By: John S. Morlu II, CPA
Homeowners Associations (HOAs) play a vital role in maintaining community standards and shared amenities. However, managing their finances involves navigating complex tax rules, including filing requirements and compliance with IRS regulations. Among the most critical elements of HOA taxation is the Form 1120-H, a specialized form designed to streamline tax compliance for HOAs. Despite its simplicity, HOAs often face unique tax challenges that, if not managed properly, can result in financial penalties, increased tax liability, or even audits.
This article explores the current tax issues and challenges facing HOAs, shedding light on Form 1120-H, key compliance pitfalls, and strategies to avoid them.
Understanding Form 1120-H
The Form 1120-H, or the U.S. Income Tax Return for Homeowners Associations, is a tax form specifically designed for qualifying HOAs. It offers a simplified way for associations to meet federal tax obligations.
Key Features of Form 1120-H:
- Flat Tax Rate: HOAs filing Form 1120-H are taxed at a flat rate of 30% on their taxable income.
- Exclusion for Member Income: Most member dues and assessments used for HOA purposes are exempt from taxation under the 90% test (explained below).
- Non-Member Income Taxable: Income derived from non-member sources, such as rental income or interest, is subject to tax.
Key Qualification Requirements for Form 1120-H
To file Form 1120-H, an HOA must meet the following criteria:
- Exemption Purpose Test: The HOA must operate for the management, maintenance, and improvement of residential property.
- Exempt Function Income Test (90% Test): At least 90% of the HOA’s revenue must come from member assessments, dues, and other exempt function income.
- Expenditure Test (85% Test): At least 85% of the HOA’s expenditures must go toward maintaining or managing association property.
- Non-Commercialization Test: The HOA must not provide services that are akin to a business, such as managing properties not owned by members.
Current Tax Issues and Challenges Facing HOAs
1. Misclassification of Income
One of the most common tax challenges is the misclassification of income. HOAs often generate revenue from both exempt and non-exempt sources, including:
- Exempt Income: Member dues, assessments, and fees specifically allocated for HOA activities.
- Non-Exempt Income: Rental income (from clubhouse rentals), interest income, or income from vending machines on association property.
The Challenge:
Misclassifying non-exempt income as exempt can lead to underreporting taxable income, triggering penalties or audits.
Tidbit:
Did you know that even something as simple as renting out the HOA-owned clubhouse for private events can be taxable? If these activities exceed 10% of the HOA’s total revenue, it could disqualify the HOA from using Form 1120-H.
2. Meeting the 90% and 85% Tests
The 90% and 85% tests are strict requirements for filing Form 1120-H. Falling short of these thresholds can disqualify the HOA, forcing it to file the more complex Form 1120 (U.S. Corporation Income Tax Return) instead.
The Challenge:
- Non-compliance often arises when HOAs generate significant non-member income or make expenditures unrelated to property maintenance (e.g., unrelated legal fees).
- Filing Form 1120-H despite failing these tests can result in IRS penalties or reclassification of the tax return.
Fun Fact:
Switching from Form 1120-H to Form 1120 requires meticulous tracking of expenses and income, as Form 1120 has no automatic exemption for member dues. This could lead to higher tax liability if exemptions aren’t clearly documented.
3. Recordkeeping and Documentation
HOAs are required to maintain detailed financial records to demonstrate compliance with IRS regulations, including:
- Member dues and assessments.
- Expenditures for maintenance and management.
- Income derived from non-member sources.
The Challenge:
Poor recordkeeping can result in an inability to meet the 90% test or properly allocate expenses, leading to an audit or additional tax liability.
Industry Fact:
According to a 2022 IRS report, 25% of HOA audits revealed discrepancies in income classification and expense allocation, highlighting the importance of accurate financial records.
4. Reserve Fund Management
HOAs are often required to maintain reserve funds for future repairs or capital improvements. While contributions to reserve funds are typically exempt, how these funds are used can have tax implications.
The Challenge:
- Income earned on reserve funds, such as interest, is taxable.
- Misusing reserve funds for non-property-related expenditures can jeopardize the HOA’s compliance with the 85% test.
5. Unrelated Business Income Tax (UBIT)
If an HOA generates income from activities unrelated to its exempt purpose, such as running a for-profit business, it may be subject to Unrelated Business Income Tax (UBIT).
Examples of UBIT Activities:
- Operating a non-member fitness center or community pool.
- Managing rental properties not owned by the HOA.
The Challenge:
Failing to report unrelated business income accurately can result in IRS penalties and increased scrutiny.
Practical Strategies to Address HOA Tax Challenges
1. Stay on Top of Financial Reporting:
- Use accounting software tailored for HOAs to track exempt and non-exempt income.
- Generate detailed financial reports to meet the IRS’s recordkeeping standards.
2. Conduct Regular Tax Reviews:
- Periodic tax reviews by a CPA familiar with HOA taxation can help identify and correct potential issues before filing.
3. Educate Board Members:
- Provide training on the importance of maintaining compliance with the 90% and 85% tests.
- Ensure the board understands the tax implications of non-member income and reserve fund management.
4. Engage a CPA with HOA Expertise:
- Tax rules for HOAs are unique, and working with a professional experienced in Form 1120-H ensures compliance and minimizes liability.
5. Plan for Reserve Fund Taxation:
- Factor in potential taxes on interest earned by reserve funds when budgeting for future projects.
Conclusion
Navigating the tax challenges of managing an HOA is no small feat, especially with the complexities of Form 1120-H and strict IRS compliance requirements. Misclassifying income, failing the 90% and 85% tests, or overlooking recordkeeping can lead to significant financial repercussions. By understanding these issues and implementing proactive strategies, HOAs can minimize tax liability and ensure the financial health of their communities.
Interesting Tidbit:
Did you know that some HOAs opt to file Form 1120 instead of 1120-H to take advantage of lower corporate tax rates on lower income levels? While this approach can save money in certain cases, it requires significantly more recordkeeping and effort to justify the deductions.
Whether you’re an HOA board member or a homeowner, staying informed about these tax issues ensures your community remains compliant, transparent, and financially secure.
Author: John S. Morlu II, CPA
John S. Morlu II, CPA, is the CEO and Chief Strategist of JS Morlu, a globally acclaimed public accounting and management consulting powerhouse. With his visionary leadership, JS Morlu has redefined industries, pioneering cutting-edge technologies across B2B, B2C, P2P, and B2G landscapes.
The firm’s groundbreaking innovations include:
• ReckSoft (www.ReckSoft.com): AI-driven reconciliation software revolutionizing financial accuracy and efficiency.
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• Fixaars (www.fixaars.com): A global handyman platform reshaping service delivery and setting new benchmarks in convenience and reliability.
Under his strategic vision, JS Morlu continues to set the gold standard for technological excellence, efficiency, and transformative solutions.
