James Ernst, CPA, explains what impact the newly-passed Tax Cuts and Jobs Act will have on Common Interest Realty Associations (CIRAs) beginning Jan. 1, 2018:
The Tax Cuts and Jobs Act, that was passed by both the House of Representatives and the Senate, and was signed into law by the President, will have an impact on Common Interest Realty Associations (CIRAs) for taxable years beginning January 1, 2018.
Federal Form 1120
Under current law, a CIRA (both residential and commercial) is required to file Federal Form 1120 (U. S. Corporation Income Tax Return) and is subject to graduated tax rates beginning at 15% on taxable income of up to $50,000. Income in excess of this amount is taxed at rates ranging from 25% to 39%.
Under the new law, all taxable income will be subject to a flat tax rate of 21%.
When filing Form 1120, both non-member income (bank interest income and other non-member income) and membership income are subject to taxation. However, if the association elects to rollover the excess in the operating fund to the following year (done by a membership election under IRS Rev Rul 70-604), and they transfer reserve contributions to a separate bank account timely, these amounts will not be taxable. This leaves only non-member income, net of various expenses, being subject to the graduated tax rate beginning at 15% in 2017 and a fixed tax rate of 21% in 2018 – therefore, those associations may pay higher taxes on the first $50,000 of net non-member income.
Federal Form 1120-H
As an alternative, under IRS Code § 528, a residential CIRA (homeowners’ association) may elect to file Federal Form 1120-H (U.S. Income Tax Return for Homeowners Associations). If they make this election, only net non-member income is subject to tax, membership income is exempt. The downside is that there is a flat tax rate of 30% on net non-member income. We know that this 30% flat tax rate is effective for 2017; however, we do not know whether the new tax law will ultimately change the flat tax rate for homeowners’ associations filing Form 1120-H from 30% to 21%. – Code § 528 was not mentioned in the new law.
If they do change the tax rate from 30% to 21%, and they retain the exemption for membership income, we would recommend that all residential associations file Form 1120-H for 2018 and beyond.
Additional clarification regarding the filing of Federal Form 1120-H.
Federal Form 1120
As originally stated, homeowners’ associations can elect to file Federal Form 1120 and pay taxes on all income at graduated tax rates from 15% to 35% for 2017, and at a fixed tax rate of 21% for 2018 and beyond. These tax rates apply to net non-member income as well as excess membership income. Although the tax rates may be better in 2018 when electing to file Federal Form 1120, there is the potential for an association being taxed on excess membership income and reserve cash, resulting in a substantially higher tax liability for the year.
Under Federal Form 1120, excess membership income in the operating fund is subject to tax; that is, unless the membership elects to rollover the excess to the following year – this election is available under IRS Rev Rul 70-604. Further, if an association does not transfer reserve fund cash into a separate bank account, the IRS could consider these reserve funds to be a part of the operating fund, substantially increasing the excess and, therefore, be subject to higher income taxes.
Federal Form 1120-H
As an alternative to filing Federal Form 1120, an association may elect to file Federal Form 1120-H (available for residential associations only) and pay taxes on net non-member income only. However, the tax rate on this net income is fixed at 30% for 2017 and beyond – we don’t know whether the IRS will interpret the new law to apply the reduced tax rate of 21% to associations that file Federal Form 1120-H.
Why would an association elect to File Federal Form 1120-H and be subject to a potentially higher tax rate?
Some associations accumulate excess operating funds but the membership does not elect to roll over the excess to the following year’s assessment (under IRS Rev Rul 70-604); or, the association does not transfer the reserve fund cash into a separate bank account. Therefore, to avoid the risk of being taxed on excess operating income and reserve fund cash, an association should elect to file Federal Form 1120-H, and pay the higher fixed tax rate of 30% on non-member income only.
What is non-member income?
Non-member income is interest income received from banks and investment accounts, laundry income, clubhouse income, and the occasional rental income from a cell tower. This non-member income can be reduced, but only by those expenses directly related to the revenues earned; such as, fees for management of the investment accounts, laundry and clubhouse expenses (water, gas, electricity, insurance, maintenance, etc.), plus 5% of your management fees, to name a few.
Therefore, if the membership election is not made and/or the reserve funds are not segregated, it might be better to File Federal Form 1120-H. When filing Federal Form 1120-H, all membership income (operating and reserve fund assessments) are exempt from taxes. Therefore, for tax purposes, if the association has excess operating funds, but neglects to roll over this excess to the following year; or, the association does not segregate their reserve fund cash into a separate bank account, filing Federal Form 1120-H may provide for a substantially lower tax liability.
James Ernst, CPA is the owner of James Ernst accounting, a well respected and highly regarded CPA firm in Santa Rosa California. James Ernst Accounting specializes in auditing and accounting services for community associations and management companies. For more information, or to hire them to provide accounting services for your community management organization, please visit their website at http://www.ernst-cpa.com/