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.