Homeowner (and condominium) associations hold an unusual place in the tax world. On the one hand, most do not squarely meet the definition of a 501(C) nonprofit. On the other hand, they are not in business pursuing a profit. In fact, the vast majority of HOAs are small, volunteer-run associations that function solely to enforce covenants and maintain the common areas of its residential members.
The Tax Reform Act of 1976 created Section 528 of the Internal Revenue Code and a special carve-out for qualifying homeowner associations. Section 528 defines what an HOA is for tax purposes and gives those meeting the definition the opportunity to file Form 1120H Tax Return for a Homeowners Association. This definition has five basic tests: 1) Exempt Function Test, 2) Exempt Function Income Test, 3) Exempt Function Expense Test, 4) No Private Inurement (benefit) Test, and 5) Elect to apply section 528 for that tax year. Your HOA must pass all parts of this test to file Form 1120-H.
There are articles on Overnightaccountant.com that discuss other parts of this definition. This article will focus on test number three, Exempt Function Expense.
Exempt Function Expense: Part of the definition set forth by code section 528 states that ninety percent (90%) or more of the organization’s expenditures for the tax year must be exempt function expenses for it to be considered a Homeowners Association for tax purposes. Most associations have little problem meeting these criteria. (In fact, the vast majority of HOA’s have no nonexempt expenses at all and may qualify to take our 1120-H Basics Course.)
To determine whether an HOA meets this test, however, board members must understand what is and is not an exempt function expense. They must also know how to calculate the exempt function expense percentage. This article will help board members develop this understanding and correctly calculate their HOA’s exempt function expense percentage.
Defining Exempt Function Expense: Code Section 528-6 defines exempt function expenses as expenditures used to acquire, construct, manage, maintain, and care for association property. These costs include normal operating costs and expenditure on capital items that are association property such as roads, tennis courts or a pool.
This definition can be confusing, however, because it goes on to state that “qualifying expenditures include expenditures on association property despite the fact that such property may produce income which is not exempt function income.” What this means, basically, is that the cost of a pool or a clubhouse will not be disqualified as an exempt function expenditure simply because a proportion of income it generates is not exempt function income. However, …and this is important, where expenditures are used for both association functions and non-association functions an allocation of the expenditures between exempt and nonexempt uses must be made on a reasonable basis (discussed below).
Examples of Exempt function Expense: The vast majority of funds spent to acquire, construct, manage, maintain, and care for association property qualify as exempt function expenditures. These include but are not limited to:
The vast majority of regular association expenditures qualify as exempt function expenses, but there are some exceptions.
Nonexempt Function Expense: Code section 528-6 does not define nonexempt function expenditures and its seemingly broad definition of exempt function expenditures may leave one wondering what outflows are not exempt. The simplest answer is, funds NOT used to fulfill the association’s exempt purpose – to acquire, construct, manage, maintain, and care for association property.
The most common activity not related to the association’s exempt function are those that generate nonexempt function income. Expenses related to the generation of nonexempt income would be considered nonexempt expenses. To clarify, here are a few examples of activities that may generate nonexempt expenses.
Example One: An HOA has a clubhouse members are allowed to use as part of their annual membership fee but which is also rented out for weddings and receptions. If the HOA offers a catering service as part of the rental, costs related to the catering service would be nonexempt function expenses. Fees paid by the HOA for cleaning the clubhouse after the event would also be nonexempt function expenses.
Example Two: An HOA has a pool that is rented out to members and nonmembers for special functions. If the HOA provides a lifeguard during these events this cost would be considered a nonexempt function expense.
Example Three: An HOA has a tennis court that is not open to members or nonmembers unless they pay an entry fee each time the court is used. Under this scenario, all expenses related to the tennis court would be considered nonexempt function expenses for purposes of the 90% expenditure test.
Reasonable Allocation of Nonexempt Expenses: Code section 528 provides little guidance with regard to segregating exempt and nonexempt function income but states that “Where expenditures by an organization are used both for association property as well as other property, an allocation shall be made between the two uses on a reasonable basis. Only that portion of the expenditures which is properly allocable to the acquisition, construction, management, maintenance or care of association property, shall constitute qualifying expenditures.”
This section of the code has been interpreted to mean that associations must allocate a reasonable amount of expenses related to the production of nonexempt income to nonexempt expenditures. The benefit of this allocation requirement is that it allows associations to reduce their tax burden by offsetting taxable, nonexempt function income with expenses related to generating that income. The downside, however, is that the allocation will impact the 90% exempt function expense calculation.
As a simple example, assume an HOA brings in $40,000 in member dues and assessments. The HOA also has a clubhouse that is open to members at no additional charge but also generates $10,000 in rental fees. The clubhouse is rented 20% of the time it is open during the year. Repair and maintenance of the clubhouse costs $5,000 for the year. A reasonable allocation of these shared costs would be 20% of $5,000 or $1,000. Assume further that this HOA pays a firm $2,500 during the tax year to market and manage rental of the clubhouse. Since all of these costs are related to generating rental income, 100% of the $2,500 would be nonexempt expenditures. In this example, the $1,000 of the maintenance cost and all $2,500 of the marketing fees would be nonexempt function expenses, totaling $3,500.
Similar allocations should be made to other expenses such as association management fees, accounting services, liability insurance and any expense the HOA has a reasonable basis for allocating. The HOA should be consistent in the application of its allocative method from year to year so as not to manipulate calculation of the exempt function expense percentage.
Ignored “Expenses:” There are several outflows an HOA may have that are considered neither exempt function nor non-exempt function expenses when making the 90% determination. These expenses are simply ignored and include:
Calculating Exempt Function Expense Percentage: Once total expenses have been segregated into exempt and nonexempt categories, the exempt function expense percentage can be calculated. This is completed by dividing total exempt function expense by total expenses incurred for the tax year. For example, if exempt function expenses total $11,000 and non-exempt function expenses total $2,500, total expenses equals $13,500.
The exempt function expense percentage is then calculated by dividing exempt function expenses by total expenses or $11,000 divided by $13,500. The result (quotient) is 81.4%. In this example, the quotient is less than 90%. This HOA would NOT qualify to file form 1120-H for the tax year to which this calculation applies.
Conclusion: No article can address every transaction that may occur in your HOA but, hopefully, we have helped you to develop a better understanding of what is and is not an exempt function expense. If you have specific questions regarding exempt function expenses this link to treasury reg 1.528-6 may help or you may wish to contact a professional.
IMPORTANT INVITATION: All HOAs must file a tax return each and every year. If your HOA is among the vast majority of HOAs that has no non-exempt function expenses we invite you to learn how to prepare your own Form 1120-H. Our Form 1120-H Basics course can be used year after year to help you prepare your HOA’s 1120-H—- saving thousands of dollars in preparer fees!
All courses and articles are for informational purposes only and do not constitute tax advice. Taxes are complicated - do not act on course information without consulting a professional. Always refer to treasury regulation before making any tax decision. Read the full disclaimer.
I really appreciate you doing the class. It was quite helpful.- Debbie Y, Greensboro, NC, 1099-NEC & 1099-MISC Training Course Course
Jam packed with info. I feel ready to finalize the year and tackle my taxes!- Cassie, Biloxi, MS, Real Estate Agent Tax-Cut Library, Agent Edition Course
I just took over the Treasurer position in my neighborhood. As you know, it’s tax time! I knew I could do it with help! Thank you! I am now an expert on our HOA taxes! I would definitely recommend this to others!- Sebreania H, Marietta, Ga, 1120-H Basics Course
I haven’t practiced in the accounting field in quite some time and wanted a refresher. The Overnight Account course 1099-Misc Basics was very helpful! It was simple to follow along and understand each section. I would highly recommend this course! Staff were quick to answer my question as well. I love that I can review the modules again, if needed, at any time. I will definitely be using them again for more classes.- Tammy, Anchorage, AK, 1099-MISC Basics (Training Edition) Course
I haven’t practiced in the accounting field in quite some time and wanted a refresher. The Overnight Account course 1099-Misc Basics was very helpful! It was simple to follow along and understand each section. I would highly recommend this course! Staff were quick to answer my question as well. I love that I can review the modules again, if needed, at any time. I will definitely be using them again for more classes.- Tammy, Anchorage, AK, 1099-MISC Basics Course