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, they are not in business pursuing a profit. In fact, the vast majority of HOAs are small, volunteer-ran 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 five to file Form 1120-H for a particular tax year.
There are articles on Overnightaccountant.com that discuss other parts of this definition. This article will focus on test number one, the exempt-function test, also called the operations test.
Exempt-Function Test: Part of the section 528 definition states that a Homeowners Association qualifying to file Form 1120-H must be organized and operated to acquire, build, manage, maintain, and care for association property of a condominium project or a subdivision where substantially all of the association’s units, lots, or buildings are used by individuals as residences.
This may sound like a simple definition most associations easily meet – and most do. But, this is the tax code – determining whether your HOA passes the exempt-function test may not be as simple as it seems. So, let’s take a moment to wade through the tax-morass to explore each part of the exempt-function test in more a little detail.
Organized: The term organized means that the sole, original, purpose of the association’s formation was to acquire, build, manage, maintain, and care for association property. This purpose should be stated in the association’s founding document(s) such as a corporate charter, articles of association or organization, or a trust instrument. Additionally, the covenants and bylaws of the association should conform to this exempt-function and not contradict it.
Operated: A qualifying association must not just be organized to perform the exempt-function, it must actually do it. As a practical matter, an association will be considered to operate as a qualifying HOA if it meets both the exempt function income and exempt function expenditure test. It is important, however, to make sure your HOA’s activities conform to the bylaws and covenants of the association. If its activities stray from its exempt function, particularly into the area of private inurement (benefiting any individual or group of individuals to the detriment of other association members), it may fail the operations test and lose its ability to file Form 1120-H.
Association Property: To qualify as an HOA for tax purposes an association must be organized and operated to acquire, build, manage, maintain, and care for association property. Association property includes all property owned by the association and areas owned by members as tenants-in-common. This property must be available to all members and must exist to enhance the owner’s enjoyment of their residences. This does not mean that facilities requiring a separate fee for use, such as tennis courts and swimming pools, will be disqualified as association property. Such facilities will qualify as association property as long as all owners have similar rights to the property (such as paying an annual fee for use).
However, property not used primarily by association members or property intended to be used by nonmembers, such as property rented or operated for profit through sales to nonmembers, may not be considered association property for purposes of the exempt-function test.
Association property can also include property owned by government authorities or handed off to government authorities to maintain such as roads, sidewalks, and streetlights that are common areas or other property that benefit association members.
Association property can even include property privately owned by individual association members if the following three criteria are met:
(1) There is a covenant or similar requirement relating to exterior appearance or maintenance that applies on the same basis to all such property (or to a reasonable classification of such property);
(2) There is a pro rata mandatory assessment (at least once a year) on all members of the association for maintaining such property; and
(3) Membership in the organization is a condition of ownership of such property.
What is and is not association property can be confusing. If you have questions about a particular piece of property, please refer to Internal Revenue Code 1.582-3. If you still have questions, contact a qualified real estate attorney.
Substantially all: To qualify as an HOA for tax purposes substantially all of the association’s units, lots, or buildings must be used by individuals as residences.
For a condominium association, the term “substantially all” means that at least 85% of total square footage of all units in the project are used by individuals for residential purposes. This includes unoccupied condo units so long as the units are intended for residential use, and the previous owner used the unit for that purpose. Units used for residential-related purposes such as maintenance, laundry, or residential storage are also considered residential units.
For a residential association, the term “substantially all” means that at least 85% of the lots in the association are zoned for or intended to be used for residential purposes. This includes unimproved and vacant lots. Lots used for activities that are “auxiliary” to residential use such as schools, swimming pools, fire stations, and related parking are considered lots used for residential purposes.
Lots used for commercial purposes or intended to be used for commercial purposes (and related parking) are NOT considered residential lots or units. Also, units or buildings will not be that considered residential if for more than half of the days of the association’s taxable year the unit or building is occupied by a person or series of persons for periods of less than thirty days, such as with short-term vacation rentals.
Also, it is important to note that – to date – condo units and residences where the occupant resides but from which the owner operates a virtual business or works from home are still considered residential lots.
Keep Learning: We hope this article has helped you to better understand the exempt function test for HOA’s and form 1120-H. Please remember that all HOAs must file a tax return 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 just completed the 1099-NEC/MISC course - this was very helpful to me. It is greatly appreciated.- Tammy L, Anchorage, AK, 1099-NEC & 1099-MISC Training Course Course
This course package is thorough and will give you a solid handle on how to optimize your business expenses to minimize your taxes and keep appropriate records to handle any IRS challenges. Only want to dive into a particular topic? Jump to that video and scan forward to where your issue is addressed. Or watch the whole series to learn it all!- Josh, Charles Town, WV, Real Estate Agent Tax-Cut Library, Agent Edition Course
I took the course last weekend and it was excellent. I’ve also had a couple of e-mail exchanges with Brett to clarify a few things, which I really appreciated. I found the class to be very easy to understand. I do have a finance background, but I think it would be comprehensible to people who don’t. I will recommend that the next Treasurer of our HOA take the course when he/she takes over.- Nancy S, Glenview, IL, 1120-H Basics Course
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