1120H for Condominiums and Cooperatives (CIRA)
A Common Interest Real-estate Association (CIRA) is a cooperative or condominium association (“Association”). The Association in its first year of operation and is expecting to file its federal and state income tax return for the first time.
This discussion is general in nature and is not intended to serve as tax advise. Instead, it summarizes the basis for our belief regarding the particular situation of the homeowners’ Association. Tax planning and actual results should be evaluated periodically in order to minimize the lax liability. Results of tax filing and planning may not apply if certain theoretical conditions are not satisfied.
Under a homeowners’ association incorporation each member:
1. Is a direct owner of a portion of a real estate (apartment) and
2. Has a vote in the Association’s decision.
The two tests above are mutually dependent; a person must have a vote in order to own an apartment and must have an apartment in order to have a vote.
Section 528 Treatment
The Association may be covered under IRC section codes 277 and 528. Section 277 mandates that the income of a condominium association is treated similar to any other 1120 corporation, with the exception of section 277 improvement funds which is considered capital and not income to the corporation.
IRC section 528 maintains 4 tests to qualify a residential condominium association for section 528 treatment:
1. Residential test – substantially (85%) all the units must be for residential use
2. Income test – 60% of the gross income must be of exempt nature
3. Expenditure test – 90% of the expenses must of exempt nature
4. No benefit test – the residual income may not be used for members’ benefit.
These tests are general and have some exceptions which do not immediately apply to this homeowner’s Association.
The Income and Expenditure tests
Income is defined as exempt when it is received from owners in their capacity as association members, rather than in their capacity as customers for goods or services.
Expenditures are defined as operating and capital expenditures that directly affect the association’s property. Generally, the “association’s property” for purpose of this discussion is property owned by the association for the enjoyment of its members.
Other sources of income, for example vending machine commissions, laundry fees and recreational facilities for which a fee is paid by users (regardless of membership) are non-exempt income activities. When a direct relationship between non-exempt income and non-exempt can be established, these expenses reduce the non-exempt income directly. For example, laundry fees income is reduced by laundry maintenance expenses.
IRC regulation 1.528-9(d) provides that a once-a-year billing and payment for services provided by the association is considered exempt income. However, expenses related to such billing are still considered non-qualifying if their nature is not for construction or maintenance of association property (IRC 528. c.1.C)
Utilities and other bills that are reimbursed by members on a pro-rata or fixed basis are generally treated as exempt income.
Tax on net income from non-exempt activities is at a fixed 30% rate.
Electing 1120-H treatment
An 1120-H election can be made by filing form 1120-H. However, revocation of this treatment must have the consent of the I.R.S. If IRC 528 is not elected (Form 1120-H), IRC 277 is the default treatment.
Section 277 Tax Treatment
Under IRC section 277, membership income is taxable, and qualified expenses are deductible except for capital expenditures.
Similarly to non-exempt income under section 528, expenses directly related to income reduce the income from that source (e.g. maintenance income for laundry services reduces income from such services). Other expenses such as accounting and tax preparation fees, office expenses and management fees, fidelity bonds and state income tax may be used to off set interest income.
Excess membership income may be capitalized and deferred if such treatment is elected. Generally, such treatment (Revenue Ruling 70-604) is for excess membership income undistributed by year-end. An annual meeting is required for such deferral to be elected. Alternatively, such excess may be elected to be treated as “replacement fund” for future contingencies or specific capital expenditures (IRC section 118).
Section 277: Alternative Minimum Tax, Capital Los, Net Operating Loss, Organizational Costs
Generally, AMT is repealed for corporation with gross receipts of $5M or less or average of $7.5M over three years.
Net operating loss from membership expenses in excess of membership income can be carried forward only.
Capital gains in excess of capital losses are taxable. Capital Loss in excess of capital gains can be carried back or forward.
Organizational costs qualify as non-exempt expenses and they increase taxable income, and Net Operating Loss is disallowed to carry over.
Summery and Recommendations
Associations with taxable income lower than $100 or higher than approximately $186,000 may benefit from filing form 1120-H because its fixed 30% tax rate is lower than the 1120 marginal rate for corporations. Form 1120-H greatly reduces the potential for Alternative Minimum tax and the compliance risk for filing it is considered low.
Because of lower marginal tax rate for corporations (15% for the first $50,000 of net income) filing form 1120 has tax saving advantages. This might be important in early tax years because on the 1120 organizational expenses are written off during those years and are capitalized on form 1120H. Further, once a 1120H election is made, technically it has to be continuously used until a revocation is granted by the Internal Revenue Service.
Yigal Rechtman © 2003