Both interest and inflation considerations are important to the calculation of your future reserve requirements.  Unless the association has made a conscious decision to transfer all interest earnings to the operating fund (which is the subject of an entirely different article), it is generally assumed that interest earnings will be retained in the reserve fund.  Likewise, inflation is a factor that will cause the prices you pay for future repairs to be higher than the cost you’re paying presently for those same repairs and replacements.

Most discussions about homeowner association income taxes begin and end with the single issue of filing Form 1120 or Form 1120-H.  This is usually discussed simply from the perspective as the difference in tax rates.  But, Form 1120 carries significantly higher tax risk.  The largest risk, and the focus of this article, is the issue of reserves being considered as capital contributions for tax purposes.  This an important issue because capital contributions are automatically excluded from income.  It has no significant impact if filing Form 1120-H, as Exempt Function Income (EFI) is not taxed on that Form.  It is a critical issue on Form 1120, as any amounts received from members that cannot be classified as capital contributions may create excess member income under IRC Section 277 that is subject to taxation.

The Internal Revenue Code (IRC) is law passed by Congress.  Regulations are the Internal Revenue Service (IRS) interpretation of that law.  Revenue Rulings are specific situations described by the IRS that clarify how certain tax rules are to be applied.  Judicial decisions by various courts provide the final say in how certain tax law is interpreted.  There are actually numerous other levels of authoritative rulings, but these are the primary guiding authorities.  It is important to understand this framework to see why something as simple as a reserve contribution can actually be very complex.

The basic structure of the Internal Revenue Code is that all receipts are considered income under IRC Section 61, unless exempted from income by another section of the Code.  IRC Section 118, “Contributions to the Capital of a Corporation,” exempts capital contributions from income.  IRC Section 118 has been interpreted by numerous subsequent rulings. The balance of this article examines each of the criteria raised by those various rulings.

While IRC Section 118 establishes the broad principle that capital contributions are not included in taxable income, the detailed parameters established by subsequent rulings are:

1)      The PURPOSE of the assessment must be capital in nature (IRC Section 263, Revenue Rulings 74-563, 75-370, and 75-375, Court cases Chicago Board of Trade and Maryland Country Club)

2)      ADVANCE NOTICE must be given to members as to the intent of the purpose of the capital contribution (Court cases Gibbons and Maryland Country Club, Revenue Rulings 75-370 and 75-371, GCM [General Counsel Memorandum] 35929)

3)      Money contributed must be ACCOUNTED FOR as a capital contribution (IRC Section 118, Court case Chicago Board of Trade, GCM 35929)

4)      Money must be HELD FOR THAT PURPOSE and no other purpose (Court cases Chicago Board of Trade and Maryland Country Club)

5)      Money must be HELD IN SEPARATE BANK ACCOUNTS from the operating (noncapital) bank accounts of the association (Revenue Rulings 75-370 and 75-371)

6)      Money must be actually EXPENDED FOR THE INTENDED PURPOSE (Court Case United Grocers)

7)      Money must INCREASE THE CAPITAL ACCOUNT OF THE MEMBER or unit owner-stockholder (Court case Chicago Board of Trade , GCM 35929)

My many years of experience as a tax preparer in the homeowner association industry have provided numerous examples to me that virtually no associations are aware of these critically important rules, and few tax preparers believe they are important.  I have been retained as a consultant on dozens of homeowner association IRS audits, probably more than any other tax practitioner in the country.  In all but one case, Form 1120 was involved.  I did not prepare ANY of the tax returns being audited by the IRS; I was retained at the recommendation of the CPA firm or tax attorney as their expert consultant.  The issue of capital contributions existed in 100% of these IRS audits.

Associations that do not adhere to each of the parameters set forth above MAY not lose their reserves as capital contributions in an IRS audit, but each instance where the association fails to adhere significantly increases the risk that your reserve additions will not qualify as capital contributions.

How associations can qualify under each of the parameters set forth above.

1)      The PURPOSE of the assessment is described in IRC Section 263 as “Any amount paid out for new buildings or for permanent improvements or benefits made to increase the value . . . “ and “Any amount expended in restoring property . . . “  That pretty much describes the majority of reserve funds expended by associations.  But, it also includes additions to or replacements of personal property.  It DOES NOT include monies expended or set aside for painting or contingencies.

The purpose for which funds are being accumulated in reserves is generally set forth in the reserve study.  Is a reserve study absolutely required to establish the capital purpose?  No, it could be more informal, such as being described in the budget.  However, the reserve study is better, and this is an instance where it is better to comply than to have to fight this issue in an IRS audit.

Other critical mistakes associations make are (a) not formally adopting their reserve study, (b) having a reserve study that contains multiple proposed funding plans with no indication of which plan was adopted, (c) having a reserve study that does not agree with the amounts adopted in the association’s annual budget as reserve contributions.

2)      ADVANCE NOTICE is usually given to members as part of the annual budget, with accompanying information that discloses the reason for the “Capital” reserve assessments.  It is critical to note that if painting or contingency are part of the reserve budget and the amounts are not disclosed it jeopardizes the entire capital contribution, because painting and contingency are not capital in nature.

3)      Money contributed must be ACCOUNTED FOR as a capital contribution in the association’s financial statements.  While this is routinely done in professionally managed associations, too many small, self-managed associations fail to take this critical step.  As long as reserve monies are held in a separate bank account and there is a clear record of reserve contributions and expenditures, the association should be able to overcome this accounting deficiency in an IRS audit situation.

4)      Money must be HELD FOR THAT PURPOSE and no other purpose.  This means that once you set aside monies in reserve accounts, you should NEVER invade those reserve accounts for operating purposes.  California statutes permit associations to borrow from reserve under certain circumstances.  While permitted under California law, federal tax law does allow such use of funds.

5)      Money must be HELD IN SEPARATE BANK ACCOUNTS from the operating (noncapital) bank accounts of the association.  The IRS interpretation of this is that (as an example) roofing and paving funds, considered capital in nature, cannot be held in the same bank account as painting monies.  Why?  Painting is considered non-capital in nature.  Combining painting or contingency reserves with your capital reserves jeopardizes the entire capital contribution.  This is probably the most critical item in your reserve planning.  If you do not have these separate bank accounts, you should probably not be filing Form 1120, as your tax risk is too high.  This issue has been raised on virtually every IRS audit on Form 1120 on which I have consulted.

What this means is that most associations must maintain three different bank accounts – one for operating funds, one for capital reserve items, and one for noncapital reserve items.  Virtually no one is doing this.  This deficiency could potentially be overcome in an IRS audit if you have adequate accounting, but there is no guarantee.  This is one of those situations where, although it is a pain to comply, it is still easy to comply, and why have to fight the IRS over an issue that is so easy to comply with.

6)      Money must be actually EXPENDED FOR THE INTENDED PURPOSE.  This does not mean that if you assessed money for roofing that that exact amount must be expended for roofing.  It means that if you assess reserve monies for a capital purpose, it must be spent for a capital purpose.  Reserve bank accounts commingle various capital components (roofing, paving, fencing, etc.).  That dollar in the account does not know that it is a roofing dollar or a paving dollar.  That dollar does not know what kind of dollar it is, other than it is a capital dollar.  That is the only important criteria.

7)      Money must INCREASE THE CAPITAL ACCOUNT OF THE MEMBER or unit owner-stockholder.  This is effectively an automatic process with which the association normally need take no action.  The reason is that, as defined in other sections of the Code, a member’s “capital account” is presumed to reflect an increase in value for monies added to reserves.

What all of this means is that the association must be very careful in its handling of reserves IF IT IS FILING FORM 1120.  If you’re filing Form 1120-H, you can effectively ignore all of the above and still have a safe tax return.

If the association fails to comply with the above parameters established in tax law, THERE IS NOTHING THAT THE TAX PREPARER CAN DO TO MITIGATE YOUR TAX RISK.  The tax preparer’s responsibility is limited to properly presenting reserve activity in Schedules M-1 and M-2 of the association’s Form 1120 tax return.  Any errors at this level can generally be overcome during an IRS audit.

It is just beginning to be that reserve study time of year.  Why?  It takes a little while to select a reserve professional and get the reserve study scheduled.  And, you need to have the reserve study completed before you can complete your budget for next year.

The IRS issued Notice 2011-6 on December 31, 2010 that exempted management companies from Regulations that were due to take effect January 1, 2011 that defined management companies as “Paid Tax Preparers.”   These regulations would have placed onerous regulatory burdens on management companies nationwide.

We recently performed a reserve study for a 40-year old condominium association and discovered an all-too-familiar scenario we’ve seen in older projects.  The situation? Huge deferred maintenance obligations that should have been resolved long ago, and an assessment structure that is higher than comparable projects.

How did this association get to this place?  Forty years ago, reserve studies as we know them today were rare.  This association never prepared a complete reserve study.  Instead, they prepared an annual budget that included reserve calculations for the major reserve categories; roofing, painting, and paving.  The association then created a fixed amount reserve funding plan that fit the “political” assessment climate within the association.  This was done in the very early years of the association’s existence, but that was not based on any comprehensive analysis of the actual major repair and replacement needs of the association.  There was considerable reluctance to raise the assessment because this “senior” community consisted primarily of fixed income retirees.

Over time, the association was not able to afford all of the reserve maintenance projects that needed attention, because of their “fixed income” reserve funding policy. While they knew that special assessments or borrowing funds from a commercial lender were options, the board felt that these options were politically impractical based on their member demographics. What each board decided to do was to simply fund all of the maintenance projects that they could each year until they ran out of money.  This literally became the association’s policy.  This caused them to defer any uncompleted projects to the following year, thus passing the buck to the succeeding board.  Unfortunately, the uncompleted projects continued to accumulate, so that this “uncompleted projects” list grew to include a several year accumulation of maintenance projects.

When we came on the scene, this problem had reached critical mass and could not be ignored.  We were engaged to perform the first comprehensive reserve study for the association, and had a number of meetings with the board to help them understand how they had reached this position.  The association’s failure to perform timely maintenance caused further damage by the complete failure of certain components that would not have required replacement had the scheduled maintenance been performed.  An example of this was the failure to correct numerous water intrusion issues from poor roofing, poorly designed gutter and downspout systems, misdirected irrigation sprinklers, landscaping issues such as earth/wood contact on wood siding, etc.  These issues ultimately required the complete replacement of siding on many buildings; a cost that could have been avoided.  This is just one example of issues that caused future repair costs to escalate even further.

In the more recent years before we were engaged, the association had begun to recognize that it had a problem and had more aggressively raised reserve assessments to the point that they were higher than those of comparable projects.  But, it still was not enough to overcome decades of underfunding.  Further, our reserve study and analysis of the association’s reserve expenditures over the last few years resulted in almost doubling the reserve requirements.  This was because the association paid for numerous “small” repair projects from reserve that were clearly appropriate reserve expenditures, but for which the association had never established a reserve budget.  They were spending money on projects for which no assessments ever existed.

We have observed several associations over last 25 years attempting to fund their deferred maintenance projects in this manner. All suffered a very predictable ending. The fact is if you just spend the amount of money you’ve got available and not the amount of money it takes to actually complete a project, the projects never get completed as planned, and your deferred maintenance projects snowball into an insurmountable problem. This is not a plan, this is a reaction.

A responsible board must make tough decisions rather than passing the buck to the successor board. That often means that a current board has to resolve problems created by a prior board. The fact is that you don’t get to play the cards that you want, you get to play the cards that you’re dealt. When the board is faced with a situation of not enough money coming in and too much money going out, there are only two possible solutions. One, increase revenues, or two decrease expenses.

An association may attempt to decrease expenses by making temporary repairs that extend the life of a component or by substituting lower-cost products in making repairs or replacements. Since most associations have already done this analysis and still are coming up short, the only remaining answer is to increase revenues. This generally means that the association must make a special assessment or borrow funds, or a combination of both.

In this particular association, we also recommended that several substitute products that didn’t exist forty years ago be used in repair and replacement work.  While these resulted in higher immediate costs, it considerably reduced the long term maintenance costs to the association.

How expensive was this for the association?  They ended up borrowing $30,000,000 (about $10,000 per member) to fund major reserve repair and replacement projects. Unfortunately, they will still need more, as that does not address all the association’s needs.  Had that amount instead been assessed ratably over time to the members from inception, it would only have amounted to about $20 per month per member.  Effectively, given the age of the association and member demographics, this resulted in a shift of the entire cost from one generation to the next.