Condominium Associations: I Thought That We Were Exempt From Paying Income Taxes?

With many associations currently earning significant interest income on their reserve accounts, it may come as a surprise that associations must pay federal income taxes on that income. Even more surprising is that the applicable tax rate on that interest income can be as much as 30%, but taxes can be dramatically reduced with some thoughtful tax decisions.

Most condominium associations are corporations, and most corporations file their tax returns using IRS Form 1120. However, condominium and homeowners’ associations have the option of filing their tax returns on IRS Form 1120-H, which is a special form of tax return only for homeowners and condominium associations. What is the difference?

On IRS Form 1120, all income is taxable at a 21% tax rate. However, for associations that use IRS Form 1120-H, assessment income is exempt from income tax, and that can be very important for an association that generates surplus assessment income. For example, if an association’s only source of income is collected assessments (that is, no interest, rent or other non-assessment income) and the association has a surplus of assessment income over expenses at year-end, the association will not have to pay federal income taxes on that excess assessment income if it files its tax return using Form 1120-H. So why would an association ever not use Form 1120-H?

The drawback is that if an association uses IRS Form 1120-H, interest and other non-assessment income are taxable at a whopping 30% tax rate. Most associations receive interest income, and many associations also receive other income, such as rents on an association-owned residential unit. Therefore, the choice of tax return can have major implications. By way of example: if an association received $20,000 of interest income and filed its tax return on Form 1120-H, the association would pay $6,000 in federal taxes on that income but would pay just $4,200 by filing on Form 1120. For associations with large reserves that generate substantial interest income and/or have other sources of income, the savings could add up quickly.

As with anything relating to income taxes, there are many nuances that need to be discussed with your accountant and other professionals. For example, switching from Form 1120-H to Form 1120 requires a vote of the association’s owners (not just the Board) at a unit owner meeting with a quorum of owners present. In addition, if there is an operating surplus, proper steps must be taken in accordance with the association’s governing declaration to deal with that surplus while keeping an eye on minimizing federal income taxes.

With interest rates high and potential savings significant, associations should consult with their legal and tax professionals on best practices. Now is the time to ask.