All Associations must file income tax returns, whether or not they have taxable income.

When preparing tax returns for homeowners associations, most people are under the mistaken impression that all Homeowners associations must file Form 1120-H (Tax Return for Homeowners Associations). This is incorrect. Many CPA’s will automatically file this form as it is a simple one page tax form, but it may not be the best form for the Association to file. There are many variables that need to be reviewed each year, in order to determine how the tax returns for the Association should be prepared.

Residential Associations are required to file Form 1120 (corporation tax return) under IRC Section 277, or they can ELECT to file Form 1120-H under IRC Section 528. The form used to file the tax returns can change each year. Commercial Associations aren’t allowed an election to file Form 1120-H as it only applies to residential associations. Commercial associations must file 1120, the same as regular corporations. A few Associations qualify as tax exempt and must file Form 990.

The decision of which tax form to file is a complex one. The following applies to the differences between Form 1120-H and Form 1120:

When filing Form 1120-H, Associations must allocate its income and expenses between “exempt function activities” and “activities for the production of income”. Associations aren’t taxed on exempt function income. They are however taxed on Net Non-Exempt Function Income. Examples of activities that are “for the production of income” (non-exempt income) include Interest income, Rental income, Pool fees, Late fees; basically any income that isn’t assessed to the membership as a whole. Any expenses related to this income are an allowable deduction. There is also a $100 standard deduction. When you arrive at net taxable income, the tax rate is 30%. This is a simple form to file, but results in a higher tax rate.

When filing Form 1120, the Association must allocate income and expenses between Membership and Non-membership activities. Only Net Non-Membership Income is taxed. All membership and unrelated income is included as well as all expenses. If there is Excess Membership Income, the Association is allowed a one-year carryover of this income and it isn’t taxed until the next future year. The membership must elect to use this carryover by approving a “Revenue Ruling 70-604 election” at a membership meeting. Net Non-Membership income will be taxed even if there is a carryover of excess Membership income. If there are Excess Membership Deductions for the year, these can also be carried forward and used against income in future years (not limited to a one year carryover). When you arrive at net taxable income, the tax rate is 15%. The Form 1120 is a complex tax form and may result in higher audit exposure due to the lack of specific rulings on several areas.

Any funds transferred to a Reserve Fund during the year are not included in Membership Income and are thus nontaxable. Per the IRS, in order for a Reserve transfer to be deductible, it must be a valid reserve transfer and be based on a current reserve study. Transfers to General Reserves are not allowed, it must be a specific reserve. In addition, a separate bank account must be set up and identified as “Reserves”. Any Reserve expenditures are not deductible expenses. Although the Association might be reserving for painting and other maintenance type items, these are not capital items. Therefore, any reserves for Painting are not excluded from Membership income, however any Painting expenditures are deductible on the tax return.

Electing to file Form 1120-H might be a good idea if interest (or other unrelated business income) is low (remember the 30% tax rate) and there is Excess Membership Income. When filing Form 1120-H, the Association isn’t taxed on the Excess Membership Income, but on Net Non-Exempt Taxable Income.

Your CPA shouldn’t automatically file Form 1120-H, just because you are a Homeowners Association. A complex calculation needs to be made first, in order to determine which form gives the lower tax.

When tax planning, which should be done by November of each year, most associations (Residential and Commercial) should move any excess cash (over working capital) to a Specific Reserve account prior to year-end. This might eliminate having to carryover any Excess Membership Income to future years.

Remember to plan for taxes prior to year-end and ask your accountant if he’s considered which tax form is best for the Association to file for the current year.