What is exempt function income for HOAs?

According to this section, exempt function income is any amount the association earns in the form of membership dues, fees, or assessments from the owners in the HOA.

What Does IRS 528 Say? | Clark Simson Miller

When it comes to federal taxes, many homeowners associations find themselves in a bind. While HOAs are required to pay taxes and file tax returns, they fall into a specific category under the Internal Revenue Service — IRS 528.

Understanding HOA as Non-profit Corporations

In many states, homeowners associations are structured and formed as nonprofit corporations. Despite the term and the fact that HOAs don’t exist to earn income, associations are still subject to taxation. This is because homeowners associations still do earn income in the form of membership dues and assessments.

Before changes in the tax code, homeowners associations fell under IRS Code 501(c). There are a number of organizations under this category:

501(c)(3) Religious, Educational, Charitable, Scientific, Arts Organizations
501(c)(4) Civic Leagues and Social Welfare Organizations
501(c)(6) Trade and Professional Associations (Business Leagues)
501(c)(7) Social and Recreational Clubs
501(c)(8) Fraternal Associations

In the past, homeowners associations were typically classified as 501(c)(7) organizations, paying taxes on net income generated from nonmember activities and investment earnings. Some qualify under 501(c)(4), making them exempt from income taxes apart from unrelated business activities. However, the tax code was changed to include IRS 528, a category that is specifically dedicated to homeowners associations.

What Is IRS 528?

IRS Section 528 was enacted under the provisions of the Tax Reform Act of 1976. The objective of this section is to give homeowners associations an alternative when it comes to exemptions outside of falling under 501(c)(4).

Homeowners associations that qualify under IRS 528 are only taxable to the extent provided in the code. Under this section, the tax imposed on an HOA shall equal to 30% of the association’s taxable income. For timeshare associations, the taxable percentage is 32%.

What Counts as a Homeowners Association Under IRS 528?

According to the code, a homeowners association is a condominium association, residential association, or timeshare association if it meets the following:

The organization is organized and operated to acquire, construct, maintain, manage, and care for association property;
At least 60% of the organization’s gross income for the taxable year is solely comprised of membership dues, fees, or assessments from owners;
At least 90% of the organization’s expenses for the taxable year went to acquiring, constructing, maintaining, managing, and caring for association property (for timeshare associations, it is for activities provided to or on behalf of the association’s members);
None of the organization’s net earnings is for the benefit of a private individual or shareholder; and,
The organization elects to operate under this section for the taxable year.

Taxable Income for Homeowners Associations

According to IRS 528, these are the definitions of the following terms:

Taxable Income. This is the amount equal to the excess of the association’s gross income for the taxable year (not counting exempt function income) over the deductions permitted under this code and calculated with the modifications defined below. The deductions are those that are directly related to the production of gross income (not including exempt function income).
Modifications. The section allows a specific deduction of $100. Another modification is that no net operating loss deduction is permitted under section 172. Finally, the chapter also does not allow deductions under part VIII of subchapter B.
Exempt Function Income. According to this section, exempt function income is any amount the association earns in the form of membership dues, fees, or assessments from the owners in the HOA.

IRS 501(c)(4) vs 528

Section 501(c)(4) offers tax exemptions for certain organizations. This can include homeowners associations if they qualify. However, seeing as 501(c)(4) provides for a much stricter standard for HOAs to qualify for an exemption, most associations opt to qualify instead for either 501(c)(7) or 528.

If an HOA wishes to reap the tax benefits under section 528, it must file Form 1120-H. To do this, the association must elect to follow this section, and it must do so separately for every taxable year. The election must also happen by the due date of the income tax return (including any extensions). Keep in mind that filing an extension only extends the deadline for filing the tax return. It does not extend the due date for paying the tax itself.

The due date for filing Form 1120-H is on the 15th day of the 4th month following the end of its taxable year. If an HOA’s fiscal year ends on June 30, though, it must file by the 15th day of the 3rd month following the end of its taxable year.

After filing Form 1120-H, an HOA cannot rescind its election for the same year. The only way to do so is to have the IRS consent to the overturning of the election, which you can accomplish by filing a ruling request. There is a user fee that the HOA must pay to file ruling requests.

Qualifying for IRS 501(c)(4)

It is infinitely more difficult for a homeowners association to qualify for exemption under 501(c)(4). This is because the standard for qualification is much higher and stricter.

There are two types of organizations under 501(c)(4): social welfare organizations and local associations of employees. The only type that applies to HOAs is the first one — social welfare organizations.

To qualify as a social welfare organization, an HOA must organize as a for profit organization and exclusively operate for the benefit of the general public. Earnings may not benefit private shareholders or individuals. The operations of the association should all go toward promoting social welfare. As HOAs typically don’t operate exclusively to promote social welfare, the IRS does not approve most requests.

Homeowners Associations Must Still Pay Taxes

Since the objective of an HOA is not to primarily earn profits, it is difficult to reconcile the idea of it with having to pay taxes. But, federal law does require associations to pay taxes and file tax returns. Thankfully, changes to the Internal Revenue Code have made it much easier for HOAs. With IRS 528, associations can exclude exempt function income from taxes, and exempt function income comprises a majority of an HOA’s revenue.

Navigating the intricacies of the tax code can come as a challenge to HOA boards. Apart from federal taxes, there are also state taxes to think about. Fortunately, an HOA management company like Clark Simson Miller can help. Call us today at 865.315.7505 or contact us online to learn more about our services.

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