The question of including painting in reserves continues to arise, even 15 years after the matter should have been settled.  To understand why, you need to know that this issue first arose from tax considerations, not because of any budget, maintenance, or economic factors.

Painting is one of the largest expenditures that most condominium associations will incur. The primary purpose for establishing reserves is to assure funding is available for major repairs and replacements that do not occur on an annual basis.  Consequently it is logical that it should be included in reserves because it is not an annual maintenance expense. For most associations painting will occur every 7 to 15 years.

The tax issues causing this perceived problem arose in 1993 when the IRS audited approximately 15 associations in San Diego, California.  IRS proposed to add back as taxable income all the painting reserve assessments that had been excluded from income in calculating taxable income on the Form 1120 tax returns.  This created a national furor within the HOA industry on the concept of the inclusion of painting in reserves, but only because of the misunderstanding that occurred related to this issue.  The difference lies in definitions and perceptions, not in any differences of facts.

HOA Industry Positions

These are general statements only, and like all general statements, there will always be exceptions.

1. The HOA industry has generally always considered reserves as “capital contributions” for tax purposes

2. The HOA industry has generally excluded reserve assessments from taxable income for tax purposes.  If the association is filing Form 1120, this is a major factor in eliminating taxable MEMBER income.

3. Many tax preparers recommend Form 1120 so that the association can take advantage of the lower 15% tax rates of Form 1120, versus the 30% tax rates of Form 1120-H

It is also necessary to state certain tax facts

1. Form 1120 carries a 15% tax rate for the first $50,000 of taxable income

2. Form 1120 requires the association to delineate between capital and noncapital transactions

3. Form 1120 requires noncapital transactions to be separated between member and nonmember activities

4. Form 1120 considers all nonmember activities to be taxable

5. Form 1120 considers member activities to be taxable only if there is a net member income

6. Form 1120-H does not tax ANY exempt function activities

7. Form 1120-H taxes all nonexempt function activities at a flat 30% tax rate

It is important to note that member activities on Form 1120 are generally similar to exempt function activities on Form 1120-H, but with critical differences that can affect certain tax returns.

IRS Positions

1. The IRS has its own rules

2. The IRS doesn't care what the HOA industry thinks

3. Internal Revenue Code (IRC) Section 277 requires separation of member and nonmember activities on Form 1120

4. IRC Section 263 defines capital activities – painting is not considered a capital activity (in most circumstances)

5. IRC Section 118 (with numerous interpretations in Rulings and Tax Court cases) defines contributions to the capital of a corporation

6. Revenue Ruling 75-370 specifically states that painting does not qualify as a capital activity that may be excluded from the income of a homeowners association as a contribution to capital.  Painting is considered to be a non annual maintenance expense.

The crux of the issue is that the HOA industry refers to expenditures as being either operating or reserve in nature, and considers all reserves to be “capital” expenditures. The IRS refers to expenditures as being either noncapital or capital in nature.  These two definitions are not the same, and the major area of difference is painting expense.

The simplest way to look at this is to realize that painting is simply a noncapital reserve component.  OK.  So now what?

Let me state for the record that I, as a reserve preparer, am of the opinion that the components to be included in any reserve study should be determined by the maintenance plan, budget policies, and economic considerations.  Tax considerations should NOT be a determining factor in what components are included in a reserve study.

Certain conclusions can be drawn from the above discussion of tax issues related to painting as a reserve component.

·           It’s acceptable to include painting in the reserve study

·           Painting reserve assessments cause potential tax issues on Form 1120

·           Careful tax planning can allow you to minimize tax risks of painting reserve assessments on Form 1120

·           Painting reserve assessments cause NO potential tax issues on Form 1120-H

On April 5, the 87-12 vote by the Senate approved H.R. 4, the "Comprehensive 1099 Taxpayer Protection and Repayment of Exchange Subsidy Overpayments Act of 2011." The measure, which retroactively repeals expanded Form 1099 information reporting rules added by recent legislation, was passed on March 3^rd by the House on a vote of 314-112. Thus, H.R. 4 (the Act) will be forwarded for the President's expected signature.

Technical highlights of the tax changes in the Act:

Original information reporting rules (prior to 2011) - Before amendment by the Small Business Jobs Act of 2010 and the Patient Protection and Affordable Care Act (PPACA), Internal Revenue Code (IRC) Sec. 6041 generally required payments totaling at least $600 in a single calendar year to a single recipient to be reported to IRS.  Reporting on Form 1099 was required only when the payor was considered to be engaged in a trade or business and made the payment in connection with that trade or business. The type of payment that most commonly triggered the reporting requirement was payment for services. Corporations were exempt from Code Sec. 6041 's reporting requirements under prior law (Reg. § 1.6041-3(p)(1)).

Changes made by 2010 legislation. Beginning in 2012, Sec. 9006 of PPACA made three significant changes; (1) it added payments of amounts for ANY type of property to the list of payments subject to information reporting.

(2) corporations, which had previously been exempt from the reporting requirement, would now be subject to information reporting.
(3) The Small Business Jobs Act of 2010 provided that, subject to limited exceptions, a person receiving rental income from real estate would be treated as engaged in the trade or business of renting property for information reporting purposes. Landlords making payments of $600 or more to a service provider, such as a painter or plumber, in the course of earning rental income would have to provide an information return to the service provider and IRS.

New law. For payments made after Dec. 31, 2011, H.R. 4 (the Act) repeals each of the three above provisions.  (Code Sec. 6041(a), Code Sec. 6041(i), and Code Sec. 6041(j), as amended by Act Sec. 2, and Code Sec. 6041(h), as repealed by Act Sec. 3).

Author’s observation: In other words, under the Act, the information reporting rules effectively revert to the way they read before enactment of PPACA and the Small Business Jobs Act of 2010.

Revenue offset. In order to gain bipartisan approval, congress needed to find a revenue offset to make up for the anticipated revenue that would be lost by repealing the 1099 reporting requirements.  The Act provides an offset, estimated at $21.9 billion. It increases the amount of "excess advance payments" of the premium assistance credit (enacted as part of the 2010 health care reform legislation to help lower-income individuals acquire affordable health insurance coverage) that a taxpayer must repay under Code Sec. 36B(f)(2) for tax years ending after Dec. 31, 2013. The credit is available for a taxpayer who doesn't receive health insurance through his employer (or his spouse's employer) and whose income falls between 100% and 400% of the federal poverty line (FPL), based on the most recently filed tax return.

Under pre-Act law, if the taxpayer's income increases such that the credit exceeds that to which his current income level actually entitles him to, but his income is still under 500% of FPL, he had to repay some credit amounts. The limit on amounts he had to repay were capped and ranged from $600 to $3,500.

New law. Under the Act, for tax years ending after Dec. 31, 2013, the repayment caps are increased for taxpayers with household income of at least 200% but less than 400% of FPL, and full repayment is required for taxpayers whose incomes exceed 400% of FPL. (Code Sec. 36B(f)(2)(B)(i), as amended by Act Sec. 4)