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:

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.

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.