Construction Defect Insurance

 Question: Can an HOA be taxed on recoveries for construction defect claims?

Answer

 “Proceeds from the settlement of construction defect litigation are generally not taxable to a community association…” as long as they (1) “are used for the correction of defects, the payment of attorney fees and other costs of litigation, or other extraordinary expenses, (2) are not commingled with assessments from normal operations, and (3) do not exceed the aggregate basis of the capital assets involved in the litigation.”

Discussion

Although litigation proceeds are typically recorded as income in the financial statements of the HOA, tax treatment of the proceeds is generally different. In the case of construction defect recovery, proceeds are likely not the property of the HOA, but instead, belong to the members with the HOA acting as their agent. The party that actually gets taxed is a function of the mechanics of the lawsuit, and if the HOA is acting as an agent for the members, for purposes of the legal action, the members may be considered the taxpayers.

In Private Letter Ruling 8004028 from October 30, 1979, an HOA filed a class action construction defect lawsuit on behalf of HOA members against the developer. Prior to settlement, the HOA found it necessary to correct the defects that were alleged in the complaint because of the length of time of the legal proceedings. The funds used to pay for the repairs were assessed against the condominium unit owners. Once the case was settled, proceeds were deposited into a segregated account that was maintained by the HOA board and ultimately dispersed to make final repairs to the building and to pay attorneys fees. Further, it was noted that “the settlement proceeds did not exceed the aggregate basis of the capital assets involved in litigation.” This Private Letter Ruling emphasized that the settlement proceeds were used for repair of the defects and attorneys fees, not commingled, and did not exceed the aggregate basis of capital assets.

Oppositely, lawsuit settlement proceeds that are, “(1) payments in lieu of assessments (past, present, or future), (2) punitive damages, or (3) cumulative interest would be includable in gross income (though, in the first instance, would generally not be taxable).” In Revenue Ruling 81-152, the IRS decided that when settlement proceeds are used entirely for construction defect repairs, “there will be no net effect on the individual owners.”

 

 

 

Tax filing requirements for Condos

Condominium and other forms of community associations are entities that must account for their taxable income. Even if no tax is owed, there is still a filing requirement.

A community association will generally not qualify for tax-exempt status under Section 501(c) of the Internal Revenue Code. Nonetheless, Section 528 of the code permits a qualifying community association to make an election to receive certain tax benefits that, in effect, permits the exclusion of certain income (referred to as “exempt-function income”) from its gross income, thereby reducing (if not eliminating) its income tax liability.

If such an election is made, the community association is not taxed on its exempt-function income. However, the community association is taxed at the rate of 30 percent of the “homeowner’s association taxable income.” This rate applies to both ordinary income and capital gains.

“Homeowners association taxable income” for any taxable year is an amount equal to the excess, if any, of the gross income for the taxable year (excluding exempt-function income) over the allowed deductions. “Exempt-function income” means any amount received as membership dues, fees or other assessments from owners of condominium housing units in the case of a condominium management association or owners of real property in the case of a residential real estate management association.

Exempt-function income includes, but is not limited to, assessments made to pay the principal and interest on debts incurred for the acquisition of association property; paying real estate taxes on association property; maintaining association property; removing snow from public areas, and removing trash.

Exempt-function income does not, for example, include amounts that are not includable in the organization’s gross income other than by reason of Section 528 of the code (e.g. tax-exempt interest); amounts received from persons who are not members of the association for use of association facilities such as tennis courts, swimming pool, clubhouse; amounts received from members for special use of the association’s facilities, the use of which is not available to all members as a result of having paid the dues, fees or assessments required to be paid by all members; interest earned on amounts set aside in a reserve fund for replacement of common elements; amounts received for work done on privately owned property that is not association property; or amounts received from members in return for their transportation to and from shopping areas, or other locations.

The election to be treated as a homeowner’s association, and thus to exclude exempt-function income from gross income, is made each year by filing a properly completed Form 1120-H (U.S. Income Tax Return for Homeowners Associations). Once made, the election is binding for the particular tax year only and cannot be revoked without the consent of the Internal Revenue Service.

A community association will not always receive a tax benefit by making the election to be treated as a homeowner’s association. After computing its tax liability on Form 1120H, the community association should consider figuring the tax using Form 1120 (U.S. Corporation Income Tax Return) or Form 1120-A (U.S. Corporation Short Form Income Tax Return). For example, when the community association imposes substantial assessments for the purpose of creating reserves, it may be useful to make the election since those assessments would be non-taxable exempt income. In years when expenditures and income are more closely in balance, using Form 1120 or Form 1120-A to avoid the 30 percent tax rate on nonexempt income may reduce tax liability. Forms 1120 and 1120-A have lower tax rates that may result in less tax than figured on Form 1120-H.

Also, the type of form the community association selects to file will determine if it must make estimated tax payments. A community association that expects to file on Form 1120-H is generally not required to make estimated tax payments.

If the election to exclude exempt-function income is not made, or if the community association does not meet the requirements of a homeowners association, the community association must file tax returns in the same manner as other corporations (Form 1120 or Form 1120-A), even if it is an unincorporated association.

The laws concerning income taxation are complex. Careful tax planning, and input of an accountant is required of each community association to receive the greatest income tax benefit.