omeowners associations are often referred to as Common Interest Realty Association’s or CIRA’s in the tax world. I will use CIRA as an acronym to refer to homeowners associations in general. This article should not be used as tax advice in filing your CIRA’s income tax returns. This article is to provide general information about tax rules and options to consider in filing your CIRA’s returns.
CIRAs are generally taxed as corporations unless they have been approved by the taxing authorities as a tax exempt organization under Internal Revenue Service Code (IRC) Section 501(c). These CIRA’s are typically very large Associations who offer and maintain amenities that also regularly derive significant income from the general public as well as members such as: golf courses, tennis clubs, equestrian facilities, marinas and other recreational facilities. The few CIRA’s who have applied and been approved as tax exempt organizations will file Federal Form 990 or possibly Form 990EZ. Since homeowners associations that have tax exempt status are uncommon in Minnesota this article will not cover filing Forms 990/990 EZ. Plus, the 990 Forms are lengthy and Minnesota Community Living can’t give me that much article space.
More commonly, residential condominium associations, homeowners associations, and townhome associations may elect to be taxed either under IRC Section 277, to file their taxes using Federal Form 1120 (applies to certain membership organizations) or under IRC Section 528, to file Federal Form 1120-H (applies specifically to homeowners' associations). Commercial condominium associations file Federal Form 1120. Cooperatives are subject to subchapter T and file Federal Form 1120-C. Timeshare associations may elect to file 1120-H if they meet the exempt function income and expense tests.
No matter how an organization is treated by the IRS, all CIRAs must file an annual federal tax return. It should not surprise you that a Minnesota tax return must also be filed.
Federal and State Tax Filing
The tax forms that most CIRA’s are required to file are:
- Federal Form 1120-H - U. S. Income Tax Return for Homeowners Associations and Minnesota State Form M4NP - Unrelated Business Income Tax (UBIT)
- Federal Form 1120 - U.S. Corporation Income Tax return and Minnesota State Form M4, Minnesota Corporation Franchise Tax return.
- Federal Form 1120-C- U.S. Tax Return for Cooperative Associations and Minnesota State Form M4, Minnesota Corporation Franchise Tax return.
Regardless of which pair of tax returns your CIRA files, both the Federal and State returns are due the 15th day of the third month following year end. For example, a CIRA with a December 31st year end must file their tax returns by March 15th. A six month extension may be requested if the tax returns cannot be filed by March 15th, Form 7004 is used to file for the extension. Extensions, along with any tax payment that is due, must be filed on or before March 15th (or 15th day of the third month following year end for fiscal year CIRA’s) or the CIRA is subject to late filing and late payment penalties.
Each CIRA in Minnesota is also responsible to file its Annual Nonprofit Corporation Registration with the Secretary of State on or before December 31st, every year.
Filing using Form 1120-H – U. S. Income Tax Return for Homeowners Associations return
This tax form is the form often referred to as the "short form” or simply "1120-H”. IRC Section 528 requires the allocation of income and expenses between exempt function activities and its activities for the production of gross income (nonexempt function activities). It is not taxed on its exempt function activities but is federally taxed at 30% on its net nonexempt function income. Timeshare associations that elect IRC section 528 are taxed at 32%. A CIRA filing under IRC Section 528, makes the election by filing Form 1120-H, the homeowners association tax form. The election to file Form 1120-H is continuous until the CIRA applies for and is granted a revocation by the Internal Revenue Service. No carryover of net operating losses in allowed when Form 1120-H is used.
A CIRA must meet these tests to qualify for IRC Section 528 treatment, and use Form 1120-H:
- Residential test – substantially (85%) all the units must be for residential use
- Income test – 60% of the gross income must be of exempt nature
- Expenditure test – 90% of the expenses must of exempt nature, qualifying expenditures
- No benefit test – the residual income may not be used for members’ benefit.
Exempt Function Income
To qualify under IRC Section 528, at least 60% of the CIRA’s gross income for the year must consist of exempt function income. It must be received from owners in their capacity as CIRA members - not in their capacity as customers for goods or services.
Nonexempt Function Income
Nonexempt function income results from three principle sources:
- Revenue from non-association property (includes interest, dividends, capital gains, et cetera)
- Revenue from nonmembers (general public) for use of CIRA property (guest fees and other similar amounts)
- Amounts charged to CIRA members for specific services (special use charges – party room rental fees, laundry, vending machines, golf fees, other recreational facilities, etc.).
An association cannot qualify under IRC Section 528 unless at least 90% of its expenditures are qualifying expenditures. Expenditures are defined as operating and capital expenditures that directly affect the association’s property. Generally, the "association’s property” for purpose of this discussion is property owned by the association for the enjoyment of its members. Qualifying expenditures are either current operating expenditures or capital expenditures that are made for the acquisition, construction, management, maintenance and care of association property.
Nonexempt function income may be reduced by expenses attributable solely to that income (state income taxes) and other expenses that are directly connected to the nonexempt function income (relate to the allocation of expenses for either facilities, services, or personnel that are used for both exempt and nonexempt functions).
Common categories of expense that are allowed are:
- services provided by a management or bookkeeping company: preparing financial statements, attending board meetings, reviewing investments, making requests to withdraw monies, reconciling interest, checking interest rates at various financial institutions, changing financial institutions (or moving accounts at financial institutions) and making requests for reimbursements from reserve accounts
- tax services
- directors’ and officers’ liability insurance
- legal fees related to collection of delinquent assessments if the association cannot charge such fees back to the unit owner
- other accounting fees such as fees for annual audit or reviewed financial statements.
The Board of Directors should determine the expenditures that can be directly allocated to offset nonexempt function income. In addition, the Board of Directors should review the allocations each year to ascertain they are reasonable, because activities can change from year to year.
Filing using Form 1120 – U.S. Corporation Income Tax return
This tax form is the form referred to as the "regular Corporate Form”. IRC Section 277 requires the allocation of income and expenses between membership and non-membership activities. Only its net non-membership income (typically interest income) is taxed at regular corporate rates. Corporate rates currently are 15% on the 1st $50,000 of taxable net income and ratchets up in increments above $50,000 of taxable income. Net operating losses from membership expenses in excess of membership income can be carried forward only.
Under IRC Section 277, membership income is taxable, and qualified expenses are deductible except for capital expenditures.
Similarly to non-exempt income under IRC Section 528, expenses directly related to income reduce the income from that source (e.g. maintenance income for laundry services reduces income from such services). Other expenses such as accounting and tax preparation fees, office expenses and management fees, fidelity bonds and state income tax may be used to off-set interest income.
Excess membership income may be capitalized and deferred if such treatment is elected. Generally, such treatment (Revenue Ruling 70-604) is for excess membership income undistributed by year-end. An annual meeting is required for such deferral to be elected. Alternatively, such excess may be elected to be treated as "replacement fund” for future contingencies or specific capital expenditures.
Each CIRA must have a membership (not just a board) vote to elect to file under Code Section 277 to use Form 1120, the regular corporation tax form. This is referred to as an IRS Revenue Ruling 70-604 election. This election must be made annually.
In allocating income and expense line items to membership or non-membership activities consideration must be given to each line item about whether it is related to members or does it relate to nonmembers.
The Board of Directors should determine the expenditures that can be directly allocated to offset non-membership income. In addition, the Board of Directors should review the allocations each year to ascertain they are reasonable and consistent, because activities can change from year to year.
Cooperative CIRA – Filing using Form 1120 – U.S. Corporation Income Tax return
Cooperative housing corporations are not exempt from income taxation. Like any other taxpayer, a housing cooperative must pay tax on its taxable income, i.e., its gross income less allowable deductions similar to other business corporations. Cooperatives are disallowed from filing using provisions of IRC Section 528, and must file the Form 1120-C. To qualify as a cooperative and file using Form 1120-C, the organization must meet the following criteria:
- The cooperative must be taxable as a corporation.
- There must be only one class of stock outstanding (membership certificate).
- Tenant-shareholders must have the right to occupy their units for dwelling purposes.
- At least 80% of the cooperative's gross income must be received from tenant-shareholders (patronage); 80% or more of the total square footage of the corporation's property is used or available for use by the tenant-shareholders for residential purposes or purposes ancillary to such residential use; or 90% or more of the expenditures of the corporation during the taxable year are for the acquisition, construction, management, maintenance, or care of the corporation's property for the benefit of the tenant-shareholders. (Only one of the three requirements must be met.)
- No tenant-shareholder is entitled to receive a nonliquidating distribution that is not out of earnings and profits.
A cooperative's tenant-shareholders receive certain tax benefits allowed to homeowners, including the ability to deduct their proportionate share of the property taxes and mortgage interest deducted by the cooperative if the cooperative qualifies as a cooperative housing corporation under IRC Section 216. Whether the cooperative qualifies as a cooperative housing corporation under IRC Section 216 is determined annually.
The Board of Directors should determine the amounts of income derived from tenant-shareholders (patronage) and non-tenant-shareholders (nonpatronage) and the amounts of expenses allocable to tenant-shareholders and non-tenant-shareholders to accurately report the cooperatives activities on the tax returns. In addition to providing tenant-shareholders annual information (usually by January 31st) about their allowable deductions for interest and taxes. They may also furnish information about capital contributions.
You are not alone. Many Associations overpay taxes because a one page tax form does not look that hard to complete. Unfortunately, if your CIRA’s tax preparer is not well versed in the tax nuances of the CIRA industry, you may be paying more taxes than necessary.
If you have tax concerns and need to discuss them with a competent and experienced professional, perhaps we should talk. I have worked with CIRA’s for many years and there are not many issues that I have not seen over the years. I can tell you from my experience that it does not take a very big Federal and State tax overpayment to more than cover the cost to prepare tax returns correctly.
Please contact me to discuss your questions or concerns: firstname.lastname@example.org, 952.474.1631.