All homeowner associations (HOAs) must file a tax return every single year. But you must pass a few tests in order to file Form 1120H. One of the tests is the form 1120H 90% expenditure test. This test is not as easy as you think.
Even if there aren’t any taxes owing, this isn’t something that can be ignored and it can lead to plenty of issues when people choose to ‘forget’ the process.
In terms of the definition itself, a ‘homeowners’ association’ generally covers a residential real estate management association, a condo management association, or even a timeshare association so long as they fulfill certain requirements.
When it comes to filing an HOA tax return, each year is flexible in that either Form 1120 or Form 1120-H needs to be filed. Despite popular belief, an HOA can file a different one every year depending on their needs. Ultimately, they both offer advantages and disadvantages with Form 1120-H being less likely to receive an audit following the filing and Form 1120 offering cheaper tax rates.
When you choose Form 1120-H, you file under a specific section of the Internal Revenue Code (Section 528). Nowadays, this seems to be the most popular option because it’s much easier to avoid tax; so long as the majority of expenses are going towards the maintenance and nearly all income comes from assessments, tax is never normally an issue. Condo associations face the same issues.
Within Section 528 of the IRC, you’ll see certain restrictions and requirements and these need to be passed in order to qualify. Although there are a couple of note, the most interest seems to come around the ‘90% expenditure test’. However, we’re getting ahead of ourselves because we briefly want to show all the requirements for Form 1120-H so you have a better idea for how it all works.
Form 1120-H Filing Requirements
In total, there are four main requirements to Form 1120-H and all four will need to be met by your HOA to qualify. If these aren’t met, the only option is normally to file under Form 1120 but an accountant will help you with this if you don’t pass the requirements below.
- Of all the homes under the ownership of the HOA, over 85% need to be used as residencies. Essentially, this means you can’t own a number of condos and only use one as a residency before then filing under Form 1120-H.
- With all income the association receives over the course of a year, at least 60% needs to be exempt; this means it should be a result of owners and their role as association members. If you have goods or services within your control, income here from customers doesn’t count.
- If you have any residual income, this can’t be used to benefit the members in any way.
- Finally, a minimum of 90% of all expenses for the HOA must be exempt; much like we saw with the income test, this means the expenses need to directly impact association property and this could be any operating or capital expenditure.
Form 1120H 90% Expenditure Test
Over the years, we’ve learned that the majority of HOAs don’t have any issues with the first three requirements. If it were just these three alone, we wouldn’t have to write this guide and there would be fewer questions regarding the whole topic. However, it exists and we’re going to answer some of the most important questions here today.
Essentially, the expenditure test suggests that 90% of all the HOAs expenses should go towards things that are required for the HOA itself. For example, this could be for building, acquiring, maintaining, managing, or caring for properties. If it’s a timeshare association, the expenses will need to relate to the running of the timeshare.
When people first run into this test, they’re confused by exactly what’s covered and it does take some understanding to get it right. Let’s not forget, some accountants avoid HOAs because the forms and regulations are notoriously tricky to get right. With one simple mistake, an HOA could end up owing thousands of dollars in back-payments. However, it doesn’t just include the simple expenses as one might think.
Exempt Expenses – First and foremost, you might have an association manager and/or secretary. Since they have the sole purpose of managing the HOA (i.e. they wouldn’t be required if the HOA didn’t exist), their salary can be included within the exempt expenses. Every day, they handle all HOA-related issues and ensure the whole process is running smoothly so this should be the first expense on your list.
After this, any new purchases you made for association property can be included whether this is gardening, street signs, or even paving. Again, you’re contributing to making the owners feel more comfortable and safe as a member. For many, they even hire a security guard and this is another salary that comes as a direct impact of the HOA.
With property taxes, this is often where the most confusion lies because some think you can’t include one tax in a conversation regarding another tax. In many areas of accounting, this can be right but property taxes are a direct cost of running the HOA so they’re exempt with Form 1120-H.
Over time, things get broken and they stop working as they should. If you’re spending out on heating repairs, elevators, air conditioning, or any other costs, this all counts when filling out the form. As long as the expenses come as a benefit to the HOA, this remains true and we see it most commonly with shared buildings. Are there common buildings to which all owners have access? If so, you’ll need to keep this maintained and the expenses contribute towards the form 1120h 90% expenditure test.
In addition to repairs, this also includes all capital and operating expenditures for these common features. Whether this comes in the form of a recreation hall, tennis court, or swimming pool, they can all be listed towards reaching the target.
As you may have guessed, the form isn’t as hard as it first seems because you soon realize the allowed expenses are just all expenses that come as a result of running the HOA. Even with insurance, snow plowing, and sewage charges, they wouldn’t exist without the HOA (or at least they wouldn’t be the responsibility of the HOA) so they can all be included.
Non-Qualifying Expenses – Why do people tend to have such trouble with Form 1120-H? So far, it seems as though the requirement should be easy to calculate in advance but there are certain caveats to the rules which can make it hard to follow unless you have experience. For example, the biggest would be income and expenditure on features not designated as association property.
If you’re spending on property that doesn’t belong to the association, you can’t include this in your numbers because it’s taxable. Meanwhile, any money you spend on transferring funds or investing will also be taxable. Ultimately, your HOA doesn’t need these expenses in order to operate; they’re optional and so they don’t count towards the Form 1120H 90% expenditure test.
With the transfers, you need to be careful because they aren’t exempt even if you’re raising money to replace something that belongs to the HOA. For example, a roof may be association property but transfers to a sinking fund wouldn’t be exempt.
In truth, this rule goes for both income and expenditure and it’s where the biggest mistakes occur. If your HOA offers a swimming pool to all guests, any income you receive from non-member customers to use the pool will be taxable because it has nothing to do with the HOA itself. Additionally, the same applies with vending machines, leasing out a hall for a fee, and similar income. You could also consider a cost segregation study to lower any taxable income.
Calculating Exempt Expenditure – Once you’ve been through all your expenditures and marked it as either ‘exempt’ or ‘non-exempt’, it’s time to do the math. As we saw earlier, you need all the exempt expenditure to make up at least 90% of your overall spending.
Example – As a simple example, let’s say you spend $50,000 over the course of the year. After checking through the list, you (or your accountant) finds $47,000 of this to be tax-exempt. Essentially, this means that 94% of your expenditure went towards maintaining and extending the life of the HOA and you’ll be perfectly fine to file Form 1120-H.
On the other hand, you might have $50,000 of expenditure with $40,000 of this as tax-exempt expenditure. On this occasion, you only have 80% which means you’re some way away from hitting the target. If your accountant can’t make the appropriate changes and ensure you pass this final requirement, you might be forced into Form 1120 which is something many like to avoid.
Why Do HOAs Prefer Form 1120-H?
Generally speaking, HOAs tend to choose Form 1120-H and this is for a couple of reasons. Firstly, as we addressed earlier, Form 1120 is more susceptible to audits and this can cause numerous issues for an HOA of any size. Suddenly, there’s a mad rush to get everything in order and ensure every important document is available for the IRS to review.
However, this isn’t the only benefit because there’s also no alternative minimum tax (AMT), many states choose to exempt associations from state income taxes, there are no taxes for exempt function income, and the form is actually relatively simple compared to the alternatives.
If we look at Form 1120, state taxes are normally applicable and the tax form can leave many with sleepless nights for weeks. This being said, tax rates can be as low as half which is a huge benefit (assuming you have tax to pay!). If you do happen to owe tax in any particular year, it might be worth running the risk of being audited just to take advantage of the lower tax rates. In the future, you’ll know about the requirements of Form 1120-H and you’ll be better-placed to meet them. If you don’t have any taxes to pay, having to file Form 1120 can be a pain but we live and learn, right?
Form 1120H 90% Expenditure Test Summary
There we have it, your ultimate guide to the 90% expenditure test within Section 528. If you have any questions or concerns regarding your HOA, don’t hesitate to contact a finance professional because being up-to-date with your HOA tax forms brings its advantages. With professional help, you’ll find it much easier to pass the requirements and ensure you can file the form you desire.
In summary, at least 90% of your expenses must directly relate to the operation of the HOA including maintenance, improvements, repairs, and management! Understanding the Form 1120H 90% expenditure test may not be easy, but it is critical to filing form 1120H.