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subject to taxation is revenue received from sources outside of association membership, such as interest income, rental income, or signing bonuses for contract agreements. Some associations may receive money from cable or communication providers in exchange for allowing them to place antennas or communication equipment on their roof or property. Other associations may receive monthly or quarterly payments from entities for commission or percentage portions, such as ATM machines, laundry facilities, and the like. In some circumstances, an association may even receive income from the state in exchange for giving up a piece of its property to be used by the state. Some associations possess large amounts of reserves and invest them in financial instruments that earn significant amounts of interest, capital gains, or other returns on investments. These types of income are deemed to be subject to tax, regardless of the type of federal tax return filed. To paraphrase House Stark’s pervasive warning: “Taxes are coming…”
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DEDUCTIONS
Let’s say that an association possesses reserve cash accounts to rival Tywin Lannister’s wealth of gold, and that those reserves earn significant interest income every year. What deductions could be allowed to use to offset this taxable income?
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IRS tax code does not give specific flat deductions and/or percentages that associations can use. Some examples of expenditures that may be allocable against non-exempt income are as follows:
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In determining the allowable percentage of management fees to be utilized as a deduction, the association should consider how much time management spends on banking, investing and producing financial reports and data. The association may wish to discuss this with its management company to arrive at a percentage that is reasonable and agreeable. There was a tax court case years ago involving an association and its deductions, and the courts allowed the association to take only 5% of management fees, because the association was unable to substantiate the percentage of management’s time on financial matters, and could not defend or support a higher percentage (Concord Consumers Housing Cooperative v. Commissioner). Some accountants recommend to their association clients that
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they obtain a memo from management that indicates approximately how much of their time was spent on financial, banking, or other activities that result in taxable income.
1120-H vs. 1120?
There are two basic federal income tax forms that are available to be filed by most common interest realty associations: the 1120 standard corporate return, and the 1120-H (“short-form”) homeowners association return. The 1120 federal tax return is the same form that most corporations file. Currently at a minimum of five pages plus supporting statements, this return requires the reporting of all income and expense items for the year. The 1120-H return is specific to homeowners associations (which includes condominium and other residential associations), and as such, requires the reporting of income and deductions that are not exempt from tax. At only one page (and one supporting statement), it is much simpler to prepare.
1120-H basic facts
The 1120-H tax return has sometimes been referred to as the association industry’s answer to the 1040-EZ individual tax return. When filing this return, associations are required to report nonexempt income items, such as those discussed previously, and the allowable deductions incurred to generate the income.
There are a few tests an association has to pass in order to file an 1120-H federal tax form. First, the amount of exempt (i.e., membership) income must be greater than 60% of the total income earned by the association in the year. This means that if 40% or more of an association’s income was derived from ancillary or nonmembership sources, it may not file the 1120-H federal tax form, and would have to file the 1120 corporate tax form. Second, at least 90% of the total expenditures are qualifying expenditures, being operating or capital/reserve expenses for the association property, and not expenditures incurred to generate, or related to, nonexempt income. This means that the total deductions reported on the 1120-H may not equal 10% or more of the association’s total expenditures for the year.
As of the 2013 income tax year, the 1120-H federal tax return allows a standard $100 deduction. This means that if an Association has net taxable income of less than $100 for a year, it still may not have to pay federal income taxes (though the state of Illinois does not allow such a deduction, so any net taxable income for a year would be subject to Illinois state income tax).
1120 basic facts
As mentioned previously, the 1120 corporate federal tax form is a longer and more involved return, and actually would require a much longer article than this one to discuss every aspect of this return. Under the 1120 federal return, there are two basic categories of income that are subject to tax.
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