With the increase in commercial condominium projects in recent years, certain tax questions arise. The commercial condo association tax return can be challenging without proper tax planning.
These commercial condominium projects typically include the ability to acquire your own office suite or space and share in certain common areas of the property. These common areas may include entrances, reception areas, park areas, hallways, and walkways.
Just like a typical homeowners association (“HOA”), these commercial condo associations are managed on behalf of the owners. However, residential associations and commercial associations have very different tax rules and regulations. We are going to take a look here at some of these differences and discuss the tax reporting requirements for condo management associations.
First, let’s take a quick look at the taxation of homeowners association’s. The IRS carved out a specific section of tax code called section 528. This tax code basically states that if it is a residential association and it takes in income from it’s duties as an HOA and expenses are consistent with that of an HOA, then any net profit from these activities is not taxable. This is an over simplification. The IRS allows qualifying associations to file Form 1120-H and take advantage of these tax benefits.
But the IRS has no specific tax carve-out for condo associations. Since they are not managed as residences, they are not tax-exempt and are not allowed to file Form 1120-H. They must file Form 1120 which is the same form that C-Corporations file. The tax code they fall under is section 277 and not section 528.
Taxation of Condo Assessments
Commercial condo associations typically receive money in two distinct ways. This is either from the assessments it collects from its members or from non-member activity such as interest and dividends, parking fees, facility fees, etc.
When all this income is added together and offset with all expenses, the association would be assessed tax on any remaining net profit. In fact, they also may have a net loss that they could carry back or carryforward subject to certain limitations.
But the condo association must distinguish between profits from member activities and non-member activities. Under certain tax rules, the association can defer certain member income into the future year. This would be advisable if there was member income that exceeded member expenses.
Commercial Condo Association Tax Return: Ruling 70-604
Revenue ruling 70–604 allows the association to differ and possibly avoid taxation on this excess. This carryover is applied to the assessments in the subsequent year. In addition, should the condo association have any losses that result from the excess of operating expense over membership income it can be carried forward to future years under section 277. This carryforward is not as a net operating loss because the member activity is not undertaken as a trade or business but as an offset to future net membership profits.
Under 70-604, this excess income will be treated like it was refunded to the members and then subsequently repaid to the association as an assessment for next year. The condo association should make sure that any bylaws or agreements reflect that any excess in one year can actually reduce an assessment for a subsequent year. In addition, the association must make an annual election in order to reflect this carryover.
But how would the carryover work if member expenditures were greater than member income? This excess is treated in the subsequent years as a deduction attributed to furnishing goods or services to the members. These losses can be carried forward indefinitely, but only to be used against member income.
Although there are differences in treatment among CPAs and tax practitioners, many believe the carryforward should be reflected on line 26 of form 1120 under the title “IRC Section 277 Excess Membership Deductions Carryover”. But remember, this is in contrast to losses from non-member activities that are included as a net operating loss under section 172.
What about capital expenditures?
Commercial condo associations may have special assessments for certain capital projects like improving common areas, new roofs, parking structures, etc. The special assessments for capital expenditures would be considered a shareholder contribution and are not included in gross income under section 118(a). But realize that other requirements under section 118 must be met as well.
How an association administers and documents capital expenditures is critical. Under Revenue Ruling 74–563 and Revenue Ruling 75–370, there must be a separation of funds that are relating to capital projects. Many associations establish a reserve fund by maintaining separate bank accounts for capital items as opposed to normal operating activities. These should be properly reflected on the commercial condo association tax return.
The association should make sure that these funds are not co-mingled. The association should avoid any transfers between the two accounts, except for situations in which the documentation and requirements are met.
Associations must keep clear records that distinguish assessments to members for operating and for capital projects. Annual budgets for both items should be maintain along with any reserve studies for capital improvements. If ever the commercial condo association tax return is ever audited, the association should be able to demonstrate complete segregation in order to qualify under section 118.
If you fail to qualify under section 118, the consequences could be severe. As a result, capital assessments that are intended to go into a capital reserve could be classified by the IRS as member income. This would then, of course, be taxable income and may not qualify for deferral under Revenue Ruling 70–604.
Commercial Condo Association Tax Return
The tax treatment of commercial condominium associations can be complex. In fact, there is often inconsistent tax treatment among CPAs. Many associations believe that they are tax-exempt. We know this is simply not the case.
But if the CPA and the association undertake proper tax planning, they can minimize any tax issues and make sure that they have proper documentation and segregation if ever audited. A commercial association return is not like an HOA tax return.
I hope you now understand the complexities of the commercial condo association tax return. Make sure that you do your due diligence before filing.