HOA taxes can be confusing. There are many unique tax considerations. So just like other entities, they need to do relevant tax planning in order to minimize any potential tax impact. In this post we are taking a look at the differences between filing two different forms.
HOAs have two forms to choose from – 1120 and 1120-H. Form 1120 is used by C corporations while 1120-H is a tax form specifically designed for qualifying HOAs.
What makes HOAs unique is the ability to file two different tax returns and the ability to change those forms each year. For that tax year the rules of each of the respective forms will govern the tax criteria.
HOA Taxes – Rules
When Congress enacted IRC code section 528 they reasoned that individual homeowners should not be taxed for carrying out functions that are performed HOAs. In this case that would be managing, and maintaining and carrying for the common property of the development.
Accordingly, the HOA should not be taxed on any of these activities solely because the homeowners have an association formed to carry out these duties specifically on their behalf.
But the HOA must pass certain financial tests in order to be allowed to file form 1120-H. Specifically, at least 60% of the HOA’s gross income received for the year must consist of exempt function income; and at least 90% of the HOA’s expenses for the year must consist of expenses to manage or maintain the property on behalf of the HOA.
In most situations filing form 1120-H makes the most sense. So let’s take a look at some of the specific advantages.
Advantages of filing form 1120-H:
- There is less risk associated with completing form 1120-H. This is because the HOA is filing such a return are not grouped in for audit purposes with large corporations.
- The exempt function income of the HOA is not taxable. However, any income in excess of expenses (whether exempt or not) is taxable under form 1120.
- The tax form itself is relatively straightforward and much easier to complete than form 1120.
- Certain states exempt associations that file form 1120-H from state income taxes.
- HOAs are not subject to the alternative minimum tax (“AMT”) on form 1120-H.
But there are some pitfalls to filing form 1120-H. These need to be carefully considered before you file.
Disadvantages of filing form 1120-H:
- Any taxable income of the HOA is taxed at 30%, or 32% for timeshare associations. This is in contrast to form 1120 that is only subject to 15% on the first $50,000 of net income. State taxes have to also be considered.
- HOA’s are not able to claim a net operating loss (“NOL”) on form 1120-H. So any loss generated during the years that an 1120-H is filed cannot be carried forward. An NOL generated in a prior year when the association files form 1120 may not be deducted in a year the HOA taxes are filed under form 1120-H. However, it can be carried forward and deducted in subsequent years on form 1120 returns.
- Any organizational costs incurred by the HOA are not deductible on form 1120-H.
- Associations are not allowed to deduct any amounts under part VIII of subsection B of the tax code. This gets a little tricky but your CPA should understand these rules.
Now that we understand the advantages and disadvantages of filing the specific forms, let’s take a closer look at some of the tax planning considerations. Accountants should consider whether the income tax liability can reduced through tax planning and filing Form 1120.
Generally, filing Form 1120-H should be considered in the following circumstances:
- Considering tax filing fees and compliance, the simpler form 1120-H is the better alternative.
- The HOA’s taxable income is $100 or less (the standard deduction).
- The HOA’s taxable income is approximately $186,000 or greater. In this situation, the 30% tax rate (excluding timeshares) on Form 1120-H results in a lower overall tax than the corporate tax rate on Form 1120.
- The tax difference between the two forms does not warrant the additional risk of filing Form 1120.
- As a result of IRS tax code, the HOA is not in compliance and unable to file form 1120.
- Because of the impact of AMT on large HOAs, form 1120-H may result in lower taxation.
- When considering HOA taxes at the state level, the total tax liability is lower.
HOA Taxes – Exempt Income
At the end of the day, the decision of which form to file depends on careful consideration of the above factors. In fact, the HOA may consider alternating between the two forms.
If the HOA desires to file form 1120-H, tax planning often considers the conversion of nonexempt income into exempt income. Typically, this considers the following:
- Lowering fee and assessment income so that the entity breaks even or meets the 90% test.
- The elimination of nonexempt income (like pool or facility user fees) and increasing member assessments to offset revenue reduction.
- Charging a special assessment fee at one specific time during the year rather than on a per use basis. This allows better control over assessment revenues.
Properly filing HOA taxes can be more complicated than you think. Considering the entity has the option to choose which form and wants to file annually they’re going to be certain questions that need to be answered. Make sure these issues are discussed extensively with your CPA and make sure that proper tax planning is completed.