doesn't care what you do with excess member assessments. You can return them to members, transfer them to a capital reserve, retain them in the operating account, or put them in a separate, non-capital reserve (which may be called an operating reserve or a contingency reserve). You don't pay tax on these amounts, regardless of what you do with them, and regardless of how much you accumulate or how you choose to hold the funds. That's the main point of the law that created exempt HOAs.

As an exempt HOA you still have to pay tax on non-exempt income, which is basically anything other than member assessments (investment income, income from renting the clubhouse, etc.). Many "experts" will point out that the tax rate on this income is 30% when you file 1120-H and 15% when you file 1120, but never mention that when you file 1120, the amount you have to report as taxable income may be far larger than the amount that would be taxable when filing 1120-H. Better to pay 30% on $4,000 than 15% on $40,000.

Keep it simple. File Form 1120-H. Ignore the nonsense about Rev. Rul. 70-604. Don't worry about having IRS problems when accumulating excess assessments, because that's never a problem when filing Form 1120-H.

ArtT5, we would pay the IRS about $1300 more by filing an 1120-H (even including savings on accounting fees because the form is shorter and simpler). But I'd rather spend the 3 minutes it takes to file the 70-604 resolution. I suspect most condos in our area would be in the same situation.

EDIT: sorry, repeated.

Doesn't the IRS treat funds for painting differently? I haven't researched it, but last year someone told me at our bookkeeping firm's summer picnic that reserve funds for painting might be taxable due to the IRS's determination that painting wasn't necessary maintenance. Or something like that.

Interesting....

Snow does reoccur. Budgeting would be for normal occurrences. Anything basically outside of this would constitute normally emergency situations which are defined as "an act of God" in basic terms which is not of a recurring nature.

We had emergency snow issues in VA last year increasing higher snow removal cost. We do not reserve (plan) for snow but budget.

Reserve studies that I have seen do not include specifics to snow removal. It is considered an operating cost.

Joyce,

I'll post a copy of our policy concerning the contingency fund later tonight.
Our auditor recommend that we combine all of the board decisions into such a policy to make it easier for future audits (as we had to point to several different documents and meeting minutes to show the Boards decisions).
Our auditor had zero issues with this practice.

Tim

Thanks Tim..

What required you to create this resolution as opposed to a board motion regarding reserves?

Thank you... got stuck on the resolution thinking it was due to language in a governing document. Not up on the tax side of all this. As for audits, not sure they cover anything but checking methods they use to claim no money is missing. Not sure they do anything in terms of right or wrong governing document requirements.

Bottom line is, its your call and you seem very prudent.