A very old gemologist, intent on having a priceless ruby, summoned a young assistant, and providing him with a detailed, technical description of the stone, sent him off to find it. Unfortunately, being new in the business the assistant was confounded by the task and returned to the old gemologist empty handed. Recognizing that the assistant was sent on an exercise in frustration, the gemologist sent the assistant to find the largest, shiniest, most beautiful ruby ever. That same day the assistant returned with news that he had negotiated terms to acquire the very stone the gemologist sought.

Taxation of condominium associations, with its many facets, is like this ruby. A technical description of the relevant tax law with reference to code sections and revenue rulings would, in most cases, confound board members. On the other hand, a description of the result of proper application of the law should empower board members to know what to look for when reviewing a tax return for a condominium association.

Associations are generally taxed in a manner that treats condominium owners similar to regular homeowners. Money that is invested for future home improvements earns interest and such interest, less any expenses necessary to generate it, is taxed. A regular homeowner typically reports investment income on schedule B that is attached to their personal Form 1040. An association, on the other hand, can report its taxable income on either Form 1120, which is used by corporations, or on Form 1120-H electing to be taxed as a nonprofit homeowner’s association. In most cases filing Form 1120 results in less tax because a 15% rate is applied which is half of the rate applied on Form 1120-H. This is the first key to reviewing an association’s tax return. If the preparer has filed Form 1120-H, beware! The only cases when Form 1120-H is preferred is when investment income for the year is less than approximately $450 but greater than $300, or when the association is trying to increase operating fund cash rather than replacement fund cash. Some preparers file Form 1120-H fearing the so called "single business tax trap". However, as indicated in the instructions for the single business tax return, single business tax does not apply to condominium associations.

A second warning sign to watch out for is a large net operating loss (NOL). A net operating loss occurs when taxable income is less than deductible expenses. Most associations, if the proper elections are made, are only taxed on investment income, and can only deduct expenses associated with the production of investment income. Therefore, unless the return is prepared improperly, it would be very difficult for a large NOL to result. If you encounter this situation, discuss the calculation of the NOL with the preparer, to verify that it is legitimate. If expenses not related to investment income or rental income from non co-owners are deducted on the return, the preparer probably is not familiar with code section 277 and the return is incorrect.

You will note that tax is assessed on investment income less any expenses necessary to generate such income. A minor problem arises when the preparer’s allocation of expenses against investment income is not reasonable. The cost of preparing the tax return for the association is fully deductible against investment income. A portion of other administrative expenses and directors’ and officers’ insurance can also be deducted. A reasonable method to allocate these expenses is to use the relative magnitude of the related revenue items. The cost of preparing an association tax return, generally would not exceed $300. The allocation of other expenses will vary. However, unless investment income is less than $300 it would be unusual for the allocation of expenses to result in a net operating loss. Therefore it is a good idea to review the preparer’s allocation of expenses. First to make sure that all the deductions that can be taken have been. Second, to make sure the allocations are reasonable.

If an association has filed incorrect tax returns in previous years, it would be appropriate to contact the preparer and inform them of any concerns. One can take some consolation in that internal revenue agents in this region do not seem to understand how condominiums are taxed. As a result, enforcement of the tax law as it relates to associations in our district has been nonexistent.

It is important to keep in mind that although board members generally do not prepare the association tax returns, they are still responsible for them. Therefore, board members should review the association’s tax return before it is filed. The issues covered in this article should help identify whether any significant problems exist with the return.

ABSTRACT

Association tax law if not complex is at least atypical. Internal revenue agents and some preparers in this geographic area are not familiar with the code sections and revenue rulings that apply to associations. Therefore, it is not unusual for returns to be prepared incorrectly. Some of the warning signs of improperly prepared returns include filing of Form 1120-H instead of Form 1120, and the existence of large net operating losses. Board members are responsible for the content of tax returns filed, therefore it is important that they be able to perform an informed review of such returns.