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Pulse Exclusives (120)

Wednesday, 20 March 2013 17:00

Conflict of Interest Policy

An ethics policy or conflict of interest policy is a good idea for most associations. In California, this topic is also addressed in the corporations code, as indicated below.

Bottom line, association should consult with their legal counsel on this topic.

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Wednesday, 20 March 2013 17:00

Rules to Prevent Damage

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Rules to Prevent Damage

 

Does your condominium association have numerous part-time residents or vacant units? Are the owners within your community aware of preventative measures to take before they leave their unit for a vacation or extended period of time? Does your association have the documentation in place to address responsibility forpayment of the association’s insurance deductible in the event of damage?

 

Many condominiumassociations have experienced substantial damage (typically caused by water or fire) that could have been prevented if the owners were aware of measures to take to prepare their unit for a short-termor long-termvacancy. To help prevent and mitigate future damage, condominiumassociations should consider adopting a board resolution including rules such as: requirements for emergency contact information to be provided to the association, for water shut-off, for replacement of water hoses and tubing, and for owners to have unit inspections performed during a long-termvacancy   This board resolution should also include rules governing responsibility forpayment of the association’sinsurance deductible, as this requirement is often dependent on the type, extent, location and nature of the damage, as well as provisions in the association’s governing documents. It is importantfor the association to have rules in place regarding payment of its insurance deductible sothat the association is not scrambling after a loss occurs trying to figure out who is responsible for payment.

 

The language to be included in this board resolution is dependent of the specific association's governing documents.  While the board resolution will be different for each association, we are able to provide this service on a flat-fee basis.  The flat fee for a review of the association's governing documents and drafting of the board resolution itself is $450.  If purchased in conjunciton with our firm's Insurance, Maintenance and Mold Package, the cost of the board resolution is $350.  The Insurance, Maintenance and Mold Package provides a comprehensive review and analysis of the maintenance, insurance, repair and financial responsibilities relating to all major components of the condominium, and is available for a flat fee of $970.

 

If you have any questions relating to the boardresolution or the Insurance, Maintenance and Mold Package, or if you are interested in ordering either or both, please contact attorney Jessica Maceyko at 480-922-9292 or This email address is being protected from spambots. You need JavaScript enabled to view it.

 

Theinformation contained in thisHomeownersAssociationTip isfor informational purposesonly and isnot specific legaladviceor a substitutefor specificlegalcounsel.Readersshouldnot actupon thisinformation withoutseeking professionalcounsel.

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Wednesday, 20 March 2013 17:00

Imagine This

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Every manager in the country needs to be aware of this possible industry sea change. The scenario depicted below is not real, YET, but could be in the near future.

Imagine this – You are the owner of a management company consisting of 100 association clients and a staff of more than 20 people. You’ve invested 20 years in building your company into one of the finest in your region. You’ve made significant investments in time and money into acquiring good software, developing systems, and training staff.

You’re proud of your efforts to improve the accounting system for your clients. It not only provides them with meaningful financial statements every month, but also provides solid accounting information for the auditors. You want the audits to go smoothly. To help your various boards of directors understand their financial statements, you have listened carefully to their comments and requests, and have decided to present monthly financial statements on the “modified accrual” basis of accounting, which makes it easier for board members to understand. They don’t like accruals but you need to track receivables, so you compromised with a kind of “half accrual.”

It is January 29th, and you are welcoming back the first of this year’s auditors to begin the audits of your 100 association clients. You had no idea this morning that a recent, relatively obscure ruling by the AICPA (American Institute of Certified Public Accountants) was about to cause you significant damage. Heck, you barely know the AICPA exists; that’s for the CPAs to worry about.

John, the lead partner of the first CPA firm to visit this year, asks for a few minutes to chat before any work begins. You wonder why, and also ask yourself, “Where is John’s audit staff this morning? I don’t see them.” John reminds you that you haven’t paid attention to his several emails regarding AICPA independence rules, and didn’t attend his free seminar on the subject.   You acknowledge that, but remind John that your job is to manage associations, and his job is to know the accounting rules. All you’re worried about is that your accounting system accurately records financial transactions.

John agrees that your accounting system is excellent, but informs you that he can’t start the audits, as you have not presented him with GAAP (Generally Accepted Accounting Principles) basis financial statements, which are now required before he can begin the audits. You tell him “That’s your job. It’s always been your job. You understand those things - I don’t.” John explains that the new independence rules issued by the AICPA prohibit him from “preparing the financial statements.” He explains that your financial statements are considered to be for internal use only and as such, are not required to be prepared in accordance with GAAP. The annual financial statement submitted for audit, however, IS required to be prepared in accordance with GAAP. Under the new rules, John can no longer prepare those financial statements, as to do so would potentially impair his independence, meaning he could no longer perform the audit.

Realizing that your association clients are expecting completed audits within the next few weeks, you tell John that you’ll just have to recommend another CPA firm to perform the audits this year. But John informs you that NO CPA firm can perform the audits, as the new independence rules apply to ALL CPA firms. He suggests there are two ways to resolve the issue so that he can begin the audits:

  1. 1)You can bring your internal use financial statements up to GAAP basis. What is required is (a) converting from modified accrual basis to full accrual basis, (b) preparing the balance sheet and income statement in the proper format (like last year’s audit), (c) producing a statement of cash flows in the proper format, (d) preparing all appropriate footnotes (John hands you a 70-page disclosure checklist so you know what the proper disclosures are), and (e) summarizing the reserve disclosures in the appropriate format using information from the reserve study. (This is quite a challenge, as the reserve study report does not contain this information in any easy-to-find format. You would have to manually combine several different exhibits from the reserve study to get the correct information.)
  2. 2)John can recommend another CPA firm that is available to come in and prepare compiled financial statements; make the necessary accruals; and prepare the cash flow statement, footnotes, and reserve disclosures. That CPA has estimated his fees will be approximately $500 per association for the compilation services, except for the larger, more complex associations, which will carry a higher price tag.

As this all sinks in, you realize you have neither the staff, time, nor technical ability to handle this matter in-house. You also realize there could be some liability involved if you don’t get it right. So, option number one is not really an option.

You decide to talk to one of your long-time association clients about hiring the CPA to perform the compilation work. After all, you have a very good relationship with the president of the association, and have advised them about problems this tough economy has caused with the association’s budget.

Your board president listens, then gently reminds you that your contract with the association clearly states that your management company is contractually obligated to prepare all financial reports and information and “work with the auditors” on the annual audit. The board president states that the association believes it has paid you for financial services, and it is your responsibility to prepare whatever the auditor requires. The association will NOT pay for a compilation service in addition to an audit service.

OK, you can do this math in your head – 100 associations at $500 each is $50,000. Do you risk losing clients by forcing them to pay for the compilation, or eat the extra cost to make sure you don’t lose your association clients? You wonder for a moment about simply hiring a CPA to do this work in-, then remember that you recently saw an ad for a CPA with a stated salary of $80,000. That option won’t work either.

Now, this ruling has NOT YET taken effect. So the scenario painted above hasn’t happened yet, and isn’t going to happen within the next year. The AICPA’s PEEC (Professional Ethics Executive Committee) sets independence standards for CPAs, and in January 2013 they voted on exactly this issue. The Committee’s decision was to refer it back to the subcommittee study group for further consideration. But, it’s critical to note that the majority of committee members and those commenting on the proposed standard approved of revising the independence rules for CPAs. If this passed, it would drastically restrict the work that could be performed by a CPA performing audit or review services.

The world seems to be getting ever more regulated in an attempt to simply force good behavior. It won’t work. But, we still have to live with the rules as they are handed down from above. This issue of auditor independence has literally been discussed for decades. But in this post-Enron world, the discussion is being considered more seriously than at any time in the past. To my knowledge, this is the first time that this issue has ever come up for a full committee vote.

The AICPA has a well-established vetting process for proposed standards. The revised independence standard was proposed in June 2012, and the public comment period ended November 30, 2012. During that time, the PEEC received 41 comment letters on the proposed standard. While that may seem like a very small number, keep in mind that the majority of these letters did not come from individual CPAs, but rather from the “big four” CPA firms, state accounting societies, and the National Association of State Boards of Accountancy (NASBA). That means that these 41 comment letters represented the majority of CPAs in the country. What is critical to note is that approximately 2/3 of these comment letters supported in full or in part the proposed standard of severely restricting non-attest services that could be performed by a CPA who was also performing an attest engagement (audit or review).

The fact that the Committee did not kill the proposed independence provisions, but simply referred them back for further consideration, means that we will see this issue again. Given the significant majority support it received in its first exposure, there is a distinct probability that we will see this approved, in some form, in the relatively near future. As it was proposed, it allowed for a two-year transition period; that type of transition period will likely survive, so there will still be time to act. But, knowing what COULD come down from AICPA, it is better to act now.

What can a management company do to protect itself? The most important thing is to review your contracts and make sure there is a clear delineation between the services you provide for internal use financial statements as contrasted to preparation of GAAP basis financial statements, which should NOT be the responsibility of the management company.

See next week’s article “Proposed Independence Rules” for both a more detailed explanation of the proposed independence standards and also suggested language for how a management company / association contract can address the issues discussed above.

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Thursday, 27 December 2012 16:00

Safeguarding the Finances of Your Association

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With recent news media coverage on associations who appear to have lost funds due to actions by management companies, the question often becomes, how can an association prevent this from happening to them? For starters, it may be helpful to compare actions taken by an association who appears to be missing a significant amount of money from actions taken by an association who does not appear to be missing any funds.

Association 1 received a monthly balance sheet, income and expense statement from its management company.  It never received any backup documentation to support the financial statement, such as the monthly bank statement.  It did not receive a ledger showing the checks written on the Association’s account.  It also did not have a Board member who reviewed all invoices and signed all checks before the checks were sent.  In fact, no Board member had any access to the Association’s accounts.  The management company had the only signing power for all of the Association’s accounts (including checking, savings, and any reserve accounts).

In Association 2, the entire Board received a monthly balance sheet, income and expense statement from its management company.  In addition, the treasurer of the Board received a copy of all of the backup documentation to support the income and expense statement, bank reconciliation, all invoices paid, and a copy of the check register.  All checks required both the treasurer and the managing agent’s signature.  The management company had no signing authority for the reserve accounts of the Association  The Board member with signing power had full access to the bank records, as this person was a signer on the bank account.

Can you guess which association is missing funds?  If you guessed Association 1, you are correct.  Now, does that mean that every association that operates like Association 1 is going to lose funds?  Obviously not.  However, just like a person who shuts their garage door is less likely to get items stolen from their garage, an association that institutes tighter controls over its finances is less likely to see them taken because the opportunity is reduced or eliminated.

The following is a list of controls that an association should consider implementing to help safeguard its finances:

1.      Make sure that your management company does not comingle your association funds of other associations. This type of accounting can make it very easy for a management company to “rob Peter to pay Paul”.  Your association needs to have its own separate bank accounts for all of its funds.

2.      Obtain a full accounting of your funds every month.  Make sure that you are not just receiving a statement of income and expenditures.  You need to receive a balance sheet, a copy of your bank statement and related reconciliation, along with the documentation to show what checks have been written and to whom.

3.      Consider requiring that all checks be approved by a Board member before the check is written. Additionally, consider requiring that all checks be signed by at least one member of the Board.  This prevents easy flow of funds out of the Association’s accounts, and oversight of all checks written.

4.      Make sure that a Board member has the ability of obtaining a copy of the bank statement directly, rather than just through the management company, or have the ability to review the bank account online.  This prevents a management company from falsifying a bank statement.

5.      Keep association reserve funds separate from the operating funds, and consider not having the management company as a signer on its reserve accounts.

6.      Have your annual audit, review, or compilation performed by a Certified Public Accountant.  Even though Arizona law only requires a compilation, at a minimum, a compilation is not much more than a financial statement.  Therefore, the association should consider having an audit or review performed rather than just a compilation.  Additionally, make sure that the service is performed by a Certified Public Accountant regulated by the Arizona State Board of Accountancy.  (Note: Non-CPA accountants are not regulated by the Arizona State Board of Accountancy.)

Although the above steps cannot prevent all possible losses, they will help establish roadblocks to help protect the association’s funds.

In summary, the Board of Directors needs to remember that it has a fiduciary duty to its members.  Part of that fiduciary duty is the protection of the association’s assets.  Therefore, the Board should make sure that it is taking proactive steps to help protect the financial assets of the association

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Friday, 17 February 2012 16:00

Unit Owners Tax Basis in Condo Associations

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Condominium owners get an increase in the tax basis of their homes based upon the reserve contributions they have paid into their association over the years.  This can save tax dollars on the sale of the unit, and homeowners should be aware of this benefit.  The question for most people is “How do I calculate my increase in tax bassis from reserve contributions?”

Most associations have a reserve program, even if they don’t conduct formal reserve studies and many homeowners are now becoming aware that a portion of the dues they pay are for "reserves" or the major repair and replacement fund.  The purpose of the reserve fund is to provide monies for the ultimate major repair or replacement of the common areas of the association which include such items as roofing, fencing, streets, tennis courts, swimming pools, etc.  It is well established that at the association level these items are of a capital nature under Internal Revenue Code Section 118 as modified by Revenue Rulings 74-563, 75-370 and 75-371.  There are several rulings in this area that pertain to the association’s point of view.

However, like many areas of association tax law, there is nothing directly on point that reflects the unit owners’ point of view on the basis additions.  We have to rely on a patch- work of various code sections, regulations and revenue rulings to attempt to find an answer to this question.  While it seems clear that the items are capital in nature and may be added to the unit owners basis, the key question is when does this basis addition take place?  Is it when the unit owner is assessed the funds?  Or is it when the association expends the monies?  The answer to this question and the timing of the expenditures can have very significant impact on the individual unit owner.  To adequately assess this we must look at each of the citations related to this issue (see next page for analysis of applicable tax law).

The only logical conclusion that can be reached at this time is that a unit owners basis will include any capital assessments paid by the unit owner to the association whether the association has expended such funds or not.  We will probably have to wait for a contested court case or specific ruling on this area to get a more strongly supported answer than we have at this time.  However, existing evidence does support the conclusion reached above.

The unit owner is generally able to obtain this information from the association simply by reviewing the association budget for each fiscal year.  The unit owner should remember, however, that not all reserves may qualify as "capital" in nature.  The Internal Revenue Service has defined in Revenue Rulings 75-370 and 75-371 that painting and contingency reserve additions specifically do not qualify as capital in nature.

A practical example of how this would work is:

Assume homeowner pays $250,000 for a condominium unit and incurs closing costs of $1,000.  In subsequent years, homeowner directly expends $2,500 for interior improvements, and pays capital (reserve or repair and replacement fund) assessments of $400 per year for 4 years.  Homeowner's tax basis in residence is calculated as follows:

 

Cost - Purchase Price

$  250,000

Closing Costs

4,000

Direct Improvements

2,500

Capital Assessments (4 @ $400)

1,600

Total Basis

$  258,100
 

The basis has been increased by an additional $2,400 simply by considering the capital assessments.

Assuming a 40% combined Federal and State tax rate, this will save homeowner $960 in taxes on the gain on sale of residence.  While not a fortune, it is definitely worth the extra effort.

  

 

 

Applicable Tax Law

 

IRC Sec. 1034 which relates to computation of gain or loss on sale of a personal residence provides that "in determining the taxpayers cost of purchasing a residence, there shall be included only so much of his costs as attributable to the acquisition, construction, reconstruction and the improvements made which are properly chargeable to capital account...".

IRC Sec. 1012 relating to the basis of property, states that "the basis of the property shall be the cost of such property...".

IRC Sec. 1016(a)(1), relating to Adjustments To Basis states that "General Rule-Proper adjustment in respect of the property shall in all cases be made-for expenditures, receipts, losses, or other items, properly chargeable to capital account...".

IRS Regulation 1.1016-2 states that "the unadjusted basis must be adjusted upward to include any expenditure or other item properly included in the capital account".

 

C.W. Robinson, 32 TCM 1130, DEC.32,199(M), TC Memo.1973-242, concerns the basis of the sale of a lot.  It was held that the basis of the property sold did not include special assessments paid to a country club that adjoined the lots.  The key issue in this case, however was that the ownership of the property did not carry with it the membership of the club.  What this case implies is that there is a basis in the membership club that is separate from the basis in the lot.

T.R. Ettig, 55 TCM 720, DEC.44,736(N), TC Memo.1988-182, allowed taxpayer to claim as basis additions certain improvements to a co-owned condominium unit.  This case addressed only such amounts directly expended by the taxpayer for improvements made by himself; it did not address improvements that may have been included in assessments paid by taxpayer to the association.

Internal Revenue Service Revenue Ruling 81-152, deals with a developer litigation lawsuit on a construction defects case and tax treatment to the association of the amount of monies received.  This ruling held that the amounts received were not income to the association but constituted a return of capital to the individual unit owners.  This revenue ruling is consistent with several others citations in this same area, however this ruling went further and stated that "the money received from the builder is not income to the          individual unit owners, but instead represents a return of capital to each unit owner to the extent the recovery does not           exceed that owners bases in his or her property interest in the condominium development...requiring the individual unit owner to reduce their bases in their respective property interest in the condominium development is consistent with the congressional purpose in enacting Section 528 of the code.  The essential purpose of Section 528 is to provide homeowners associations with the same tax treatment as individual homeowners...".  The most important aspect of this revenue ruling however, is that in the last paragraph Internal Revenue Services stated,

"To the extent capital assessments are, or have been made against the unit owners for the purpose of making the necessary repairs or replacements, or the association retains the amounts recovered in the suit against the builder and uses them for capital repairs, replacement or improvements, the unit owners bases, under Section 1016, will be increased".  This is the clearest statement that exists on this issue and very directly states that if a capital assessment is made by the association the unit owner bases will be increased.  This does not indicate that the association must have expended such monies for the actual major repair or replacement of the common areas.  This also makes sense when contrasted to the Robinson case, as homeowners association the association membership runs with the property or unit; it is not a separate membership interest that may be transferred without the underlying transfer of the real estate.

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Friday, 17 February 2012 16:00

Tax Exempt Homeowners Associations

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Most discussions of homeowners association taxation focus on the issue of Form 1120 versus Form 1120-H.  But, that discussion ignores the small minority of associations that qualify as exempt associations under Internal Revenue Code (IRC) Section 501(c)(4).  The primary benefits of qualification for exemption under this section are (a) the elimination of income taxes on interest income from reserves (as well as other exempt function income), and (b) the elimination of the tax risks that are inherent in Form 1120.

But, most associations will not qualify for exemption.  For instance, all condominium associations are automatically excluded because the maintenance of the exteriors of personal residences (the condominium unit) is one of the primary functions of the condominium association.  This is a prohibited transaction under 501(c)(4), as it is considered to confer a private benefit to the unit owners.  Townhome associations that provide exterior maintenance are likewise disqualified.  In addition, those associations that are formed as cooperative housing corporations are also required to apply the mandatory requirements of Subchapter T as the code and may not qualify under 501(c)(4).

What this leaves as potentially qualifying associations are planned developments, whether residential, commercial, or industrial in nature.  As long as they do not provide exterior maintenance of privately owned structures, such as residences or commercial buildings, these associations are not automatically excluded from consideration of qualification under IRC Section 501(c)(4).

However, Treasury Regulations Section 1.501(c)(4)-1 provides that a qualifying organization must not be organized or operated for profit, and must be operated exclusively for the promotion of social welfare.  Revenue Ruling 74-99 further restricts qualification by establishing three requirements for qualification for complete tax exemption under IRC Section 501(c)(4):

  • The common areas owned and/or maintained by the association must be for the use and enjoyment of the general public.
  • The association must not conduct activities directed to the exterior maintenance of private residences.
  • The association must serve a “community” that bears a reasonably recognizable relationship to an area ordinarily identified as a governmental subdivision or unit or district thereof.

Let’s examine what each of these requirements really means.

The first restriction above, the “public use and enjoyment” requirement, is known as the “public access” clause.  An example of this type of an association is one that maintains common areas such as extensive slopes, fences, monument signs, and parks and does not have security patrol that restricts access.  A variation of this is that there may be some restrictions such as limited access to pool and tennis court areas.  So long as they are not substantial, significant restrictions, the association will still qualify.

The second restriction above eliminates all condominium associations.  It does not eliminate master associations that may contain condominium association subdivisions.  Master associations that may include a small percentage of condominiums that are not part of a separate association could still qualify, but this is much more difficult.

The third restriction, “serving a community” does not mean that the association itself must BE a community; it must just serve a community.  For non-gated associations that have sufficient public access, service to their surrounding community is virtually automatic.  For associations that don’t have sufficient public access to those outside the association, there are still two ways to qualify; (1) the association covers the same geographic territory as a governmental unit.  An example of this would be an association that has approximately the same geographical boundaries as a City or other governmental entity, (2)   the association itself qualifies as a community.  By definition, this generally must be a very large or very remote association in that it has such a large population that it would in and of itself qualify as a community even if there are restrictions on access.  This is very rare and is not usually encountered in urban areas.

The exemption process requires a formal, extensive application.  Qualifying is not automatic.  However, even if the IRS denies the initial application, you can get a second chance at approval with the IRS Appeals Office. And, once an association is granted exemption by the IRS, it must file Form 990, which is far more complex that either Form 1120-H or Form 1120.  Form 990 also requires an association to disclose key employee compensation and establish formal policies not required of other associations.  In addition, both the application and any Form 990 tax returns are considered public documents and copies must be provided to any member of the public that makes a request.

In my opinion, the benefits for an association far outweigh any perceived negatives.  The tax law is complex and generally requires assistance by a qualified professional having experience with tax exempt associations.  There are some pitfalls and traps.  My experience includes regaining exempt status for several associations who had their exempt status revoked by IRS because their advisors did not have the specialized knowledge or experience to properly argue their case with the IRS.

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Monday, 30 January 2012 16:00

Should Painting be Included in the Reserve Study?

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The question of including painting in reserves continues to arise, even 15 years after the matter should have been settled.  To understand why, you need to know that this issue first arose from tax considerations, not because of any budget, maintenance, or economic factors.

Painting is one of the largest expenditures that most condominium associations will incur. The primary purpose for establishing reserves is to assure funding is available for major repairs and replacements that do not occur on an annual basis.  Consequently it is logical that it should be included in reserves because it is not an annual maintenance expense. For most associations painting will occur every 7 to 15 years.

The tax issues causing this perceived problem arose in 1993 when the IRS audited approximately 15 associations in San Diego, California.  IRS proposed to add back as taxable income all the painting reserve assessments that had been excluded from income in calculating taxable income on the Form 1120 tax returns.  This created a national furor within the HOA industry on the concept of the inclusion of painting in reserves, but only because of the misunderstanding that occurred related to this issue.  The difference lies in definitions and perceptions, not in any differences of facts.

HOA Industry Positions

These are general statements only, and like all general statements, there will always be exceptions.

1. The HOA industry has generally always considered reserves as “capital contributions” for tax purposes

2. The HOA industry has generally excluded reserve assessments from taxable income for tax purposes.  If the association is filing Form 1120, this is a major factor in eliminating taxable MEMBER income.

3. Many tax preparers recommend Form 1120 so that the association can take advantage of the lower 15% tax rates of Form 1120, versus the 30% tax rates of Form 1120-H

It is also necessary to state certain tax facts

1. Form 1120 carries a 15% tax rate for the first $50,000 of taxable income

2. Form 1120 requires the association to delineate between capital and noncapital transactions

3. Form 1120 requires noncapital transactions to be separated between member and nonmember activities

4. Form 1120 considers all nonmember activities to be taxable

5. Form 1120 considers member activities to be taxable only if there is a net member income

6. Form 1120-H does not tax ANY exempt function activities

7. Form 1120-H taxes all nonexempt function activities at a flat 30% tax rate

It is important to note that member activities on Form 1120 are generally similar to exempt function activities on Form 1120-H, but with critical differences that can affect certain tax returns.

IRS Positions

1. The IRS has its own rules

2. The IRS doesn't care what the HOA industry thinks

3. Internal Revenue Code (IRC) Section 277 requires separation of member and nonmember activities on Form 1120

4. IRC Section 263 defines capital activities – painting is not considered a capital activity (in most circumstances)

5. IRC Section 118 (with numerous interpretations in Rulings and Tax Court cases) defines contributions to the capital of a corporation

6. Revenue Ruling 75-370 specifically states that painting does not qualify as a capital activity that may be excluded from the income of a homeowners association as a contribution to capital.  Painting is considered to be a non annual maintenance expense.

The crux of the issue is that the HOA industry refers to expenditures as being either operating or reserve in nature, and considers all reserves to be “capital” expenditures. The IRS refers to expenditures as being either noncapital or capital in nature.  These two definitions are not the same, and the major area of difference is painting expense.

The simplest way to look at this is to realize that painting is simply a noncapital reserve component.  OK.  So now what?

Let me state for the record that I, as a reserve preparer, am of the opinion that the components to be included in any reserve study should be determined by the maintenance plan, budget policies, and economic considerations.  Tax considerations should NOT be a determining factor in what components are included in a reserve study.

Certain conclusions can be drawn from the above discussion of tax issues related to painting as a reserve component.

·           It’s acceptable to include painting in the reserve study

·           Painting reserve assessments cause potential tax issues on Form 1120

·           Careful tax planning can allow you to minimize tax risks of painting reserve assessments on Form 1120

·           Painting reserve assessments cause NO potential tax issues on Form 1120-H

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Monday, 30 January 2012 16:00

Form 1099 Repeal Official

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On April 5, the 87-12 vote by the Senate approved H.R. 4, the "Comprehensive 1099 Taxpayer Protection and Repayment of Exchange Subsidy Overpayments Act of 2011." The measure, which retroactively repeals expanded Form 1099 information reporting rules added by recent legislation, was passed on March 3rd by the House on a vote of 314-112. Thus, H.R. 4 (the Act) will be forwarded for the President's expected signature.

Technical highlights of the tax changes in the Act:

Original information reporting rules (prior to 2011) - Before amendment by the Small Business Jobs Act of 2010 and the Patient Protection and Affordable Care Act (PPACA), Internal Revenue Code (IRC) Sec. 6041 generally required payments totaling at least $600 in a single calendar year to a single recipient to be reported to IRS.  Reporting on Form 1099 was required only when the payor was considered to be engaged in a trade or business and made the payment in connection with that trade or business. The type of payment that most commonly triggered the reporting requirement was payment for services. Corporations were exempt from Code Sec. 6041 's reporting requirements under prior law (Reg. § 1.6041-3(p)(1)).

Changes made by 2010 legislation. Beginning in 2012, Sec. 9006 of PPACA made three significant changes; (1) it added payments of amounts for ANY type of property to the list of payments subject to information reporting.

(2) corporations, which had previously been exempt from the reporting requirement, would now be subject to information reporting.
(3) The Small Business Jobs Act of 2010 provided that, subject to limited exceptions, a person receiving rental income from real estate would be treated as engaged in the trade or business of renting property for information reporting purposes. Landlords making payments of $600 or more to a service provider, such as a painter or plumber, in the course of earning rental income would have to provide an information return to the service provider and IRS.

New law. For payments made after Dec. 31, 2011, H.R. 4 (the Act) repeals each of the three above provisions.  (Code Sec. 6041(a), Code Sec. 6041(i), and Code Sec. 6041(j), as amended by Act Sec. 2, and Code Sec. 6041(h), as repealed by Act Sec. 3).

Author’s observation: In other words, under the Act, the information reporting rules effectively revert to the way they read before enactment of PPACA and the Small Business Jobs Act of 2010.

Revenue offset. In order to gain bipartisan approval, congress needed to find a revenue offset to make up for the anticipated revenue that would be lost by repealing the 1099 reporting requirements.  The Act provides an offset, estimated at $21.9 billion. It increases the amount of "excess advance payments" of the premium assistance credit (enacted as part of the 2010 health care reform legislation to help lower-income individuals acquire affordable health insurance coverage) that a taxpayer must repay under Code Sec. 36B(f)(2) for tax years ending after Dec. 31, 2013. The credit is available for a taxpayer who doesn't receive health insurance through his employer (or his spouse's employer) and whose income falls between 100% and 400% of the federal poverty line (FPL), based on the most recently filed tax return.

Under pre-Act law, if the taxpayer's income increases such that the credit exceeds that to which his current income level actually entitles him to, but his income is still under 500% of FPL, he had to repay some credit amounts. The limit on amounts he had to repay were capped and ranged from $600 to $3,500.

New law. Under the Act, for tax years ending after Dec. 31, 2013, the repayment caps are increased for taxpayers with household income of at least 200% but less than 400% of FPL, and full repayment is required for taxpayers whose incomes exceed 400% of FPL. (Code Sec. 36B(f)(2)(B)(i), as amended by Act Sec. 4)

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Monday, 30 January 2012 16:00

Consideration of Interest and Inflation in the Reserve Study

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Both interest and inflation considerations are important to the calculation of your future reserve requirements.  Unless the association has made a conscious decision to transfer all interest earnings to the operating fund (which is the subject of an entirely different article), it is generally assumed that interest earnings will be retained in the reserve fund.  Likewise, inflation is a factor that will cause the prices you pay for future repairs to be higher than the cost you’re paying presently for those same repairs and replacements.

The two questions that continually arise are “Should interest and inflation be included in the reserve study; don’t they cancel each other out?” and “How do you calculate what interest or inflation rate to use?”

I believe that both inflation and interest earnings should generally be considered in the funding plan of a reserve study.  To ignore these would be to ignore reality. While it is a policy matter of the board of directors whether or not to include these items, it is common practice to include both interest earnings and inflation in the funding plan of the reserve study.  Inflation should never be ignored.  Failure to consider inflation will generally lead to significant future underfunding, unless the association updates its reserve study and underlying cost assumptions annually.

The fact is that interest earnings do not offset inflation.  While interest and inflation rates may be similar, the inflation factor is applied to the total estimated future expenditures for all common area components included in the funding plan.  This is (virtually) always a higher number than the current funds set aside for reserves.  Conversely, the funds set aside for reserves are (virtually) always a smaller amount.  That means that the dollar amount of interest earnings will grow far slower than the dollar amount of inflated costs, even if the rates are the same. An example is that an association may anticipate spending $3,000,000 over the next 30 years, which includes inflation calculations.  The current reserve cash on hand may be as little as a few hundred thousand dollars, as that is all that is required to pay for planned expenditures arising in the next few years.  Inflation of 2% on $3,000,000 is $60,000 annually.  An interest rate of 2% on $500,000 of cash invested generates only $10,000 of interest earnings annually, creating an annual funding gap of $50,000.

The second question, how do you calculate these rates, has no correct answer.  Some people use a rule of thumb.  Others look at their current interest earnings rates as a guide.  Current interest earnings rates cannot be ignored, but if they unusually high or low, it is not practical to expect those rates to continue indefinitely. However, so long as you keep your assumed interest earnings rate relatively the same as your inflation assumption, you shouldn't get into too much trouble, as they do usually move in tandem.  California associations should be aware that California law limits the interest rate assumptions that may be used in a reserve study to 2% above the discount rate published by the San Francisco Federal Reserve Bank.

Since the funding “window” of a reserve study is normally a 30-year projection, many believe it is legitimate to consider average rates rather than current rates in establishing your funding plan.  The attached historical tables of interest and inflation rates allow you to put current rates into perspective.  Table 1 reflects solely at annual rates.  Table 2 reflects the 5-year average rate in any given year.   Table 3 reflects the 30-year average rate in any given year.  You will note that Table 3 does not contain the sharp peaks and valleys of the annual rates in Table 1.  However, general trends are still similar.

Note that regardless of sometimes significant annual variations in rates, the moving 5 and 30-year averages smooth out the rates considerably, eliminating the extreme spies and valleys that generally occur for only short periods of time.  Since the reserve funding plan typically projects for a 30-year period, it is usually safe to ignore current extreme changes in rates in favor of longer term moving averages.

I was forced to address this issue when I first started preparing reserve studies in 1982.  Look at the annual rates for that year and you can understand why.  If we had used the current interest and inflation rates of that year, NO reserve study could be developed that would provide adequate funding without “breaking the bank” by forcing reserve assessments so high that no one could pay them.  We opted then for using approximately 5% interest and inflation rates, because we knew the current situation was abnormal and could not be sustained.  Time proved us right on that assumption, but the fact is no one could reliably predict future rates.

Current interest rates are at an all time historical low.  Despite political pressure to keep rates low, they are beginning to trend back up.  Inflation rates reported by the government are also at all time lows, actually reflecting a deflationary rate in 2009.  However, because of changes made in recent years to the government data as to what is included in their calculations of the official inflation rate, current inflation rates are not comparable to prior data.

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Monday, 30 January 2012 16:00

Reserves as Capital Contributions

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Most discussions about homeowner association income taxes begin and end with the single issue of filing Form 1120 or Form 1120-H.  This is usually discussed simply from the perspective as the difference in tax rates.  But, Form 1120 carries significantly higher tax risk.  The largest risk, and the focus of this article, is the issue of reserves being considered as capital contributions for tax purposes.  This an important issue because capital contributions are automatically excluded from income.  It has no significant impact if filing Form 1120-H, as Exempt Function Income (EFI) is not taxed on that Form.  It is a critical issue on Form 1120, as any amounts received from members that cannot be classified as capital contributions may create excess member income under IRC Section 277 that is subject to taxation.

The Internal Revenue Code (IRC) is law passed by Congress.  Regulations are the Internal Revenue Service (IRS) interpretation of that law.  Revenue Rulings are specific situations described by the IRS that clarify how certain tax rules are to be applied.  Judicial decisions by various courts provide the final say in how certain tax law is interpreted.  There are actually numerous other levels of authoritative rulings, but these are the primary guiding authorities.  It is important to understand this framework to see why something as simple as a reserve contribution can actually be very complex.

The basic structure of the Internal Revenue Code is that all receipts are considered income under IRC Section 61, unless exempted from income by another section of the Code.  IRC Section 118, “Contributions to the Capital of a Corporation,” exempts capital contributions from income.  IRC Section 118 has been interpreted by numerous subsequent rulings. The balance of this article examines each of the criteria raised by those various rulings.

While IRC Section 118 establishes the broad principle that capital contributions are not included in taxable income, the detailed parameters established by subsequent rulings are:

1)      The PURPOSE of the assessment must be capital in nature (IRC Section 263, Revenue Rulings 74-563, 75-370, and 75-375, Court cases Chicago Board of Trade and Maryland Country Club)

2)      ADVANCE NOTICE must be given to members as to the intent of the purpose of the capital contribution (Court cases Gibbons and Maryland Country Club, Revenue Rulings 75-370 and 75-371, GCM [General Counsel Memorandum] 35929)

3)      Money contributed must be ACCOUNTED FOR as a capital contribution (IRC Section 118, Court case Chicago Board of Trade, GCM 35929)

4)      Money must be HELD FOR THAT PURPOSE and no other purpose (Court cases Chicago Board of Trade and Maryland Country Club)

5)      Money must be HELD IN SEPARATE BANK ACCOUNTS from the operating (noncapital) bank accounts of the association (Revenue Rulings 75-370 and 75-371)

6)      Money must be actually EXPENDED FOR THE INTENDED PURPOSE (Court Case United Grocers)

7)      Money must INCREASE THE CAPITAL ACCOUNT OF THE MEMBER or unit owner-stockholder (Court case Chicago Board of Trade , GCM 35929)

My many years of experience as a tax preparer in the homeowner association industry have provided numerous examples to me that virtually no associations are aware of these critically important rules, and few tax preparers believe they are important.  I have been retained as a consultant on dozens of homeowner association IRS audits, probably more than any other tax practitioner in the country.  In all but one case, Form 1120 was involved.  I did not prepare ANY of the tax returns being audited by the IRS; I was retained at the recommendation of the CPA firm or tax attorney as their expert consultant.  The issue of capital contributions existed in 100% of these IRS audits.

Associations that do not adhere to each of the parameters set forth above MAY not lose their reserves as capital contributions in an IRS audit, but each instance where the association fails to adhere significantly increases the risk that your reserve additions will not qualify as capital contributions.

How associations can qualify under each of the parameters set forth above.

1)      The PURPOSE of the assessment is described in IRC Section 263 as “Any amount paid out for new buildings or for permanent improvements or benefits made to increase the value . . . “ and “Any amount expended in restoring property . . . “  That pretty much describes the majority of reserve funds expended by associations.  But, it also includes additions to or replacements of personal property.  It DOES NOT include monies expended or set aside for painting or contingencies.

The purpose for which funds are being accumulated in reserves is generally set forth in the reserve study.  Is a reserve study absolutely required to establish the capital purpose?  No, it could be more informal, such as being described in the budget.  However, the reserve study is better, and this is an instance where it is better to comply than to have to fight this issue in an IRS audit.

Other critical mistakes associations make are (a) not formally adopting their reserve study, (b) having a reserve study that contains multiple proposed funding plans with no indication of which plan was adopted, (c) having a reserve study that does not agree with the amounts adopted in the association’s annual budget as reserve contributions.

2)      ADVANCE NOTICE is usually given to members as part of the annual budget, with accompanying information that discloses the reason for the “Capital” reserve assessments.  It is critical to note that if painting or contingency are part of the reserve budget and the amounts are not disclosed it jeopardizes the entire capital contribution, because painting and contingency are not capital in nature.

3)      Money contributed must be ACCOUNTED FOR as a capital contribution in the association’s financial statements.  While this is routinely done in professionally managed associations, too many small, self-managed associations fail to take this critical step.  As long as reserve monies are held in a separate bank account and there is a clear record of reserve contributions and expenditures, the association should be able to overcome this accounting deficiency in an IRS audit situation.

4)      Money must be HELD FOR THAT PURPOSE and no other purpose.  This means that once you set aside monies in reserve accounts, you should NEVER invade those reserve accounts for operating purposes.  California statutes permit associations to borrow from reserve under certain circumstances.  While permitted under California law, federal tax law does allow such use of funds.

5)      Money must be HELD IN SEPARATE BANK ACCOUNTS from the operating (noncapital) bank accounts of the association.  The IRS interpretation of this is that (as an example) roofing and paving funds, considered capital in nature, cannot be held in the same bank account as painting monies.  Why?  Painting is considered non-capital in nature.  Combining painting or contingency reserves with your capital reserves jeopardizes the entire capital contribution.  This is probably the most critical item in your reserve planning.  If you do not have these separate bank accounts, you should probably not be filing Form 1120, as your tax risk is too high.  This issue has been raised on virtually every IRS audit on Form 1120 on which I have consulted.

What this means is that most associations must maintain three different bank accounts – one for operating funds, one for capital reserve items, and one for noncapital reserve items.  Virtually no one is doing this.  This deficiency could potentially be overcome in an IRS audit if you have adequate accounting, but there is no guarantee.  This is one of those situations where, although it is a pain to comply, it is still easy to comply, and why have to fight the IRS over an issue that is so easy to comply with.

6)      Money must be actually EXPENDED FOR THE INTENDED PURPOSE.  This does not mean that if you assessed money for roofing that that exact amount must be expended for roofing.  It means that if you assess reserve monies for a capital purpose, it must be spent for a capital purpose.  Reserve bank accounts commingle various capital components (roofing, paving, fencing, etc.).  That dollar in the account does not know that it is a roofing dollar or a paving dollar.  That dollar does not know what kind of dollar it is, other than it is a capital dollar.  That is the only important criteria.

7)      Money must INCREASE THE CAPITAL ACCOUNT OF THE MEMBER or unit owner-stockholder.  This is effectively an automatic process with which the association normally need take no action.  The reason is that, as defined in other sections of the Code, a member’s “capital account” is presumed to reflect an increase in value for monies added to reserves.

What all of this means is that the association must be very careful in its handling of reserves IF IT IS FILING FORM 1120.  If you’re filing Form 1120-H, you can effectively ignore all of the above and still have a safe tax return.

If the association fails to comply with the above parameters established in tax law, THERE IS NOTHING THAT THE TAX PREPARER CAN DO TO MITIGATE YOUR TAX RISK.  The tax preparer’s responsibility is limited to properly presenting reserve activity in Schedules M-1 and M-2 of the association’s Form 1120 tax return.  Any errors at this level can generally be overcome during an IRS audit.

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