Buying a unit in a condominium development is a huge commitment, especially for a first-time buyer. Far too much has been written in the media about the evils of condominium projects and the regimented, oppressive rules owners must abide by - rules that are clearly unreasonable to enforce on any human being. The condominium management team (the manager and board of directors) are generally depicted in very unflattering terms, with words like "Nazi" and "Gestapo" routinely being inserted into the story. In contrast, the individual condominium owner is generally depicted as a helpless victim.
While we understand that there may be a few instances where these kinds of situations may occur, industry surveys indicate that they are definitely not the norm. When a homeowner ends up facing difficulty with association management, the situation more often is that the homeowner violated some rules - the very rules that he or she agreed to abide by when purchasing a unit. Occasionally the unit owner is aware of the rules but for whatever reason thinks that they don't apply to him or her. More often, homeowners have never actually read the rules and think they can do whatever they want. After all, since they bought a "home", they can act as they please in their own home.
It is important to ask why the homeowner wasn’t made aware of the rules. While there are several possible answers to that question, the most common one is that the homeowner did not educate himself about what he was buying before he purchased. The condominium lifestyle is not for everyone. A wise prospective buyer will first take some time to understand the general framework of condominium ownership, then perform some research about the specific condominium development in which the desired unit exists.
Condominiums often appeal to homebuyers because of pricing, location, common amenities, or lack of an upkeep requirement. For some, the ability to just lock the door and leave on a trip without having to worry about the "house" while they're gone is attractive. But these factors are just the most visible ones- though unfortunately for many people, they are the only ones considered.
What other issues should a prospective buyer be considering? The list below provides a starting point, though there are likely even more items to consider. Even prospective buyers who are experienced in the condominium lifestyle could save money and/or frustration by taking the time to review some facts regarding a particular condominium before submitting an offer. The three areas of consideration are Governance, Finances, and Community.
Governance
The prospective buyer should obtain and read the governing documents of the association, and inquire about management and the board of directors.
Finances
Community
As a prospective buyer, you should perform a brief "walk the project" and attempt to meet your potential future neighbors. Ask them what they like about living in the Association. Ask them what they don't like. Is the enforcement of rules too stringent? Are there too many renters or rowdy neighbors?
It is this last step that is often the most important, as a friendly neighborhood is what builds "community." Even if all the governance and financial indicators are positive, this still may not be the right place for you if you get a negative vibe on the issue of "community".
Below is a look at two different aspects of association capital gains and losses that our firm has had to deal with this tax season. The concepts are interesting primarily because their tax answers are so different from what our association clients expected. Also, our clients had to do some homework before we could determine the answers.
Have you ever lost money on an investment when the market moved against you? Investment losses – nobody wants them. But when this happened recently to several associations, they told us that at least they could deduct those losses - right? Wrong! The rules for capital gains and losses for associations are different from those that apply to individuals.
On a slightly different topic, it can be easy to think it’s really a simple question when your association has a capital gain on the sale of property – but that’s only if you know the answers to these questions:
We have worked with several associations already this year that have incurred capital losses on their investment activities. In each case, the associations had invested in interest rate-sensitive investment vehicles, particularly U.S. treasury bonds. Interest rates on treasury bonds have been at the lowest point ever in recent years, but have recently experienced some significant (percentage) rate increases. When this caused the value of existing low-interest bonds to plummet, these associations panicked and sold the bonds to avoid further losses. By doing so, they incurred capital losses.
Capital losses are a significant problem for associations, as they are not treated like any other form of income or expense. For corporations, the rule is that capital losses may not be used to offset other regular income, but can only be used to offset other capital gains. What this means is that an Association with a $10,000 capital loss from investment activities may generally not be able to use this loss on its tax return. The loss must be carried back three years and may be carried forward for a period of five years, but may only be used to offset past or future capital gains. For most associations, this means it is lost forever.
Moving on to capital gains, another association recently posed a question regarding a significant capital gain from the sale of common area property. Their take on the matter was that since they consider themselves to be a nonprofit organization, they should not have to pay any tax on the gain resulting from the sale of this property. They also considered it to be such a simple matter that they were going to have the association treasurer just show no gain on the Form 1120-H tax return. For this association, taxes had always been such a simple matter that they had always prepared their own tax return. This year, since they had this sale of common area property, they thought they should at least ask the question. As soon as we started asking them questions about the gain, however, they realized they were in way over their head on this one.
Before an association can properly reflect a capital gain on its tax return, its board of directors need to know the answers to the following questions:
Who is the taxpayer? While that may seem like a dumb question with an obvious answer, it's amazing how many people can't answer the question. If the Association is a planned development that holds title to its common area property and is selling a parcel of property to which it has title, then the answer is simple: the Association is the taxpayer. If, however, the Association is a condominium association, which generally does not hold title to its common area property, then it becomes a more complex question.
If it is determined that the Association is the titleholder of the property, then the Association is the taxpayer.
However, in the more common circumstance where the Association is simply acting as the agent for the members of the Association, then the members of the Association are the taxpayers, not the Association. If you have determined that the members of the condominium association are in fact the titleholder to the property, you are then led to the remaining questions two, three, and four above.
Tax Basis. Assuming the Association is a planned development, or a condominium association in which it is determined that the Association itself is the titleholder of record, this is a taxable transaction that must be recognized on the Association tax return. That makes the tax basis very important. There are generally only three possibilities for determining tax basis:
For a condominium association that does not hold title to the property sold, the members are the taxpayers, so this sale is NOT reported on the Association tax return. Because the Association acted as an agent for the members in facilitating the sale, however, it does have an obligation to disclose to its members the information THEY may need to report. Each member-owner is going to have a different tax basis. The Association will never know this information.
Complete or partial sale. If the sale of a common area parcel does not completely terminate the members’ interest in the Association, then it is a partial sale. In the case of a partial sale, the rule is that any net proceeds received from the sale first reduce tax basis, then are recognized as capital gains to the extent that sales proceeds exceed the tax basis (Revenue Ruling 81–152). The Association generally should be able to determine if the transaction is a complete or partial sale as it affects members.
What did you do with the money? This becomes a critical question when there is a partial sale, as the overriding assumption is that the sales proceeds will represent a reduction in basis to the members. It is not uncommon, however, for the Association to retain the proceeds to either shore up the operating budget or apply toward specific capital reserve projects. The tax treatment for the individual members depends on how the Association uses that money. There are generally three possible uses of sales proceeds:
Proceeds are distributed prorated to the members.
Proceeds are retained by the Association to be used in the operating budget.
Proceeds are retained by the Association to be used for capital reserve projects.
If the money is either refunded to the members or is held by the Association and expended for operating budget purposes, then to that extent the members will have a reduction in tax basis for their distributable share, even if they did not receive the money.
If instead the money was retained by the Association for capital reserve projects, this represents an increase in tax basis for each individual member. What that means is that if the full amount was used for capital reserve projects, there is no net tax impact to the individual members, as the sales proceeds which reduce basis are offset by the reserve contribution which increases tax basis.
Notice to members. If the Association is the taxpayer, there is no need for disclosure to members. But if the Association is a condominium project that does not hold title and is not reporting the sale, then the Association has the obligation of notification and disclosure toward the members, no matter how the proceeds are used. A word of caution: the Association should not be in the business of dispensing tax advice to its members. Our standard recommendation in this instance is that the Association should notify its members in writing that the sale has occurred, disclose the gross proceeds received, and inform how the proceeds were used. In our clients’ situations, since we are generally involved as the tax advisor at this point, we suggest that the notice to members also states that the Association's accountant believes that this is a possible taxable event for each member, and that they should contact their own tax advisors to determine appropriate tax treatment. The notice could describe the basis issues above.
As you can see, what can seem like a very simple little question regarding the sale of the property is, in fact, a very complex tax issue that generally requires a seasoned tax professional to review and understand its possible tax impact to the Association. This is generally not the type of an issue that a board treasurer filing a tax return on behalf of the Association should handle himself or herself.
Most managers tend to know a little bit about a lot of things, and may even be experts in a few aspects other than Association management. But there are generally large gaps in other areas of their knowledge. As a result, managers often rely on various service providers to provide expertise for the Association that they are lacking. This certainly doesn’t minimize the manager’s role; it enhances it. The manager still retains overall authority, pulls projects together, and communicates results back to the board of directors who are ultimately responsible.
The Association’s service providers are actually a critical element in the overall success of the Association. The industry has quietly begun recognizing this over the last few years and has modified terminology accordingly. While the term “vendor” is still used frequently, the term “business partner” is becoming a more commonly used term. The Community Associations Institute (CAI) has taken the lead in this effort by creating a Business Partners Council as part of the management structure of CAI. That action has caused many in the industry to reevaluate how “vendors” are treated.
The term “business partner” is more appropriate. The term "vendor" simply implies one who sells to the Association, without recognizing the added value that a business partner can bring to the table. In contrast, the term "business partner" conveys the added value that service providers can offer, and infers to managers and service providers that “vendors” are not simply disposable objects, but are also valuable resources that can help improve the entire management effort. Association management has grown more complex over the years, and the constant development of new methods and materials channels the manager towards collaborative relationships with what were formerly just “vendors.” Service providers are partners in creating excellence in community management service to their mutual Association clients.
Below are some suggested guidelines for “getting the best” out of your business partners:
Respect the business partner’s time - Just like managers, business partners are busy. They don’t want their time wasted. Those who serve the industry are well aware that most products and services are competitively bid by associations, and accept that as the norm. But, they also don’t like to be “used.” If the manager or board has effectively already made a selection, then the bid process just becomes window shopping. Most business partners will quickly see through this type of sham, and, at an extreme, may even stop providing bids for you. The bid process takes time, and that time is wasted if the business partner does not occasionally “win” a bid. You should only ask business partners to bid jobs they actually have a fair chance of getting. Typically, the larger the job, the more effort is required in the bid process. If you “burn” a service provider with too many “no win” requests for proposal (RFP), that partner may just be too busy to help you out when you need him most. You also need to provide the business partner with complete information so he can prepare an accurate bid. You will quickly lose the trust of your business partners if you withhold information, either purposely or by simply being too busy, that would help a prospective bidder.
Respect the business partner’s knowledge - Business partners provide the manager with a path to expertise in their various disciplines. Managers should pay close attention, even if - and especially if - that business partner is giving information that the manager doesn't want to hear. When receiving surprise information, the manager shouldn’t simply dismiss the information, but rather should attempt to use it as a learning experience, recognizing that your business partner probably has more expertise than you do. If the expert advice you are receiving isn't what you were hoping to hear, ask questions and gain clarity. The wider your knowledge base, the more valuable you are to your boards and your employer. The information business partners have to impart is invaluable - if not for the problem at hand, then for the next. Rejecting a business partner's expertise is risky if you’re the manager, as it will reflect poorly on you if you’re wrong. While the board of directors can’t expect the manager to always be right, they do expect him to bring the best knowledge and expertise to bear on any given matter.
Remember that business partners underwrite industry events and education - Business partners provide the funding for almost all industry events, often spending thousands of dollars each for the opportunity to get your attention in a non-bid situation. Talk to them. Let them educate you about their products or services. While they’re engaged in a marketing activity, you are engaged in an educational activity. Business partners want you to be educated about their products and services, because they know that the more you know, the more likely you are to request a bid from them. By making you more knowledgeable and successful, they also make themselves more successful. It is this mutually beneficial relationship that brings the “partnership” concept into play.
Don't blame the partners – What? Never? I had a hard time trying to figure out how to phrase that. The fact is, some business partners, even very good ones, will occasionally make mistakes. In those cases, they may deserve blame. But the point I’m really trying to get at here is something I’ve seen too many times, unfortunately, where the business partner is blamed (“thrown under the bus” is the current terminology) for bad outcomes that are completely beyond their control - or even worse, to deflect blame from the person actually responsible. Sometimes, that person has been the manager. (A couple of stories below illustrate this point.) Chances are, most managers have done this - maybe not knowingly, but it does happen. Don’t ever deflect blame by pointing towards the business partner. Your temporary benefit will likely be short-lived, and the potential long-term damage to yourself is much larger than any temporary gain. Once this type of deception is discovered, your credibility will suffer. This industry is still so small that word gets around.
Story # 1 – This was told to me by a CPA that I have used in the past. The manager called the CPA to say he needed the audit report for a board meeting that night. The CPA responded that the manager had still not provided the final information that would allow the CPA to complete the audit, and reminded him of the two emails requesting information to which the manager had never responded. The manager stated that he would just inform the board of directors that he had requested the audit report from the CPA (and he had), and that the CPA said he didn’t have it completed (which was true), and that it was the CPA’s fault that the manager couldn’t present the draft audit report at the board meeting (which was completely false). When the CPA protested, the manager told him that he (the manager) was in charge and had the ear of the board, and he could tell them anything he wanted to. Here’s an egregious example of a purposeful act of blaming the service provider.
Story # 2 – This was related to me by a reserve study professional with whom I have worked in the past, and found to be very knowledgeable and reliable. A month after receiving the draft reserve study report for review, the manager called the reserve professional to express his extreme frustration with the reserve study report: some cost numbers were too low; he couldn’t find certain components in the report; and why didn’t the report look just like the prior report that had been prepared by someone else? This guy was loaded for bear. He had already decided that the reserve professional was wrong, and nothing was going to change his mind. In discussion, the reserve professional pointed out that certain component costs had been decreased because the manager indicated that a lesser scope of repair work was to be performed. The manager pushed back, saying the cost on one component was far too low, as he had bids for the work. The reserve professional asked why that information had not been provided if it was available. No response. Regarding the “missing” components, the reserve professional pointed to a report by location to demonstrate that the components were, in fact, included. Again, no response. Regarding report formats, the reserve professional indicated that he could provide reports in exactly the same format as the prior reserve study report, but that he felt they were not the best format to present the report. The manager said he didn’t care at that point.
The manager should have contacted the reserve professional far earlier in the review process to avoid the frustration that built up, and should not have acted in such a belligerent manner when contact was made. One can’t back down from a belligerent position without losing face, and this manager was not willing to lose face. Can this manager cause the reserve professional some damage? Yes, but he would be very unwise to do so because (1) other managers do know and respect the reserve professional, and (2) it is more likely to be perceived by knowledgeable people that the problem lies with the manager, not with the reserve professional. This is an example of an inadvertent misunderstanding where the service provider got the short end of the stick.
Business partners can work collaboratively with management to form a better team in solving problems that face community associations. They can leverage managers to make them more effective.
One of the things that all association members can agree on is that they want their Association to look nice. The common name for this is “curb appeal,” something that real estate sales agents emphasize when marketing homes for sale. In an association, the individual homeowner has little control over the curb appeal of his or her Association. By default, the maintenance task is the responsibility of the board of directors.
Landscaping is the most immediately visible area impacting curb appeal. Can you rely on your landscape service provider to accomplish this task for you? The answer is no. While that service provider is a very important part of the process, somebody needs to have overall control of the management of the maintenance process. This process involves looking through two different lenses. One lens deals with day-to-day maintenance and upkeep issues. The other lens focuses on the long-term maintenance plan of the Association, which should be reflected in its reserve study. Having the ability to see both the short-term and long-term aspects of Association maintenance is not something that can be expected of any single contractor or service provider - with the exception of your management company, which generally has a team of people involved in the management of your Association. If no management company is involved, you generally rely on an experienced on-site manager.
While it is possible that one or more board members, or the board as a group, may possess the ability to perform this task, you then have to ask the question - is this board going to be here one year from now, three years from now, five years from now? The answer is, probably not. The most common solution, then, is to hire an outside independent management company or on-site manager for the overall management of the Association, including oversight of both the short-term and long-term maintenance plan. While working with other associations, experienced managers have already dealt with most of the issues they are likely to encounter. They bring this experience into play for the benefit of your Association.
Several aspects of this truth have already been explored in other articles published in HOA Pulse. The manager is primarily beneficial to the Association in knowing:
An experienced manager will also provide on-site supervision and inspection, an important part of the Association management process. S/he can perform regular inspections of each building and property common areas, as well as evaluate on-site equipment. The goal of these activities is to provide the board of directors with enough information so that they can make repairs earlier rather than later, when the expense could be greater. Preventative maintenance is the name of the game. It is the best course of action for the board to take to both keep costs as low as possible over the long term while also keeping the curb appeal as high as possible.
One struggle that affects many associations is the fact that keeping long-term costs under control may require expenditure of more money in the short run. This seems to be a particularly difficult situation for board members who have campaigned to get elected to the board by promising to reduce costs and keep assessments low. Too many times, that short-sighted attitude results in larger overall costs in the long run.
The manager can also provide useful insight to the board regarding normal degradation of facilities which inevitably occurs over time. Because s/he has a number of business contacts, s/he knows which contractors are reliable, have good pricing, and possess the specific knowledge needed to accomplish a given task.
Because neglected short-term maintenance can lead to much larger expenses in the long-term, it is important that the current operating budget be adequate to perform the maintenance tasks that are needed. It is also critical that the reserve funding is adequate to perform the long-term maintenance tasks when necessary. Even new properties require maintenance that must be completed on a regular basis. An Association is wise to create a maintenance plan that is designed to both maintain and improve the quality of the community. It must consider both current day-to-day activities, as well as long-term major repair and replacement activities that are commonly funded in the reserve plan.
We find that too many associations are under the impression that the reserve study is in fact their maintenance plan. It should not be. The reserve study should be a reflection OF the maintenance plan that the Association has put in place.
Curb appeal is important to the satisfaction of members of the Association and often determines whether they are happy with their lifestyle or if instead they constantly complain to management and the board of directors regarding the Association. More importantly, everybody is ultimately hit in the pocketbook if an association is not well-maintained.
What does an association do when the money runs out? I hope we’re not going to find out too soon, but we are living in interesting times.
Despite government assurances that the recession is over and things are getting better, the real story on the street seems different. The most recent jobs report indicated that unemployment has dropped from 6.7% to 6.6%. While that’s being spun as an “improvement” in the economy, what it actually represents is that hundreds of thousands of workers have simply given up looking for employment, so they are no longer included in the jobless statistics. They certainly aren’t showing up in the new jobs gained. In fact, job gains aren’t even keeping up with the number of new people entering the workforce. To make matters worse, unemployment benefits, which had been extended for longer than any time in history, are also now ending for hundreds of thousands of workers.
The American economy hasn't seen anything like this in the nearly 100 years since the Great Depression of 1929. Have we really come out of the current recession, or are things simply changing from “very bad” to “less bad”? And will that be good enough? The Federal Reserve is “tapering” the quantitative easing, which is estimated to remove nearly a quarter trillion dollars from the economy in 2014. The Fed has acknowledged that the “taper” will hurt job growth. What will happen? The fact is, nobody knows for sure, and while nobody can predict what’s next, it appears that we’re in for several more years of financial uncertainty.
Let’s return to the question posed above. What does an association do when the money runs out? Homeowners’ associations can also face a time of financial uncertainty. Many associations have entered a period when the available cash pool is drying up. The reasons are many: foreclosures, job layoffs, developer bankruptcy, or owners simply deciding to conserve their cash for personal needs rather than paying assessments. The reason doesn't matter; the result is the same: fewer assessments being collected, and less cash in the association's bank accounts.
Association assessments move down the list of priorities for an owner when times are tough. The fact is that many owners see no value in continuing to pay a mortgage - much less assessments - on a condominium unit that has no equity due to the major hit that the real estate market has taken. As a result, many associations face tough collection situations. Collection actions don't work when the owner is out of work and is struggling to feed his family. You can't garnish wages that don't exist. Recording a lien and foreclosing is difficult when the lender has a senior lien and there is no equity in the property. Small claims court may get you a judgment, but it is of little value if there are no assets to attach.
So what does the association do when the money runs out? If there’s not enough money to pay all of the association’s expenses; and you can’t get any more from assessments; and you can’t borrow any more from reserves; and you can’t borrow from a bank; then it's time to prioritize expenses. Who does the association pay? Who does it not pay? Imagine discussing that in your next board meeting.
When considering priorities, you may have to (for the first time) ask the question of what is the most important obligation of the homeowners’ association. The health and safety of the owners should be top priority. Here is a list of typical expenses that should have very high priority:
The next tier of expenses to be paid would include management services and accounting services.
Other operating expenses and contributions to reserves come next.
What expenses should be last in terms of priority - or better yet, what services should be postponed or cancelled, at least for the short-term? How about closing down the pool? That saves money on gas for the heater, electricity for the pump, and water for the pool. Reducing frequency of landscape services is another short-term option. Postponing or cancelling window washing is another possibility. Cable TV service for the clubhouse is another expense that is a convenience, but since it does not promote health or safety for members, it can be eliminated. Lastly, consider postponing any repairs that do not promote health or safety for the members - but be cautious of postponing any repairs that might result in much larger long-term costs.
Most directors have never had to face a situation like this - and should they ever, feedback from those members that are still paying assessments is likely to be very loud and very negative. If you do find yourself in these circumstances, you should communicate with all members, share your decisions and reasoning, and perhaps even ask for other suggestions.
Before taking any of the above actions, consult with your manager (assuming he or she is not the one that first brought this matter to your attention). Consider consulting with your accountant, as he/she is the financial expert. Contact your reserve professional to recast the reserve study funding plan to shift dollars away from immediate years to future years ( a short-term solution only). Most importantly, consult with association legal counsel to make sure your actions are in compliance with both statutes and the association’s governing documents.
Worst-case scenario? Well, it could be worse - bankruptcy of the association is the next step.
It’s that time of year again -tax time. Sometimes we CPAs wonder if associations never think of taxes at all for 364 days per year, and then only think of them that one day per year when they realize, “Whoa! It's time to file taxes.”
Every year about this time, many associations reach out to ask us to prepare their income tax returns. Many times, the contact is from a new treasurer of an Association who, upon accepting the job, discovered that the prior treasurer had prepared tax returns for the Association, but has no interest in assuming that responsibility. Other times, it is because an individual or board read something online or heard something from another person that makes them think that there may be more to this Association tax return issue than previously thought.
For whatever the reason, we get the call. With virtually every contact we get, the first question asked is, “Should the Association be filing Form 1120 or Form 1120-H?” While that's always a good question, the answer is actually, “It depends.” The answer varies depending upon the unique situation for each Association.
For the majority of associations, interest income is the only taxable income that the Association must report. Given the current economic situation offering the lowest historical interest rates of the last century, the decision of which tax form to file becomes a little easier. Form 1120-H is currently the best choice for many associations.
Let's review the basics of association tax forms again quickly.
Form 1120-H was designed specifically for homeowners associations and can only be used by residential homeowners associations that meet certain qualifying tests. The primary qualifying tests are:
There are additional tests that apply for determining residential use, but those additional tests apply to a very small subset of associations, generally condominium associations located in resort areas where there are short-term rental programs in place that may disqualify a project from meeting the residential test.
Form 1120-H is a very safe form for the Association to file, as it has virtually no tax risk if the Association meets the qualifications to use this form. One of the biggest benefits of Form 1120-H is that any exempt function net income is automatically excluded from taxable income. That means only the net non-exempt income( normally interest income less any related deductions) is included in taxable income.
People tend to consider the biggest negative factor on Form 1120-H to be that taxable income is subject to a flat tax rate of 30%.
Form 1120 was NOT designed specifically for homeowners associations. It is the tax form used by all taxable corporations that do not qualify for, or are not required to file, another tax form. An analogy we’ve used many times in the past is that using Form 1120 for an association is the equivalent of trying to shove a square peg (your Association) into a round hole (Form 1120). It's not a good fit. You have to jump through a lot of hoops in order to do this safely. In essence, jumping through those hoops is trying to “shave the corners” off your square peg so that it will fit into the round hole. There are ways to do this safely, but it generally requires advance planning. In other words, it's not a decision that should be made after year-end.
This image shows the overlay of the “square peg” association over the “round hole” Form 1120. |
This image shows how the corners of the “square peg” are removed to fit into the “round hole” of Form 1120. |
Key:
118 = Code Section 118
277 = Code Section 277
263 = Code Section 263
70-604 = Revenue Ruling 70-604
These are the primary technical rules that apply in trying to make Form 1120 “safe.” Such rules should be applied only by experienced individuals.
Too many people don't look at the technical issues that can arise with Form 1120, and look only to the one single item that matters to them: the tax rate is only 15% for the first $50,000 of taxable income. Since most associations don't have $50,000 of taxable income, their tax rate is 15%, which makes Form 1120 about twice as attractive as Form 1120-H with its 30% tax rate.
Many people are either not aware of or ignore the many technical issues that exist with Form 1120, so they do not appreciate the tax risk associated with this tax form. Please take a look at the Form 1120 checklist on our website to appreciate all the technical requirements that your Association would need to meet in order to safely file this tax form.
IRS no longer publishes statistics regarding how many homeowners associations file Form 1120-H versus those that file Form 1120. However, in the last year that such statistics were published, it was noted that approximately 75% of homeowners associations filed Form 1120-H, and only 25% filed Form 1120. Informal surveys taken by the Community Associations Institute’s (CAI) accountants’ committee (in which we have participated for many years) show the statistics to be almost exactly reversed – for associations represented by accountants who are very active in CAI, approximately 75% file Form 1120 versus only 25% filing Form 1120-H. The implication is that the accountants who participate actively in CAI are more likely to have the appropriate level of knowledge to guide their Association clients to safely file Form 1120.
Still, Form 1120 carries considerably more inherent tax risk than Form 1120-H. At Association Tax Services, LLC, our tax manager, Gary Porter CPA, has consulted with or represented associations in more than 50 IRS tax audits. In all but one of these cases, Mr. Porter was not the CPA who prepared the tax return. Rather, he was called in to consult either by the Association or preparer of the tax return, or by the tax attorney representing the Association in the IRS audit. Mr. Porter’s expertise is well-known, having authored dozens of articles written on various aspects of homeowners association taxation. As he has stated, of 50 Association IRS audits, one was performed on a Form 990, two were on a Form 1120-H, and the rest were on a Form 1120. Even more important is the fact that, of the associations that filed Form 1120 and were audited, the audit resulted in a negative tax consequence 100% of the time, meaning the Association paid more tax. In virtually every one of those cases, had the Association filed Form 1120-H, they would have paid less tax once the results of the IRS audits were completed.
At Association Tax Services, we continually recommend Form 1120-H for most of our Association clients because it eliminates tax risk. We do not universally recommend Form 1120-H, as there are certain circumstances where Form 1120 is clearly more appropriate. However, the bottom line for most associations is that there has never been a better time to file Form 1120-H than right now. The reason is because interest rates are so low that there is generally little difference between the tax you would pay on Form 1120 and the tax you would pay on Form 1120-H. Therefore, our recommendation is to go with the safer form, Form 1120-H.
We hear too many stories about the (awful) board meetings that occur in associations. We know that this is not the norm, as not all board meetings are awful. Those are simply the ones we hear about. Just like the mainstream media, it’s only news if it's bad. When it comes to HOA meetings, whether a meeting is considered good or bad may depend on who’s telling the story. Those that complain probably have a bias about either the board or the Association in general, or about a specific issue that they don’t feel is being properly addressed.
The fact is that board members often have to make unpopular decisions, and emotions can run high over controversial issues. However, board members also make a number of more mundane, but still important, decisions. These decisions generally revolve around Association finances and common area maintenance. The topics of rules and regulations tend to be much more emotional.
There are two things that an Association can do to make sure board meetings are effective and have a minimum amount of conflict: (1) give members the opportunity to voice their concerns, and (2) make sure that each meeting runs as efficiently as possible.
Providing members the opportunity to talk is normally done through an open forum process where members are given a few moments to speak. It should be made clear to these individuals that the board is simply listening to and receiving information from them, as the board should not be able to make any decisions on any issue unless it is an agenda item. It is in this open forum process where emotions can get out of control. To maintain order, the board should establish written rules that are emphasized as the open forum session begins. An example might be that each member is allowed to speak for five minutes on a subject, and is not to be interrupted during that time, nor is the board allowed to comment on the member’s discussion. However, it may be wise to allow the board to question the member just for purposes of clarification.
Maintaining efficiency in the meeting requires advance planning and attention to the agenda and meeting protocols to keep the meeting on track. There are three things that are generally mentioned as keys to holding an effective and efficient board meeting: (1) preparation, (2) a good agenda, and (3) useful minutes.
The Manager’s Job
By: Chuck Miller
I was asked once about the skills that are required to be a manager of a community association. The young man questioning me was considering the possibility of a manager position among options as he tried to forge a career for himself.
From my own years in HOA and condo association management, I learned that it takes a variety of skills to make a good association manager. A manager must interact with a variety of people who have different needs and wants, and must deliver positive results in a very timely fashion, executed with a smile and accomplished on budget. The managerial position also requires good organizational abilities, personal attentiveness, and a variety of property management skills.
When looked at from this perspective, it becomes apparent that the association manager position is really several jobs in one. Below is a list of some essential skills that go into making a good HOA manager.
Communication Specialist
The association management business is not really about "property management" as much as it is about "people management." By this, I don’t intend to imply that people need to be managed, but that the job of manager is more about interacting with people and solving problems than anything. This role can involve supervising staff, leading by example, acting as advisor to the Board of Directors, etc. A good manager must be able to communicate and work with people of all shapes, sizes, and backgrounds. Some boards of directors have a “hands off” approach, while others are very involved - perhaps sometimes too involved. When the contractors and homeowners are added in as well, the result is that you’ll be dealing with many different people - some friendly and some not so friendly. A good manager will find that right mix of communication based on experience and working with their audience over time. The better the communication is between the manager and the board of directors, the more secure they will feel with you as their community manager – and the easier your job will be!
Consultant / Advisor
Consulting with and advising the Board of Directors is an important aspect of being a good community manager. I have observed managers who simply take orders from their Board as opposed to advising the Board about the appropriate course of action. This can happen for several reasons. The manager could be just taking the path of least resistance, or perhaps interpreting what the board wants or needs as the correct answer. The board of directors could also be a group of “Type A” personalities who believe they have all the right answers. An experienced manager shouldn’t be afraid to speak up if he sees the community headed towards a bad decision. In fact, it would be a mistake to not speak up and simply watch an association make mistakes that could be prevented. There is a fine balance between acting as an advisor as you assist a community versus trying to completely calling the shots yourself.
Accountant
An association manager should have a good understanding of the financial basics of the association. He should be aware of the standard monthly, quarterly, or annual cash inflows and outflows for an association. Knowing these basics is important when creating the annual budget for the association. In fact, without basic accounting and financial knowledge, it is difficult to plan for maintenance and other projects. The most important question that every HOA manager faces is, "Where does our money go?" A good manager needs to be prepared to answer this question.
Contractor
While an association manager does not need to have a contractor license to be a manager, he does need to be familiar with contractors and how they operate. This means knowing a few key things to help projects progress smoothly. Your contractors, just like you, are professionals in their line of work. They deserve to be compensated for their time when they assist you. At the same time, the more you know about routine repair and replacement projects that are common to associations, the better off you will be as a manager. By having an understanding of approximate costs of small projects and the time frames that are associated with completing them, you will be able to better coordinate completion of the jobs with minimum disruption to association members, as well as understand jobs specifications and project bids.
Negotiator
Negotiation skills are something you expect an agent or lawyer to have, but good negotiation skills are also very helpful for an association manager. Because the manager has to answer to many people with different agendas, being able to negotiate and mediate different issues is very important. Whether it is negotiating a better price from a contractor, solving a neighbor vs. neighbor dispute, or pleasing the different personalities on your board of directors, the ability to be a problem solver is invaluable. Unfortunately, it is not possible to please everyone. The job of the association management professional is simply to please as many people as possible, while still upholding the responsibilities for which you were hired: maintaining and improving property values, and managing the community with efficiency, while still acting within the constraints of state laws.
It takes a variety of skills to make a good association manager. Not all managers are the same, nor should they be. In fact, many managers have skills in addition to those listed above, which just adds to their overall value as an association manager.
Our firm was recently contacted by a condominium association that requested us to perform a reserve study for their small California community of 20 units. The Association was approximately 28 years old and had never conducted a prior reserve study, even though a reserve study is required by law in California.
The board member who contacted us stated that while the Board didn't feel that the Association needed a reserve study, they had agreed to have one performed to satisfy one of their members. This member was trying to sell his unit, and the prospective buyer was demanding to know the status of the Association’s reserves before he would commit to the purchase. Because this member was quoting California statutes and threatening legal action against the Association for failure to conduct a reserve study, the Board decided it would be easier to just have a reserve study prepared rather than fight this issue. Though this was a good decision, it was a little late- - and it didn’t erase the bad decision of never having had a reserve study prepared to begin with.
The board member stated that the Board didn't place much value on the reserve study and was not willing to pay much money for it. He further stated that because the Association was following FHA guidelines by setting aside 10% of its assessments into a reserve fund, the Association was complying with necessary requirements and was adequately funded.
We finally negotiated a reasonable fee to prepare the reserve study. (It was a reasonable fee simply because the Association was so small). As the reserve study report came together, it became clear to all concerned that the Association was seriously underfunded. This was the result of a failure to fund reserves in the early years, and the fact that several major components were now nearing the end of their useful life and would require replacement in the relatively near future. Although that “near future” was still several years away, the fact that adequate funding had not previously been made left the Association in an underfunded position.
The funding plan we constructed as an initial draft kept the same 10% funding that the Association was already making for the first year. We did this for two reasons: (1) the Association had requested us to keep the same funding, and (2) we wanted to demonstrate how clearly inadequate that funding level was. The result was that within five years, a significant special assessment was going to be necessary to replace the roof.
Once they had seen the initial draft of the report, the entire board of directors became involved in the process as they protested our recommendation of a special assessment. We simply asked them how they intended to raise the money to replace the roof if (a) they wanted to maintain a reserve assessment at the 10% level of total assessments, and (b) they didn't want to have a special assessment. Obviously, there was no answer to this question.
We then entered into a conversation regarding funding theories for reserves. Using several models, we demonstrated to them why it was necessary to project future expenditures as opposed to simply relying upon the rule of thumb of setting aside 10% of the assessments. We showed them examples of association funding plans where 10% was clearly less than adequate (just as in their own case), and also examples where 10% of assessments as a funding plan resulted in the overfunding of reserves. They ultimately decided upon an increase in monthly assessments, and started preparations for the future special assessment for roofing. Under California law, notice of that planned, future special assessment became an annual budgetary disclosure.
The fact is, using a flat percentage of assessments just doesn't work as a reserve funding model. FHA funding requirements notwithstanding, an association must project future expenditures to determine an appropriate funding level. No two associations are the same; therefore, no two funding plans are necessarily the same, and no flat percentage number will work for all associations.
One of the facts of life about being a manager is that you get to observe the behavior of lots of people. Not spying, just noticing what goes on around you. Conflict is inevitable in a community association. My interest is in observing how different people react to conflict.
Living in a condominium project means that people live closer together than they do in single-family detached housing. Diverse individuals living in relatively close proximity can create the perfect atmosphere for conflict unless everyone tries to work together. Everyone has expectations about almost everything in their lives. We have expectations about how our family, friends, and neighbors should behave. When they don’t act in the manner expected, people often react by falling into a state of anger. Expectations aren’t limited just to people we know, but also extend to most of those with whom we come into contact or depend upon. We have an expectation that our leaders should make decisions that we believe to be right.
Road rage is often the result of failure to meet expectations. We expect the drivers of other vehicles to obey the rules of the road. Their failure to meet those expectations causes some people react with anger. Many times, what we expect of others is a reflection of what we expect of ourselves.
For most people, anger is not an emotion that feels good. It’s a negative emotion that disrupts your daily flow and brings out the worst parts of your personality. Anger generally makes people more aggressive and limits how they think about and treat others. It is usually directed outward towards someone else and creates distance between people. You isolate the party to whom your anger is directed, but, more importantly, you isolate yourself. Anger becomes a prison that keeps people from making better choices that reflect understanding, compassion, and caring. Those are attributes that contribute to your own happiness and the happiness of those around you.
One way to avoid anger is to transform your habit of expectations. That doesn’t mean that you allow people to walk all over you. It means you change what you expect of others. You understand that people can’t read each other’s mind, and their reasons for doing what they do usually have nothing to do with you.
Your neighbor didn’t take your assigned parking spot to make you angry; she did so because she couldn’t carry her groceries the longer distance from her own parking spot. Your neighbor didn’t let his dog poop on the lawn in front of your unit to make you angry; he did so because he hasn’t read or understood your Association’s rules. Changing your expectations to better understand other people’s positions will do a lot to disarm your anger.
If your neighbor behaves in a manner that fails to meet your expectations and makes you angry, the only way you are going to resolve the problem is by choosing to make an honest effort to remedy the situation “together” with your neighbor, not by creating an even wider distance between yourself and them through anger. Effective communication can only occur when there is a process of two-way listening. Anger prevents people from honestly listening to anything but your anger. Transforming your expectations reduces your opportunities to get angry, and puts you in a position to make better choices about how you relate to the people around you - and in turn, how they relate to you. When people work together, anything is possible!
This article shared with permission by Association Tax Services
We recently received an inquiry from a board member of an association referencing an article in one of our newsletters from three years ago - the January 2011 issue.
That article concerned IRS Notice 2011-6 (issued in December 2010) that exempted management companies from what were at the time paid tax preparer requirements related to Form 1099. The poorly drafted regulations would have defined any person that prepared a Form 1099 for compensation as a paid tax preparer. Those regulations were created as a result of an IRS study in 2010 that identified significant problems with tax returns prepared by individuals that were not professional tax preparers (meaning they were not attorneys, CPAs, or enrolled agents). The root problem was not who was preparing the forms, however. Rather, the problem was in defining Form 1099 as a tax return. Fortunately, IRS Notice 2011-6 corrected that folly by redefining Form 1099 as not being considered a “tax return.”
What triggered the current question was that the board member became concerned when he was elected to the board of his Association and discovered that an employee of the management company was preparing the tax return for his Association. Upon questioning the management company, he learned that this individual also prepared tax returns for most of the associations managed by that company. This board member had also just learned in a general discussion with his own CPA that ALL paid tax preparers are required to be registered with the IRS.
The specific question to us was whether or not the management company, or the employee of the management company, was required to be registered as a tax preparer with the IRS. The short answer is yes! Because the management company receives compensation for the services it performs, if those services also include preparation of association income tax returns, then the preparer of those returns (the employee) is considered to be a paid tax preparer.
The authority for this is found in Internal Revenue Code (IRC) Section 7701.
7701 Definitions.
(a) When used in this title, where not otherwise distinctly expressed or manifestly incompatible with the intent thereof—
(36) Tax return preparer.
(A) In general. The term “tax return preparer” means any person who prepares for compensation, or who employs one or more persons to prepare for compensation, any return of tax imposed by this title or any claim for refund of tax imposed by this title. For purposes of the preceding sentence, the preparation of a substantial portion of a return or claim for refund shall be treated as if it were the preparation of such return or claim for refund.
(B) Exceptions. A person shall not be an “ tax return preparer” merely because such person—(i) furnishes typing, reproducing, or other mechanical assistance, (ii) prepares a return or claim for refund of the employer (or of an officer or employee of the employer) by whom he is regularly and continuously employed, (iii) prepares as a fiduciary a return or claim for refund for any person, or (iv) prepares a claim for refund for a taxpayer in response to any notice of deficiency issued to such taxpayer or in response to any waiver of restriction after the commencement of an audit of such taxpayer or another taxpayer if a determination in such audit of such other taxpayer directly or indirectly affects the tax liability of such taxpayer.
Treasury Decision 9527, issued June 6, 2011, announced Final Regulations for IRC Section 7701 that became effective August 2, 2011. Those Regulations established the requirement for all tax preparers to register with the IRS for a Preparer Tax Identification Number (PTIN). For all paid preparers that are not subject to the continuing education requirements applicable to attorneys, CPAs, or enrolled agents, the Regulations also established education requirements for tax preparers.
Tax preparers must register annually with the IRS, and pay a fee to renew their PTIN. All PTINs expire on December 31 each year. Failure to re-register annually would prevent an individual from legally preparing tax returns.
So, after all that explanation, our answer to the inquiring board member is to find out if the management company employee is a registered tax preparer. If not, insist that your Association’s income tax returns be prepared by an outside registered tax preparer, preferably one experienced in the preparation of association tax returns. Many people are lulled into a sense of complacency by the belief that association income taxes are very simple. That’s a mistaken impression given by the one-page Form 1120-H. In fact, association income taxes can be very complex. An experienced tax preparer will understand the complexity of the tax law and be able to offer advice on the best way to file to minimize both taxes and tax risk.
We put this story together by interviewing two of the people that were involved in the process. Though it actually occurred more than 20 years ago, it could have happened yesterday, or it could happen tomorrow. It is really a heartbreaking story of sorts. There were half a dozen associations involved, and while it is a board’s responsibility to protect Association assets, only one took that responsibility seriously. As a result, only one avoided the fraud.
The situation existed because the owner of a management company needed money. Motive and opportunity are two of the cornerstones of fraud, and both were present in this particular case.
Motive - Why did the manager need money? Because her daughter had contracted cancer and without expensive medical treatment, would probably die. And of course the young lady was uninsured.
Opportunity - The manager performed all accounting services for her association clients. She collected and deposited funds, wrote checks, and prepared bank reconciliations and monthly financial statements. The manager did insist that the board sign all checks “for the safety of the Association.” Because of this one fact, the associations thought they were safe.
If the board members signed all checks, how was the manager able to divert Association funds for her own personal use? The answer is a simple scam. Each time a new board was elected, the manager would make sure that new signature cards were prepared for the bank, and that those signature cards included only the signatures of board members. The manager would later obtain a second signature card from the bank, stating that the first one had been lost, and would place only her own signature on that second signature card. Only this second signature card was actually presented to the bank. The manager would dutifully have a board member sign all regular operating and reserve checks every month. To keep the scam alive and to make sure that the bank was properly recognizing checks drawn on the Association accounts, the manager would add her own signature above the board member’s signature after she had received the signed checks back from the board members. She also controlled the mailing of all checks.
The bank didn't have a problem with this because every check contained the proper signature, the manager’s signature. What the manager didn't tell the board was that she was writing additional checks made out to her company that contained only her signature. These checks were disguised in the accounting records by assigning these checks to various different accounts and using the names of actual vendors to hide the fact that the checks were in fact made out to the management company. As an example, some of the checks might have been coded as landscape extras and contained the landscape company’s name. Others might have been charged to repair or reserve general ledger accounts and would bear the name of the appropriate contractor for those activities.
If the board members didn't question too closely, these bogus checks would appear to be appropriate expenditures. Further, none of the checks individually were large enough to cause alarm. The manager also insisted that no audit or review of the financial statements was necessary since the accounting was so transparent and those services were too costly. As a result, there was never anyone to double-check the work of the manager and review the appropriateness of the underlying transactions.
There were several ways that this fraud could easily have been stopped:
Unfortunately, most of the associations had board members that were either apathetic, did not understand their duties and responsibilities, or did not possess the skills necessary to review and analyze the financial records. Only one Association escaped this fraud. They did it simply by having a strong treasurer who demanded monthly financial statements and bank reconciliations along with bank statements, and he looked at them every single month. The manager took no funds from this Association, for she could not have done so without being discovered.
This manager was able to steal approximately $160,000 over a two-year period. Upon discovery, she admitted to the scheme and provided details. All of the monies stolen were in fact used for her daughter's medical bills, and none were used to benefit the manager personally. That is what makes this such a heart-wrenching story. The manager ultimately was sent to prison for her crime.
One Association that suffered a relatively small loss at the hands of this manager did make a claim against their insurance company for the funds stolen under the terms of their crimes policy. The insurance agent had already been in contact with the insurance company and notified the Association that the insurance company was denying the claim. Their reasoning was that the Association had made certain representations in their insurance application regarding their practices and procedures to protect Association funds, which included reviewing financial statements and bank reconciliations and signing checks. As the insurance company pointed out, the Association had failed to perform its duties; therefore, the insurance company would not be liable for the loss. The Association’s attorney advised the insurance agent that if the insurance company would not pay under the crime policy, then a claim would be made under the board errors and omissions policy. As he said, “One way or the other, you will pay, or it will be a bad faith claim.” The insurance company paid the claim.
There are probably dozens or even hundreds of such stories similar to this one throughout the industry. This one was particularly touching simply because of the motive of the person stealing the Association funds. From the Association’s perspective, however, the lesson to be learned is that the Board of Directors needs to do its job to make sure the Association funds are safeguarded.
Almost every manager experiences difficulties with Association members at some point in time, but board members can also catch their share of grief. Governing a homeowners’ association can be challenging. Though there are many personalities and attitudes to deal with, former board members who become argumentative and angry represent a special group, especially if they lose a contested election to someone holding an opposing view. Because of their former leadership role on the board, they can often develop a following of members. If they are particularly vocal in their disagreement, they can become disruptive to Association operations. Occasionally, some people even go a step further, carrying out completely inappropriate actions, such as sending wrathful emails or spreading untrue rumors.
An instance several years ago demonstrated to me how bad it can get. One board member was very insistent that, because the board had made a tax election to “roll over” excess income to the following year, the board was “required by (tax) law” to refund that excess to the members immediately. Another board member joined him in this interpretation. The board consulted with their CPA, who stated that there was no such requirement. But why let facts get in the way? Still upset that he had lost a contested election, he became even more vocal as a former board member.
Inappropriate activities followed, including sending accusatory emails to board members, spreading false rumors, disrupting board meetings, harassing professionals hired by the Association, establishing an “anti-Association” website which included statements taken out of context (partial sentences grabbed from his opponents that were reconstructed to indicate the exact opposite of what was said), and even making complaints of fraud to the police department and IRS. This continued for months because, although every professional consulted with disagreed with this former board member, he refused to accept any position other than the one he had staked out. The complaint to the IRS actually resulted in an IRS audit that cost the Association a small amount of money. The IRS audit defense costs were higher than the tax paid.
It also seemed that any member that had a complaint against the Association for any reason joined with this individual, because he was “leading the charge” against the existing board. The net result was that this individual created considerable acrimony in the Association, and ended up costing all members money because of his antics. But because he had developed a loyal following, he was actually re-elected to the board at the next election. That slowed him down, but at least he now had a voice back on the board. It was widely believed that he had made so much noise as a former board member just to keep the spotlight on himself.
That series of events caught the Association somewhat unprepared to respond to those kinds of personal attacks against board members. Although it was a little too late to make a difference in the above instance, that Association later developed a set of general guidelines for the Association and board members to follow:
Open communication with the community is important at all times, but particularly when unfounded accusations are made. The Association should always keep members informed about what is happening, or not happening, within the community. The Board is the voice of the community. They have been voted to a position of authority and leadership, and it is their job to keep members up to speed on all actions taken by the Board. Minutes of meetings must be available, and all meetings should be open. Do not do anything in secrecy unless you are discussing personnel, litigation, or contract negotiations. Always try to be as transparent as possible.
One caveat relates to the “send all” option in email communications. If you have seen the television commercial regarding the guy trying to grab everybody’s computer before they can read the email he sent after inadvertently hitting “send all,” you understand. One advantage of email communications is that email is a quick response vehicle and establishes a permanent record that, while it can be misunderstood or misconstrued, can’t be modified by a recipient to say something else entirely. One disadvantage of email communications is that email establishes a permanent record that may not be what you really wanted to say. Emotions and context aren’t communicated in email, just text. Email can be easily misconstrued. It’s best to always stop, count to ten, and then compose your email. It’s also always a good idea to have a separate email account for Association business. Keep it separate from your personal email account. Your email is discoverable in the event of litigation.
Remember that there will be homeowners with differing opinions. That’s generally a good thing, as it forces all parties to consider alternate positions that they may not have considered. Listen to the homeowners’ concerns and opinions. Consider if they can easily be resolved. Consider how many people feel an issue is important. Consider if actions are cost-effective and reasonable.
Some people can go too far. The situation described above is a clear example of someone with whom you could not reason. If a board member is a victim of libel or slander, then it’s time to consult with an attorney to discuss options. It’s even been suggested that in more extreme situations, it may be helpful to hire a mediator to assist in the communication and resolution process.
No matter how the situation arises, board members were elected to a position of leadership because people thought they could do the job. Board members should lead with patience and professionalism, and more importantly, integrity.
Reserve loan interest could become deductible under the right circumstances.
In recent years, loans have become more popular with homeowners’ associations as a means of smoothing out reserve funding plans for several reasons: (1) they avoid a huge, one-time special assessment that many members may not be able to afford; (2) they allow the Association to perform larger projects all at once when needed rather than spreading them out over years because of cash flow limitations; (3) they keep property values higher; (4) most importantly, they make more sense because newly-developed specialty industry banking services have created structured loan packages for homeowners’ associations. Unless a bank understands the industry, it probably wouldn’t know how to structure a loan within its own lending guidelines, simply because the HOA industry is so different from the commercial real estate market.
I receive frequent inquiries from board members asking how the interest expense on such loans is treated for income tax purposes on the Association’s tax return. Most people understand that real estate-related loan interest is deductible for individuals, and many know that it is also deductible for partnerships and corporations. So the question is, is HOA loan interest treated differently just because this corporation happens to be a homeowners’ association? And the answer is, maybe.
The general rule of the Internal Revenue Service (IRS) is that it is the use of funds, or the purpose of the borrowing, that determines the nature of the deduction. Personal interest expense is not deductible. For instance, the interest on your auto loan is not deductible unless the vehicle is held for business use. Applying this same concept to a loan for common area repairs in a homeowners’ association, the implied answer is that since the repairs are related to assets and are not held for business purposes, then any loan interest takes on that same characterization, and is not considered a deductible expense. That concept would apply whether the Association filed Form 1120 or Form 1120-H.
In a normal situation, the Association borrows money for specific, large projects because it does not have enough money otherwise to make the repairs. As an example, an Association may have only $100,000 in cash reserves, but needs $1,500,000 to replace roofs. The Association borrows and immediately (or at least in the very near future) spends the money it borrowed. Its $100,000 cash position is relatively unchanged, except on a very temporary basis. Given these circumstances, how is the matter treated on the tax returns?
IRC Section 528 (Form 1120-H)
If the Sec. 528 election is made, the interest on the loan to repair association property will not be deductible by the Association. The borrowed money was used to fund nondeductible personal expenses – repairs to common area residential property not held for business use. This interest is incurred with respect to repairs that would have otherwise been made from member assessments (exempt function income or capital contribution). Since these assessments would have been exempt function income, the loan presumably assumes the same status. IRC Sec. 528 (d) (1) (B) prohibits any deduction associated with exempt function income.
IRC Section 277 (Form 1120)
If the Sec. 528 election is NOT made, the Association is taxed as a regular corporation, subject to the limitations of IRC Section 277. The interest on the loan to repair association property will not be deductible by the Association. The borrowed money was used to fund nondeductible personal expenses – repairs to common area residential property not held for business use. The interest is incurred with respect to repairs that would have otherwise been made from member assessments, and the interest expense becomes part of "member deductions" (as opposed to "nonmember deductions").
But, what if the circumstances are changed slightly, as I have seen occur on several occasions? Each situation needs to be looked at closely, as, under certain circumstances, the interest expense could be deductible. The key here lies in the very assertion by IRS that it is the purpose and use of the borrowing that determines deductibility.
Assume instead that the Association had $2,000,000 in reserves rather than $100,000 in the above example. That is more than enough to pay for the roofing project, but, because those funds are earmarked for other projects, the Association still decides to borrow $1,500,000 for the roofing project. What has just happened is that the purpose for the loan has just changed. Even though the borrowed money was used to pay for the roofing project, the actual purpose of the loan was to maintain existing cash balances. In other words, this became a economic decision rather than a financing decision.
The $2,000,000 in cash balances is generating taxable interest income that would not exist had the money been used to pay for the roofing project. Consequently, the interest deduction on the reserve loan simply reduces net interest income (interest income less interest deduction) back down to where taxable interest income would have been had no loan been used for the roofing project. However, the differential between the interest rate earned by the Association versus the interest rate paid may mean that there is no net interest income at all.
This basic concept applies no matter which of the two tax forms is filed. However, IRS bias will be against allowing such a deduction, because IRS agents generally look only at the use of the borrowed money, not the underlying reason (purpose) for borrowing the money. With respect to Form 1120, the relevant citation appears to be from the now withdrawn Treasury Regulations Section 1.277-1, certain paragraphs of which are reproduced below:
1.277-1 (d)(5) Total deductions. For purposes of this section, the total deductions a membership organization may take into account are the sum of its membership deductions and nonmembership deductions.
1.277-1 (d)(6) Membership deductions. Membership deductions are the expenses, depreciation and similar items of deduction attributable to membership activities. Such items of deduction may, however, be taken into account only to the extent that such items are otherwise allowable as deductions under Chapter 1 of the Code (applied without regard to whether the activity giving rise to such items was engaged in for profit).
1.277-1 (d)(7) Nonmembership deductions. Nonmembership deductions are the expenses, depreciation and similar items allowable as deductions under Chapter 1 of the Code other than those items described in subparagraph (6) of this paragraph.
1.277-1 (d)(8) Allocation of deductions. Items of deduction attributable in part to nonmembership activities and in part to membership activities shall be allocated between the two classes of activities on a reasonable and consistently applied basis.
Several years ago I fully discussed this issue while at a meeting at the national IRS office in Washington, D.C., specifically with the Special Industries and Pass-throughs Group, which is the particular group within IRS that considers tax law for this industry. These individuals are extremely well-versed in association tax law, and are the individuals who would either write the IRS' position on such a matter in the form of a Letter Ruling or Revenue Ruling, or provide technical support for IRS lawyers in a tax litigation setting. For these reasons, I can feel comfortable with their response, even though it was informal. Their response, which is not documented in writing, was that the circumstances I set forth above would allow the interest expense to be deductible, unless the cash balances dropped below the loan balance. At that point, IRS contended, it was no longer an economic decision. So, any association contemplating taking this position must be careful to maintain reserve cash balances in excess of the loan balance for the full term of the loan.
The table below illustrates the difference in results depending on how the law is interpreted. I’m assuming an association with $1,000,000 invested earning 3% that elects to borrow $500,000 at 5% rather than lose the 3% rate it has locked in on long-term investments.
Position assuming no interest deduction allowed |
|
Position assuming interest deduction allowed |
|
Interest income |
$30,000 |
|
$30,000 |
Deductions against interest income |
(4,000) |
|
(4,000) |
Interest deduction |
0 |
|
(25,000) |
Net taxable income |
$26,000 |
|
$1,000 |
Income tax at 15% |
$3,900 |
|
$150 |
The deduction of loan interest saves $3,750 in taxes.
The above discussion is valuable because it points out two significant issues: (1) not all the tax law issues are written in stone - there is room for interpretation; and (2) not all tax practitioners agree on all issues, nor should they.
The deduction of interest expense for a homeowners’ association is an issue that, in my opinion, is not clearly delineated in existing tax law. Looking at the same citations as my colleagues, I can legitimately reach a different conclusion. The only way this issue will be finally resolved is through the issuance of guidance by the IRS or guidance from the courts (and even then, due to appeals and possible subsequent interpretations, it may not be finally resolved). As Yogi Berra said, "It ain't over 'til it's over!"