Condominium living offers many benefits and has become a very popular form of housing.  Those choosing to become condominium owners understand that they will pay a monthly fee responsible for funding both day-to-day operating costs as well as future major repairs and replacements (known as a reserve fund).  The intent when determining this fee is that if monthly assessments are set at an appropriate level, special assessments and bank loans will be avoided.  In my 35 years as a reserve professional, however, I have observed a very different reality.

The impact of inflation alone is enough to constantly increase operating costs and reserve funding requirements. In addition, observable trends in multiple associations over the years have indicated there are often four specific, predictable events that create “waves” of increased assessments or special assessments. While they won’t affect every association, history has shown that they will affect many.  The fourth wave is the biggest and, because it hits so long after the association’s construction, most original owners aren’t affected; instead, secondary owners feel the full impact. So, what are these four waves? 

The first wave can occur relatively early in the life of the association if developers set initial monthly assessments at the lowest possible level. This virtually guarantees significant short-term increases.  Assessments must often be raised to cover increased operating expenses and reserve funding.  Occasionally, they are often also necessary because members demand increased services such as on-site management, maintenance staff, better service providers, etc.

The second wave generally hits at about the 10-year mark.  This is often when large reserve expenses begin to occur, such as exterior building paint, asphalt treatments, pool resurfacing, carpet replacement, etc.  The scope of these costs are often unexpected for several reasons: estimated repair and replacement costs were set too low; no reserve study was ever performed; reserve assessments were kept artificially low due to developer transition; or reserve funds were diverted to the operating budget without raising the homeowner’s dues over recurring years. 

The third wave generally hits at about the 30-year mark. This occurs when an unfortunate confluence of events takes place: roofing needs replacement, exterior painting is required, and asphalt needs either a significant overlay or complete removal and replacement.  This is what is called a peak expenditure year.  When significant, large expenses do not all occur in the same year but occur close together, the process is referred to as a peak expenditure event (usually occurring over multiple years for communities aged 25 to 30 years).  The big-ticket items listed below are the ones that most associations will encounter in the third wave:

• Roofing – Depending on roof type and material, costs often range from $4,000 to $25,000 per unit, and life generally ranges from 15 to 50 years, with the majority of roofing types not exceeding 30 years.
• Siding Replacement – Some siding types may never require replacement and may be considered “lifetime components,” meaning they will last as long as the building structure. There are too many different siding materials to discuss here, and each has significant variations in life and cost.  In my experience, wood siding has the worst combination of both short lifespan and high replacement cost, but it is a widely-used product because of its aesthetic characteristics.
• Painting – Depending on underlying surface, paint quality, climate, and proximity to salt air, the lifespan of paint can vary significantly. Most associations adopt painting cycles ranging from five to 15 years.
• Asphalt – Depending on original construction quality, climate, and traffic conditions, the life of road surfaces can vary significantly. Even with interim maintenance such as slurry seal and overlay, most asphalt surfaces will require a complete replacement approximately every 30 years.
• High-Rise Associations – Additional expenses to factor in include elevators, HVAC equipment, plumbing equipment, lobby remodels, interior hallways, lighting, and fire safety equipment.

The fourth wave generally comes as a complete shock to homeowners because 1) (almost) nobody plans for it,  2) most reserve preparers ignore it, and 3) it generally includes the most expensive components in any condominium project.  What are they?  The roof, paint, siding and paving are not actually the most expensive components; instead, the pipes and utilities inside your walls are.  Natural gas piping is less likely to fail and most electrical systems are replaced only if the walls are already open for another purpose, but domestic water and wastewater pipes, vent pipes, water mains from the street, irrigation mains and lateral lines, and sewer mains to the street all fail over time.  These are the most expensive components requiring replacement in virtually every condominium project.  It is extremely rare to see funding in a reserve study for these items, or to hear any mention that they exist through disclosures educating residents about these potential major future expenses. 

When are these costs likely to occur?  Engineers have testified in construction defect cases that the above utilities have a life range of 40 to 60 years; nominally, we tend to assume life expectancies of 50 years for planning purposes.  Therefore, if you’re living in a 50-year-old condominium that has not yet replaced these components, it’s prudent to investigate the current condition of your in-wall and subterranean utility lines.

There are two reasons these costs are normally not funded: standards and cost.

Standards - Most reserve specialists are following the National Reserve Study Standards established by trade organizations which allow them to ignore the most expensive component in a condominium project.  These standards even recommend that utilities be excluded until “a history of repairs exists,” and do not require disclosure of this omission.  Unfortunately, since these particular components have such a long life, by the time a history of repairs exists, it’s too late.  In contrast, our reserve study company follows the International Capital Budgeting Institute’s (ICBI) Generally Accepted Reserve Study Standards, which require either inclusion of these components or disclosure of their omission.  It’s critically important for industry trade organizations to recognize this major deficiency in disclosures to condominium owners.  Standards matter. 

Cost - On the low end, ignoring inflation, cost works out to $25 per month for fifty years. ($300 annually for 50 years is $15,000.)  It’s very difficult to convince anyone to pay $25 per month for 50 years.  Therefore, this particular item virtually always becomes a special assessment issue.  I’m not advocating that every association should be funding for this future cost, but in our reserve study reports we do insist that a disclosure is included so members are aware of the obligation if it is not being funded.

Except for those prepared by our company, I have never seen these components included in any reserve study unless the components had already started to fail.  Only once have I ever seen another company disclose the maintenance obligation, indicating it was not included in the study.  If these components are included in a reserve study only once they start to fail, it’s about 50 years too late. Disclosure of the obligation without funding for it should be the norm, as it is virtually impossible to get members to agree to a budget that has them paying that much money for that period of time, especially when many of those people will no longer be members of the condominium when the cost is incurred.

Of the more than 1,000 association clients represented by our reserve study company, only five have actually funded for utilities replacement starting when the condominium was constructed.  I have personally worked with 12 associations that have had to either completely or partially replace their in-wall and under slab utilities.  Costs have ranged from $15,000 to $50,000 per unit, resulting in special assessments.  These projects were in 35 to 60-year-old associations. 

The very large numbers of condominium associations that were constructed in the 1970s and 1980s are now reaching that 40 to 50-year age when these components begin to fail.  I anticipate that we’re going to be seeing many more associations faced with these large costs in coming years.  This will not be a wave; it will be a tsunami. Most of these associations will not be prepared for such unanticipated major costs, especially when many are not even well enough funded for their known reserve projects. 

Many associations have been relying on the wrong metric to determine the adequacy of their reserve funding, relying exclusively on “percent funded.”  Many reserve preparers promote this simplistic concept as the best means of determining the adequacy of reserve funding, which only serves to add to the confusion of funding for an aging community. The percent funded concept is a clumsy simplification that can be dangerous because people place so much importance on it without even knowing if it is an accurate calculation. (Unfortunately, in many cases it is not.) Many people have been indoctrinated to assume that if an association is 70% funded, it has a “strong” reserve fund, which virtually eliminates the possibility of a special assessment. 

While we generally disclose percent funded when our clients request it, we hesitate to place any emphasis on percent funded, as we have seen an association only 30% funded that never required a special assessment, and another that was 88% funded that needed an immediate special assessment.  A cash flow analysis is a much more reliable tool in analyzing a funding plan. Percent funded works only if all significant components are included in the reserve study, if it is properly calculated, and if it considers peak expenditure events.

Accurate planning is the answer to avoiding problems. Always remember, you can’t reserve for what you can’t see…in your report. Your “hidden” components still exist, and the replacement cost, if not properly budgeted, can lead to a political and financial disaster in your community.

Gary Porter, RS, FMP, CPA

Facilities Advisors International

www.reservestudyusa.com

This email address is being protected from spambots. You need JavaScript enabled to view it.

(877) 304-6700

Gary Porter served as CAI’s national president (1998-99), and is coauthor of CPA’s Guide to Homeowners Associations and Reserve Studies – The Complete Guide.  He is also President of the International Capital Budgeting Institute.  As a Facilities Management Professional (FMP), an experienced valuation consultant, and a CPA, he has the multidisciplinary training critical for the reserve study process.

A caller recently told me that his association had made an election under Revenue Ruling 70-604 to roll over the excess income to the subsequent year.  His issue was that the association did not then decrease the assessment for the next.  He believes the association is obligated to either decrease the assessment or refund the excess income to members.  He is an active member in his association and wants to make sure that the association is doing the right thing by its members.

I get at least a half dozen such phone calls per year.  As a CPA I received more tax questions related to Revenue Ruling 70-604 than for all other tax matters combined.  What I find as a common thread in all such calls is that the member really just wants to see his or her assessments decreased because they think they’re paying too much.  It’s frustrating for me to have to continually attempt to educate people that this is a tax issue, not an economic issue.  And, they already know what they believe, so don’t want to hear anything that doesn’t conform to their understanding of the issue.

So let me say it very bluntly.  Revenue Ruling 70-604 is a TAX election.  It has NOTHING to do with your association’s budget.

Let's discuss the basics, again, of Revenue Ruling 70-604.  That ruling allows an association that files Form 1120 to make election to either refund to the members or rollover to the subsequent year EXCESS MEMBER INCOME for the specific purpose of avoiding paying tax on that excess member income.  Please note that “excess member income” has a very specific definition under tax law, and does not necessarily correlate to “net income” for accounting purposes.  The tax definition has NOTHING to do with the accounting function or whether or not monies should be refunded or assessments decreased in the subsequent tax year.  Also, this ruling does not apply to an association that files form 1120-H.

The fact is, the Board of Directors does not have a crystal ball.  They can't know exactly how much money they're going to spend the next year.  In fact, they haven't even finished their current year, and they're putting a budget together for next year when they probably still have three months remaining in the current year.  They don’t know and are simply estimating where they’re going to end up for the current year.  Likewise, they are estimating expenditures for next year, and next year’s budget and the resulting assessment level are based on those estimated expenditure levels.

So, could the Board be wrong in their estimates?  That’s not even a question – they WILL be wrong in their estimates, the only question is how wrong – because they don’t have crystal ball.  When the Board of Directors is constructing next year’s budget, they will make an assumption regarding the amount of excess income (and remember that this is different than the tax definition of excess MEMBER income) for their current year.  That assumption could be one of three things:

1) - There will be an excess

(2 - There will be a deficit, or

(3 - Actual results will be a breakeven.  

For practical purposes, there is never a breakeven.  There will either be a surplus or a deficit.  And the board is trying to estimate what that amount will be for the current year.  Only one thing is certain, they won't get it exactly right, but hopefully they will be close.

The Board also has two other cash flow considerations as part of the budget process; working capital, and contingency expenses.  We usually recommend that an association should have the equivalent of one or two months operating expenditures on hand in the form of “working capital.”  This is money set aside just to make sure that there is always sufficient money to pay bills when they come due.  And that doesn’t consider the unknowns that attack every budget, the contingency expenses.  These are unforeseen expenditures that do pop up from time to time.  Many associations handle this by building a “contingency” expense line item into the budget.  But, if no such expenditure occurs, it means you have some excess income.

So, let’s come back to our interested member caller.  Let’s call him “Joe” for convenience.  Joe and other members have become aware that the board has made the TAX election under Revenue Ruling 70-604 and have interpreted it that excess net income exists for accounting purposes, must be rolled over to the subsequent budget year, and must result in a decrease in their assessment for next year.  Joe further indicated that assessments have gone up for three years in a row, and because an election was made, excess income must have existed in each of those three years, and that clearly the Board of Directors was doing something wrong and perhaps even something illegal.

It is not beyond the realm of possibility that assessments could go up each and every year, even while there is excess income.  Why would assessments go up?  Simply because expenditures keep increasing, every single year, due to inflation.  Everything costs more, vendors must raise their prices so they can cover their expenses.  Employees need raises so that they can cover their expenses, all the association's expenses are typically slightly higher from year to year because of inflation.  So the expectation is that assessments will go up year after year after year is reasonable.  But, while there is “excess” income?  That probably happens because of all the estimates involved in the budget process, trying to have adequate working capital, and making sure you can cover contingencies.  Also, that lack of that crystal ball.

This brings us back to Joe, who is expecting either a refund or at least a decreased assessment.  What are the possibilities?

If the association should end up with a deficit at the end of the current year, that almost always means we cannot expect a decrease in assessments for next year.  

If the association should magically end up with a breakeven for the current year, we can expect an increase in assessment for the next year just to counteract inflation, so we won't have a deficit next year.  

The third possibility is that the association has a surplus for the current year.  Does that automatically mean that we will have a decrease in assessments next year?  No.  If the surplus is equal to 1% of the budget, and we're expecting a 3% inflation next year than there would still have to be a 2% increase in assessments for next year just to stay even.  And that assumes we’re right about all of our assumptions (and we won’t be).

Let's try another example.  Your monthly expenditures are $100,000.  That means to be safe, you should have between 100,000 and 200,000 cash on hand at the end of the year as working capital.  If you do not have at least that much, you should not be considering a decrease in assessments.  One way to view that is to consider this as your minimum balance.  If you do have an adequate working capital amount on hand, and are planning your expenditures on a very tight budget, then you should also have a contingency amount.  How much should the contingency be 1% 2%?  Picked a number.

Most associations are either constricted by their own governing documents or by state statutes (nonprofit laws) to not operate at a profit.  On the other hand, the Board has a fiduciary obligation statutory in some states to levy assessments sufficient to cover the association’s anticipated expenditures, including setting aside an appropriate amount for reserves.  I always marvel when I see these two restrictions because those that created the statutes or governing documents seem to think that the Board of Directors DOES have a crystal ball and will be able to manage their assessments of expenditures to arrive at exactly $0 net income at the end of the year.  This also assumes that the association is magically be able to collect all of the next month's expenses on the first day of the next year or so that they will have sufficient money to pay their bills for that month.  These are great guidelines, but interpreted as literal are totally unrealistic language.  Every time I see this type of language, I want to say to these people join the real world.  Things don't always work out as planned.

So Joe, please look at the numbers for your association and tell me what your crystal ball says.  If you were on the Board would you be willing to decrease assessment for next year?  When you're operating on net margins as thin as 1%, can you take the risk that you are 99% right in all of your assumptions and take the risk that you may have to levy a special operating assessment just to get through next year?  If you're wise man, the answer is no.

Another Look at Fraud

In my professional career as an auditor of community associations I have been involved in the investigation of approximately 20 embezzlements (embezzlement being one form of fraud, the most common form in the community association industry) over the years.   Most frauds are not discovered by auditors, but are found based on internal reviews or tips from employees. Contrary to what many people believe, discovery of fraud is NOT the primary goal of an audit; the audit is intended to determine the (relative) accuracy of the association's financial statements.  CPAs performing audits have an obligation to consider the possibility that fraud may exist in the performance of our procedures.  

At the core  of any form of fraud are three underlying factors referred to as the "Fraud Triangle."

• Incentive to commit fraud

• Opportunity to carry out the fraudulent act

• Ability to rationalize fraud

The incentive to commit fraud is normally caused by personal financial pressures that can't be relieved by ordinary, legitimate means.  Such pressures are often caused by divorce, health issues, bad investments, gambling, or addictions.

The opportunity to commit fraud exists where there are weaknesses in financial processes; internal controls over financial transactions.  

Rationalization of fraudulent activity takes place where an individual thinks they are justified in taking money because they are underpaid or under-appreciated,  or because it is for their family, or because it's just temporary and they intend to pay it back.

Exposure to fraud, or risk of fraud, differs depending on type of organizations and processes used.  

1. Smaller, self- managed associations that depend on directors/members to process transactions have a higher degree of risk because there is usually no one reviewing the transactions.  The association is completely dependent on the honesty of the member.  Risk is reduced if an outside contractor performs some or all of the accounting function.

2. Larger, self-managed associations that employ staff usually have the issue that no more than one or two people are involved in the accounting process, so there is little, if any, segregation of duties, which is one of the cornerstones of strong internal controls.  Use of outside lockbox and payroll services help reduce risk.

3. Associations that employee an outside management company enjoy some level  of automatic protection against internal fraud risk.  Most management companies have a sufficient number of staff in their employ that they can achieve an adequate segregation of duties.  However, use of an outside management company exposes  the association to risk of fraud at the management company level.  Fortunately, that occurs very infrequently.

In all instances, the association should make sure that they have adequate insurance to mitigate losses.  Consult with your HOA insurance specialist, as different kinds of insurance policies may be required depending on which of the three categories above that you fall into.

Regular review of association financial statements by a knowledgeable board or finance committee member is another action that limits ability by anyone to divert funds.  Consistently late delivery of financial statements to the board or finance committee is another potential sign of problems.  Make sure that the association gets an annual audit or review of financial statements.  Even though those engagements are not specifically designed to detect fraud, discovery can occur during this process.

Weaknesses in internal financial controls cover a very wide range of activities, but there are a few generalizations that exist.  

Money can be diverted from either the billing/cash receipts cycle or the purchase/cash disbursements cycle of financial transactions.  One of the "tracks"  that perpetrators often leave are "journal entries" in the general ledger to cover up funds diverted.  Example - assessment payments received in the form of cash can be diverted, but a journal entry must be made to show the account as "paid" in the receivables listing.  Reviewing general ledger accounts for cash, assessments receivable, and accounts payable should normally not show any general journal entries, as all entries to these accounts should come from billing journals, cash receipts journals, purchase journals, or cash disbursement journals.  General journal entries in these accounts are a red flag.

Using an outside bank lockbox system is one of the best ways to reduce risk on the billings/cash receipts cycle of transactions, as it eliminates the most common methods of diverting funds.

Establishing a fake vendor, often with a name virtually identical to the name of a legitimate vendor, is one method perpetrators use to divert funds from the purchases/cash disbursements cycle.

The basic steps that an association or board member can take to protect themselves are:

1. Never sign blank checks or checks payable to "cash"

2. Control the blank check stock

3. Require dual signatures on checks

4. Demand and review monthly financial statements

5. Review monthly bank statements and bank reconciliations

6. Make sure you are familiar with all association vendors

7. Segregate financial duties as much as possible amongst staff/members

8. Use an outside collection service for delinquent assessments receivable

9. Consider using a bank lockbox system for collecting assessments

10. Consider using an outside payroll service

11. Consider using a professional management company

12. Maintain adequate D & O (Directors and Officers) and fidelity bond insurance

13. Insist on an annual audit, which requires the auditor to document and understand your internal control system.  Such procedures are not required in a review of financial statements.

I've been asked many times to perform what is referred to as a forensic investigation where fraud is known or suspected.  It is possible to do, but be advised that such an investigation can, and usually does, cost many times more than a traditional financial statement audit.  The reason is that the normal  concept of "materiality" that is part of audit or review engagements does not exist in a forensic  investigation.  Instead, the investigator  must look at much lower levels of transactions than would be considered in a financial statement audit.

In addition, while a financial statement audit is relative predictable and can often be bid on a fixed fee basis, a forensic investigation is usually an hourly billing engagement, because you never know what you will encounter.  As an example, I was once engaged to perform an investigation that was discovered by the business owner.   He showed me what he discovered, but asked me to investigate further and determine the total losses.  We discovered five additional schemes used by the employee to divert funds, and the amount was quite large.

In summary, the best way to deal with fraud is to avoid it completely.  You do this by designing strong accounting controls where there are always checks and balances rather than reliance on a single individual, and review financial statements frequently using year to year and budget to actual comparisons to look for anomalies.  And, last but not least, request an annual audit or review of the association's financial statements.

Reserve Studies – The Complete Guide was published in October 2015.  This book is the definitive guide on the topic of reserve studies.  More than 400 pages explaining the conceptual principles, and dozens of exhibits that show you exactly how the calculations are made.  If you prepare or use a reserve study, this guide is a “must have.”

The Generally Accepted Reserve Study Standards issued April 16, 2015 by the International Capital Budgeting Institute (ICBI) have been making waves in the community association industry.  Due to normal work pressures, I, as president of ICBI, only had time to send out about a dozen emails to select individuals regarding the new standards.  However, the professional standards page of the ICBI website had more than 650 “hits” as people visited the site to see the new standards within the first few days.  Turns out those few emails were forwarded around to lots of people.

Stay tuned for more news as these new reserve study standards are more fully distributed within the industry.  These standards resolve the biggest complaints about reserve studies by requiring a uniformity in format and consistency of calculations.

Reproduced below is the table of contents of Reserve Studies – The Complete Guide. 

To order, click here.

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The International Capital Budgeting Institute (ICBI) announced the adoption of new professional reserve study standards effective April 16, 2015.  These standards, known as Generally Accepted Reserve Study Principles and Generally Accepted Reserve Study Standards, represent the culmination of a year-long effort by ICBI to provide standards for reliable, consistent reserve studies for the community association and timeshare industries.  These standards represent the biggest change in the reserve study process in twenty years and will result in better reliability and consistency of reporting in reserves.  

ICBI formed a team of 16 industry professionals from six countries for this process.  The ICBI standards committee included a broad spectrum of industry professionals that were able to provide a perspective reflecting all stakeholders in the industry.  These are truly global standards and are already being applied in several countries.

The primary differences of the new ICBI standards as compared to previously existing standards are best summarized in four broad categories:

1) A more comprehensive definition of components – The standards expand and clarify the definition of components to reflect the true maintenance responsibility of the association.  This results in greater consistency and reliability in reserve studies.

2) A more definitive description of service levels – ICBI provides for three service levels; independent study, reserve management plan (collaborating with the association), and consulting.     

3) A requirement for consistent calculations – ICBI standards establish requirements for consistent calculation methods and software capable of making accurate calculations.  Standards also require consistent terminology definitions.      

4) A consistent and uniform approach to reporting on reserve studies – ICBI standards require specific, consistent reporting formats on a summary basis, generally with a report of no more than 20 pages.  Supplemental schedules providing the detail are generally separated from the basic report.

The result to the public is a reliability and uniformity that benefits all users of reserve studies.

There are articles providing a more complete description of these standards in the Linkedin groups “Condo and HOA Finances” and “Condo and HOA Reserve Studies.”  Another financial related group is “Condo and HOA Taxes.”  All are open groups, but you have to be a member of Condo and HOA Finances before you can join the other two.

The recent articles on Revenue Ruling 70-604 generated a number of questions from readers. One of the questions related to how carryovers under Revenue Ruling 70-604 interact with member losses (excessive member expenses over member revenues) calculated under Code Section 277.

The Internal Revenue Service issued Revenue Ruling 2003-73 to explain this issue, providing four examples that illustrate the calculations. Simply stated, an association choosing to file Form 1120 can have only three possible outcomes as it relates to that member income:

1. 1)The Association could have an excess of member income over member expenses, which generally is either refunded or rolled over to the following year under the provisions of Revenue Ruling 70-604. If the excess member income is not refunded or carried over to the subsequent year, it’s considered gross income under Code Section 61 and is added to taxable nonmember income.
2. 2)It could have an excess of member deductions over member income under Code Section 277, which by law is required to be rolled over to the subsequent year. It may not be carried back, nor may it be used to offset nonmember income.
3. 3)It could have exactly $0 net member income, though that outcome is virtually impossible.

The following table is reproduced from Revenue Ruling 2003 – 73.

Note that in Year 1, the member loss cannot be upset against the nonmember income, resulting in the full $4000 of nonmember income being reported as taxable.

In Year 2, the same situation exists in that after applying the member loss carryover from Year 1, there is still a net member loss in Year 2. That cannot be offset against nonmember income, so the $3,500 nonmember income stands alone as being taxable.

In Year 3, a different situation occurs. There is a net member income which is not fully offset by the member loss carryover from Year 2, thus resulting in a net member income in Year 3. This calculation assumes that no election has been made under Revenue Ruling 70-604, so net member income is added to nonmember income and the combined amount is taxable income. Had the Association made an appropriate election under Revenue Ruling 70-604 in Year 3, the net member income of $1,750 would have been either refunded or carried over to the subsequent year and would not be taxable in Year 3.

In Year 4, there is the unusual situation of a net member income of $1,000 and a net nonmember loss of $1,500. This is similar to Year 3 in that member income and nonmember income are both considered taxable and are combined. Please note, however, that member losses may not be offset against nonmember income.

In a subsequent article, we will address additional questions that were raised relating to Revenue Ruling 70-604.

Most people have heard of the Mayan calendar that was created hundreds of years ago, even before the Americas were discovered by explorers. Of particular concern(once the calendars were deciphered) has been the prevailing interpretation of the Long Count calendar that some cataclysmic event would occur on December 21, 2012. Many believed this would be the end of the world.

December 21, 2012 is now behind us, and obviously the world did not end. Up until that date, however, many people were so convinced the world would end that they just refused to plan for any future beyond that date. Their attitude was, why plan for something in the future if you're not going to be here? There are others who believe that the year 2012 was simply misinterpreted, and that the end of the world is still relatively imminent.

This continued insistence that the world is going to end (soon) is nothing more than a convenient form of denial. It’s often referred to as the “2012 syndrome” since that date is so widely known, and since it was proven to be a false alarm. Those who suffer from the 2012 syndrome tend to use denial as an excuse for not taking action today. It doesn't really matter in what context this occurs. The person simply believes that there is no reason to plan because . . . (insert whatever reason you want here).

How does this concept apply to the community association world? We mostly see this in connection with reserve planning. Very few associations reach the 100% funded level, and many never even aspire to do so. We have performed reserve studies for many associations whose stated goal is to "reach 65% funded in 20 years." Some associations can get away with this by using the cash flow method of reserve funding to document that the association can get by with lower levels of reserve funding and still avoid special assessments. In one sense, there is nothing wrong with such a funding plan so long as members are fully advised to and supportive of this plan. However, it is not an "equitable" method of funding, as it means that the individuals "using up" the community components are not paying for the full use and enjoyment they are receiving - they're passing the buck to future owners.

On the other hand, too much reliance on the "percent funded" concept can also be a problem. The Association really needs to carefully conduct a cash flow analysis to make sure that enough funds will be available in "peak expenditure years." These are the years where multiple significant expenditures are scheduled to occur based on dates placed in service and estimated useful lives. As an example, if a condominium association has exterior painting, roofing, and paving projects all occurring at the same time, that would be considered a peak expenditure year. The only ways an association can accommodate the cash flow requirements for these kinds of years are to (1) build up the required cash flow in advance, (2) spread the projects out to fall on different years (although there is great danger in deferral of projects simply because they are inconvenient), and (3) borrow funds when needed and repay at a later date.

From experience I’ve learned that the "2012 crowd" is alive and well within the community association industry. These are the folks who don't want to fund reserves at all, or only at a very minimum amount. To be honest, I don't think most of these folks really believe that the world is about to end. I think they're just in denial that, for instance, the roof really needs to be replaced. After all, it has not been a problem for the last 20 years, so why should it be a problem now? Let somebody else worry about it. This kind of thinking affects association reserve funding plans by resulting in absolute minimum reserves being established and funded, and by necessary maintenance work being either deferred or funded by special assessments. This strategy might work on a relatively short-term basis, but is doomed to failure on a long-term basis.

Unfortunately, I believe the 2012 believers will always be with us. As for me, I have long been a skeptic of the 2012 theory. Think of it this way - you're creating a calendar consisting of future time periods. How far into the future do you take it? Until you run out of paper? Using a computer, you could theoretically run the calendar to any future period. However, the Mayans didn't have computers, nor did they have paper. They only had stone. I have always maintained that the Mayans simply ran out of stone, so they had no more room to continue - and after all, their calendar already looked hundreds of years into the future. Maybe they just didn't bother to get another stone.

Moral of the story? Don't be a denier. Carefully consider your association's future funding requirements and start setting aside an appropriate amount of money to fund those future expenditures.

Having just completed another tax season, and having again dealt with the issue of educating new clients on the REAL differences between Form 1120 and Form 1120-H, it’s time to have this discussion again.

Over the years I have heard many CPAs make presentations about the advantages of Form 1120 over Form 1120-H. Virtually all of those discussions boil down to a single point – the 15% tax rate of Form 1120 versus the 30% tax rate of Form 1120-H. The position generally set forth is that it’s crazy to pay taxes at a 30% tax rate on Form 1120-H when you can just as easily pay taxes at a 15% rate on Form 1120. I am not aware of ANY tax practitioner, other than myself, who has ever included a dialogue of the risk factors of Form 1120 as part of this discussion.

While the IRS no longer publishes statistics on homeowners associations, the last year they did so it was noted that approximately two thirds of associations filed Form 1120-H. It was also reported that the average association reported $5,582 of interest income. With today’s low interest rates, that number is probably now substantially smaller. But let’s assume that those old averages are still accurate and examine the differences between the two tax forms. To make the calculations easier, we will assume that deductions allocable against interest income, composed primarily of tax preparation fees (fully deductible) and management fees (allocated at 10% deductible based on the Concord Consumers Housing Cooperative v. Commissioner case), total $1,582, leaving exactly $4,000 as taxable income. (That makes this illustration easy to follow.)

Form 1120 – The $4,000 taxable income at 15% results in a tax of $600. Assuming no problems, that’s all the tax liability. But if you apply risk factors, the answer changes dramatically. Risk Factor #1 - What if the Revenue Ruling 70-604 election is disallowed (for several possible different reasons, as discussed in a previous article – see below) and that (assumed) $10,000 of excess member income becomes taxable? The tax just increased by $1,500. Your tax savings not only just disappeared, but became multiples of the tax you would have paid on Form 1120-H. Risk Factor #2 - Worse yet, consider that the IRS audits this tax return and assesses tax on ALL your entire reserve balance because you didn’t exactly comply with the requirements to exclude reserves from taxable income. Assuming reserves of $100,000, which gets added back as additional excess member income, your taxes just increased another $20,000. You’re now so far behind the curve you can never catch up.

Form 1120-H – The $4,000 taxable income at 30% results in a tax of $1,170 because of the special $100 deduction allowed on Form 1120-H. Since excess member income is not taxed on Form 1120-H, you don’t have to worry about the Revenue Ruling 70-604 election, nor excess member income. It also doesn’t matter if you fail to exactly follow the rules on excluding reserves from taxable income on Form 1120-H, as reserves failing to meet the “capital contribution” test are reclassified as excess member income, which isn’t taxable on this Form.

Comparison – Form 1120 initially saves $570 as compared to Form 1120-H, but exposes the Association to risks (in this example) of an additional $21,500 of taxes. That’s a lot of risk to assume for a very small tax savings. Are the members going to appreciate, or even notice, a $570 savings? Maybe, but not likely, and certainly not if the Association gets tagged by IRS for the additional tax. In that instance, the members will only accuse the Board and tax preparer of making a bad decision on the tax form to file, and hold them responsible for failing to take advantage of the safety offered by Form 1120-H.

I have offered the analogy in the past that purposely filing Form 1120 when any possible risk at all exists is the same as saying that you believe insurance is an unnecessary expense and premiums should not be paid. How do you know if there is risk? Look at the following two articles to see if you’ve complied regarding Revenue Ruling 70-604 and treating reserves as capital contributions.

Making the Revenue Ruling 70-604 election

Reserves as Capital Contributions for Tax Purposes

Background - Let’s review some of the basics. On Form 1120-H, Congress purposely created a safety net that allows associations to accumulate reserves without doing anything special at all. Apparently, just identifying some money as reserves is sufficient. No specific record-keeping requirements are mandated. No election under Revenue Ruling 70-604 is required, and even if the IRS audited the tax return and took the position that the Association reserves didn’t qualify as capital contributions, it doesn’t matter – those reserves would then be reclassified as exempt function income, which is not taxable on Form 1120-H. All the tax law you need to comply with is located in a single Code (Internal Revenue Code – IRC) section; IRC § 528.

Form 1120 is a completely different matter. When you file Form 1120, it means that you are no longer a homeowners association. The term “homeowners association” is defined in IRC § 528, and applies only to an organization that meets the qualifying criteria and files Form 1120-H. So if you are no longer a homeowners association, what are you? A nonexempt membership organization is defined in IRC § 277 (as a matter of law - you don’t have a choice in the matter). Those rules were not written with your Association in mind. The Association must now contort itself to look like the type of organization that Congress had in mind when they created IRC § 277, and that is NOT an organization that has an obligation to accumulate huge cash reserve accounts to meet future needs. The Association must comply with a very large body of tax law. Unfortunately, and unlike IRC § 528, this body of law is not codified into a nice, neat set of rules. You have to look at many different categories of rulings to be able to see the whole picture. Too many people see a few key rulings and think they see the whole picture. You are doomed to failure on Form 1120 unless you are familiar with the entire body of applicable tax law. Practitioners Publishing Company’s Homeowners Association Tax Library (of which I am the co-author) contains more than 100 different rulings at eight different levels trying to capture these concepts in a coherent manner. More than 900 pages (and that’s after deleting the least important sections) of this book are devoted to Form 1120. The majority of these rulings deal with associations that file Form 1120, so only when you are familiar will all these rulings are you really prepared to consider Form 1120.

The major risks you assume with Form 1120 are quite simple. First, there is the risk that you could expose excess member income to taxation. Unlike Form 1120-H, where the excess exempt function income (a roughly similar concept and definition to excess member income) avoids taxation, it is taxed on Form 1120, unless you successfully get rid of it. There are only three options: (1) pay tax on the excess income, (2) either refund it to members or roll it over to the next year under Revenue Ruling 70-604, or (3) transfer it to reserves (subject to strict rules). Second, there is the risk that you could expose your reserves to taxation.

Commentary - Are these risks really that great? Yes! Many associations apparently just rely on the “IRS audit lottery.” Fewer than 1% of associations get audited. No professional tax preparer can advise you to consider this factor when making a decision on what tax form to file. An association may itself take that into consideration, but ethics rules prohibit the tax preparer from considering it.

I have been involved in 50 IRS audits of associations, but in only one of those instances did I actually prepare the tax return myself. I am generally retained by the tax preparer/CPA, the tax attorney, or the Association as soon as they realize that IRS has raised tax issues that had not previously been considered. Of the 50 tax audits, one was on Form 990 (an exempt association), two were on Form 1120-H, and 47 were on Form 1120. The two Form 1120-H audits resulted in no additional taxes being assessed. ALL 47 of the Form 1120 tax audits resulted in additional taxes being assessed.

I was presented with the following challenge this past tax season: informing several new clients that they had tax exposure on their prior year Form 1120 tax returns; educating them as to the risks inherent in that form; and convincing them that the minor additional tax they would pay on Form 1120-H should really be viewed as buying an insurance policy against a future tax assessment.

We keep thinking that the issue of filing Association tax returns is so well-settled and well-documented by numerous articles on the subject that we shouldn't have to address it again. But apparently we were wrong. The answer is YES, Associations do have to file income tax returns. Failing to file tax returns caused the Association in this article major problems.

Why are we looking at this again? We were recently contacted by an Association that had not filed tax returns for a five-year period. The newly appointed treasurer wondered why. He asked the prior treasurer, who told him that since the Association did not have any taxable interest income in excess of $100, he had been advised that there was no need to file income tax returns. Bad advice.

This small, 15-unit condominium project located in California is a volunteer-run Association. They felt that because of their small size, professional management services were too expensive. Apparently they felt the same way about tax and legal services, as they did not consult with outside professionals for either of these services. Clearly this was a case of penny wise and pound foolish. The added fact that this is a California association just makes the problem worse.

An association is always required to file a federal tax return, even if they have no taxable income at all. Federal tax rules (for most associations) are that the Association can either elect to file Form 1120-H (assuming they meet the qualification requirements), or Form 1120 if they do not elect to file Form 1120-H. We routinely advise associations to file Form 1120-H to avoid the tax risks inherent in Form 1120.

Because Form 1120-H is a simple, one-page form, many associations just have the treasurer prepare it. The simplicity of the form was intentional when Congress created the tax law, so that associations could easily comply. The lack of professional advice, however, means that many associations could be making poor decisions in selecting which tax form to file. There are times when Form 1120 is clearly advantageous, and tax risk can be minimized.

The federal tax issues related to five years of delinquent tax returns are fairly straightforward. One simply needs to prepare and file the delinquent returns. The problem is that Form 1120-H can only be elected on a timely-filed return. Since the tax returns in this case are all delinquent, the Association is technically required to instead file Form 1120. Form 1120 is a much more complex form, and also exposes the Association to taxation of excess member assessment, which would not have been taxable on Form 1120-H.

The treasurer had visited the local IRS office and explained the situation. He was provided with Forms 1120-H for all five years. His question to uswas which form to file. In this circumstance (which we encounter several times annually), most associations will file the Form 1120-H, even though technically they are not allowed to do so, since they did not make a timely election. It is interesting to note that we have never seen IRS reject the Forms 1120-H, even when it was brought to their attention that the forms were not timely filed. In a rare example of common sense, IRS has apparently realized that simply getting the tax returns filed and up-to-date is most important, and that there is likely no tax going uncollected by allowing Form 1120-H rather than insisting on Form 1120.

For our California association, the federal taxes were the easy part. It was California that caused the problems. This Association had applied for and was granted California tax exemption as a homeowners’ association in the early years of its existence. That means that the Association was required to file two tax forms annually for California: Form 199 to comply with the exempt organization rules, and Form 100 to report taxable activities.

The Association's failure to file tax returns for five years caused two things to happen. First, their exempt status was revoked. Second, their Association's corporate status was suspended.

The revocation of exempt status meant that the Association was now subject to the California minimum corporate tax of $800 annually. (For those of you counting, five years amounts to $4,000 in taxes, plus penalties and interest). Overcoming this issue required re-filing for exemption by preparing a new exemption application and submitting all the delinquent tax returns for the five-year period. it was fairly easy to resolve, but expensive.

The biggest issue was the suspension of corporate status.   That meant that legally, in the eyes of the state of California, the corporation no longer existed. That became a huge problem because the Association had entered into a contract for roofing and was having difficulty with the contractor. That's when the Association finally consulted with a lawyer and discovered the suspension. The attorney had advised the Association that they must immediately resolve the suspension issue in order to legally conduct business as a corporation. Otherwise, the individual owners may have exposure to risk, as they no longer had the protection of the corporation.

We also inquired and discovered that the Association had failed to file its biannual officers’ statement with the Secretary of State, and had been assessed a $250 penalty.

Resolving the corporate suspension required filing all delinquent tax returns, paying the $4,000 in minimum tax (which would later be refunded after the new exemption application was approved), filing the officer statements, and filing a Certificate of Revivor with the Secretary of State to be reinstated.

Because of the contractual and legal issues, the attorney advised immediate resolution. It can take several months for the exemption application to be approved by the California Franchise Tax Board (FTB) (California's equivalent of the IRS), so the only way to quickly resolve the issue was to move forward as a for-profit corporation and pay the $800 per year minimum tax, plus related penalties and interest. We prepared the delinquent tax returns for the five years, and had the Association file the federal returns and Form 100 for California. We also prepared the Certificate of Revivor, and had the Association file that form and pay all delinquent taxes, penalties, and interest.  

We then immediately prepared the exemption application, and had the Association submit that application along with Form 199 for all five delinquent years, as well as a request for refund of minimum taxes paid. The California FTB refunded only four of the five years of minimum tax, as the fifth year was considered to be beyond the statute of limitations. Penalties and interest were NOT refunded.

Bottom line, this was a very expensive lesson for a very small Association. They would have not only saved money but also avoided risk had they sought competent professional advice on a timely basis.

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:

1. Who is REALLY the taxpayer?
2. What is the tax basis in the property sold?(This will probably surprise you.)
3. Was this a complete or partial sale? (Didn’t see that one coming, did you?)
4. What did you do with the sale proceeds?

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:

1. Who is REALLY the taxpayer?
2. What is the tax basis in the property sold?
3. Was this a complete or partial sale?
4. What did you do with the sales proceeds?

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:

1. If the Association purchased the property it later sold, the tax basis is the purchase price plus any subsequent capital improvements made to the property.
2. If the developer transferred the property to the Association while it still retained at least 80% control of the Association, then the Association has the same basis in this property as it had in the hands of the developer, assuming that the developer did not take a deduction for this property on the developer's tax return. And that is generally an unknowable fact, particularly 20 years down the line.
3. If the developer transferred property to the Association at a point in time in which it no longer retained at least 80% control of the Association, that is generally considered a contribution to capital and there would be no tax basis in the property.

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.