| Question: Can an HOA be taxed on recoveries for construction defect claims?
“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.”
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.”