OvernightHomeowner (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-ran associations that function solely to enforce covenants and maintain the common areas of its residential members.
Although HOAs have existed in their present form since the early 1960s, the IRS was very slow to recognize their unique nature. From the IRS’s perspective, any HOA not formally approved as a 501(C) nonprofit was a business (a corporation) for tax purposes. It was not until Congress passed the Tax Reform Act of 1976 that the true nature of HOAs was formally recognized. The Tax Reform Act of 1976 created Section 528 of the Internal Revenue Code and a special carve-out for qualifying associations. It also defined HOAs for tax purposes and gave those meeting this definition the opportunity to file a new tax return, 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.
Exempt Function Income: Part of the definition set forth by code section 528 states that sixty percent or more of the organization’s annual gross income must be exempt function income for it to be considered a Homeowners Association for tax purposes. Most associations have little problem meeting these criteria. The board members of these associations, however, must understand what is and is not exempt function income to make a correct determination. They must also know how to calculate the exempt function percentage. This article will help your board members develop this understanding and correctly calculate your HOA’s exempt function income percentage.
Defining Exempt Function Income: Code Section 528 defines exemption function income as “membership dues, fees or assessments” received from the residential owner-members of the association. To qualify as exempt function income these dues, fees, and assessments must also be made to further the association’s exempt function: enforcing covenants and managing/maintaining association property. Dues, fees, and assessments should be assessed equally on all members or assessed ratably, meaning they are based on an objective factor such property value or unit/lot size.
There is an exception to this rule for the use of association property such as docks and pools. If members have the option of renting or using the facility for a year by making a special payment that payment will generally be considered exempt function income if: 1) the payment is only made once in a twelve month period, and 2) the right to use this association property extends for the twelve-month period for which the payment applies (or the period the facility is open for that year). For example, if a family has the option to pay an additional $300 per year to use the community’s pool for that year’s season that payment will be considered exempt function income.
It is important to note that exempt function income also includes interest, fines, penalties and late fees received from association members for breaking association rules or for late payment of dues and assessments. It does not include other forms of interest income such as interest earned on checking or savings accounts.
For the vast majority of HOAs, qualifying dues, fees, and assessments represent all of the income received during the year with the common exception of interest on their savings or checking accounts.
Non-Exempt Function Income: Non-exempt function income includes most money received during the year that is NOT considered exempt function income. Here’s a brief list of common non-exempt function income payments:
- Payments for services from members or non-members
- Payments from the sale of items such as at a pool snack bar
- Payments from nonmembers
- Tax-exempt interest
- Taxable interest on checking, savings, or sinking funds
- Dividends and capital gains on investments such as mutual funds
- Fees for the temporary use of facilities such as a pool or tennis court paid by members and nonmembers (think entrance fees).
- Payments for work done on non-association property including specific members’ properties.
- Payments for transportation paid by members and nonmembers
Ignored “Income:” There are several forms of payment an HOA may receive that are considered neither exempt function nor non-exempt function income when making the 60% determination. These include:
- Assessments made specifically for a current or future capital improvement (such as building a facility or paving a road). These are considering capital investments by members.
And,
- Payments received from members that are refunded or applied to a future year (such as when a member pays two years dues in advance) are not included in that year’s calculation as gross income or exempt function income. An advance payment, however, is considered exempt function income in the year to which it applies.
Calculating Exempt Function Income Percentage: Once total receipts have been segregated the exempt function income percentage can be calculated by dividing exempt function income by total gross income (taxable and nontaxable) received for the year. Gross income equals the sum of exempt function income and non-exemption function income. For example, if exempt function income is $11,000 and non-exempt function income is $2,500 gross income equals $13,500.
The exempt function income percentage is calculated by dividing exempt function income by gross income or $11,000 by $13,500. The result (quotient) is 81.4%.
Summary and Invite: We have not had time in this short article to classify every nuanced financial transaction that may occur in your HOA and there are several other criteria your HOA must meet to be considered an HOA for tax purposes. If you have specific questions regarding exempt function income this link to treasury reg 1.528-9 may help or you may wish to contact a professional.
It is important to remember that all HOAs must file a tax return each year. If your HOA is among the vast majority of HOAs that either has no non-exempt function income or whose only non-exempt function income is from interest earned on savings or checking accounts 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 HOAs 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.