Taxes: Common Interest Realty AssociationsIf a homeowners' or condominium association elects to be taxed under IRC Section 528 and filing Form 1120-H, it must allocate its income and expenses between its exempt function activities and its activities for the production of gross income (or nonexempt function activities). It is not taxed on its exempt function activities but is taxed at the rate of 30% on its net nonexempt function income. If a qualifying timeshare association elects to be taxed under IRC Section 528, it is taxed at the rate of 32% on its net nonexempt function income. Under IRC Section 277and filing Form 1120, a CIRA must allocate its income and expenses between membership and non-membership activities but pay income tax on the combined net income at regular corporate tax rates unless the CIRA makes tax elections to refund the excess of membership income over membership expenses to the association's members or apply the excess to the following year's assessments.
The taxation of homeowners' and condominium associations and timeshare associations presents an option that is not available in any other area of taxation: the ability to choose which tax form to file and, therefore, which tax rate applies. The decision, however, is not as clear-cut as it may appear at first glance. Form 1120-H is a relatively simple form to prepare but has certain qualification requirements and a higher tax rate for most associations than the alternative Form 1120. On the other hand, Form 1120 is extremely complex. While it will normally result in a lower tax rate than Form 1120-H unless the CIRA is very profitable, its complexity and the lack of specific rulings in several areas create a much higher tax exposure risk when using that form.
It is important to know the purpose of the enactment of IRC Section 528 in order to understand its intent and to contrast it with the application of IRC Section 277. IRC Section 528 was added to the Internal Revenue Code in 1976 to provide CIRAs two benefits. They were given a simple method of filing their tax returns, and exempt function income that was inadvertently being taxed on Form 1120 was exempted from taxation. It was the intent of Congress that a CIRA, as defined in IRC Section 528, receive no benefit or suffer no penalty compared to the tax treatment accorded the individual members of the CIRA. Specifically, IRC Section 528 allows the CIRA to build reserves with no tax consequences other than taxation of the interest earned on such amounts. IRC Section 528 is elective and may generally be considered to be an elective, beneficial code section.
The other filing option available to the majority of CIRAs is to file Form 1120. When Form 1120 is filed, the CIRA may be subject to the provisions of IRC Section 277, which was enacted in 1969. The intent of IRC Section 277 was to prevent abuse by nonexempt membership organizations in the same manner that IRC Section 513 prevented abuse by exempt organizations. Its purpose was to prevent taxable membership organizations from avoiding tax on non-membership income by operating membership activities at a loss and using that loss to offset the nonmembership income. IRC Section 277 may be considered to be a mandatory anti-abuse section.