Real property used for business purposes is sometimes owned as one or more distinct units in a multi-unit condominium building, or as one or more detached buildings in a larger development that shares certain common areas. In a single building, common area elements typically include hallways, garages, multi-purpose rooms, pools, tennis courts, building entrances and landscaping–together with personal property that may be used for maintenance or operations. In a multi-building development, common areas may include roads, landscaping and ground maintenance equipment. The owners’ associations that manage these common areas on behalf of the unit owners may appear similar to a homeowners association or residential condominium association. However, they are subject to very different tax rules when the units or properties are used for business purposes and not principally as residences for individuals. This article discusses the major issues involved in the taxation of such associations, which we refer to as Commercial Condominium Management Associations (CCMAs).
Overview of tax structure
Unlike a homeowners association, a CCMA is not tax-exempt, and may not file Form 1120-H (U.S. Income Tax Return for Homeowners Associations). CCMAs that manage the common property of unit holders who use their units for business purposes are required to file a Form 1120 (U.S. Corporation Income Tax Return) and are subject to tax on the association’s net income at regular corporate rates.
A CCMA generally receives income in two ways, either from assessments collected from its members, or from non-membership transactions, which would include any income that would not be considered membership income, such as interest or parking fees from visitors. Not surprisingly, any income that comes from non-membership sources and activities is not deferrable, and any losses from such operations may be carried forward only to the extent permitted by section 172 relating to net operating losses.
The excess of any member assessment income for the year over the association’s deductible operating expenses for member activities is taxable income, subject to the normal corporate tax. Fortunately, Rev. Rul. 70-604 effectively allows the association to defer (and potentially avoid) taxation of any such excess, to the extent it is applied to the assessment otherwise due for the succeeding year. In addition, any losses resulting from an excess of operating expenses over membership income may be carried forward to future years under section 277, not as a net operating loss under section 172 as membership activity is not considered trade or business activity, but as an offset to future net membership income. Special issues may arise with non-deductible capital expenditures and assessment income related to such expenditures.
Deferring membership income – Rev. Rul. 70-604
On its face, Rev. Rul. 70-604 only provides for a deferral of excess income to the succeeding year, and impliedly only to the extent of the otherwise applicable membership assessment for that year. In effect, the ruling states that the excess is treated as if it had been refunded and immediately repaid to the association as the next year’s assessment. In practice, some argue that this effectively means that the excess income can be deferred again, indefinitely, as if it were being refunded in each succeeding year and then paid back for the next succeeding year’s assessment. Out of an abundance of caution, a best practice would be to ensure that the by-laws or other provisions reflect that any excess in one year actually reduces the otherwise applicable assessment for the succeeding year, and that any excess in the second year that is not fully used in that year be refunded in cash, with fresh funds used to pay the third year’s assessments.
Excess member expenditures
For associations filing a Form 1120, overall net membership losses are carried forward to be used in future years to offset membership income. Technically, such excess is treated in the succeeding year as “a deduction attributable to furnishing services, insurance, goods, or other items of value to members paid or incurred in the succeeding taxable year.” Accordingly, such losses can apparently be carried forward indefinitely, but only for use against income from members. Although it is not entirely clear, some practitioners believe the carry forward should be reflected on Line 26 of Form 1120 under the naming convention “IRC section 277 excess membership deductions carryover.” Again, losses from non-membership activities are subject to the normal rules for net operating losses under section 172.
Capital expenditures and associated assessments
CCMA’s may have special assessments for capital projects relating to the replacement or substantial rehabilitation of common areas. It is important to note that assessments for capital projects are considered a shareholder contribution to capital and are not included in gross income under the general rule of section 118(a) as long as the other requirements under section 118 are met.
The manner in which an association’s capital items are administered, utilized and documented is paramount in achieving the favorable treatment provided by the general rule of section 118. Under revenue rulings 74-563 and 75-370, there must be a clear segregation of any cash intended for capital projects. This can be accomplished by maintaining separate bank accounts for capital and non-capital items, and avoiding any co-mingling of the funds. Thus, the association should not pay capital expenditures from an operating account and vice versa, should avoid any transfers or inter-fund loans between operating and capital reserves, although this is allowed in certain situations if certain documentation and requirements are met. The association should also be diligent in maintaining documentation to substantiate the amounts assessed and their purposes. For example, the organization’s annual budget for operations and a reserve study for any capital projects should be available to support the amounts collected for operating and capital purposes. It is also important to show a clear segregation between the two types of assessments when issuing and documenting member assessments. There should be one assessment for operations and a separate and distinct assessment for any capital items or capital reserves. Under audit, the documentation will be vital in proving the clear separation and delineation required under section 118. Keep in mind that the tax consequences of failing to satisfy section 118 could be severe. A series of capital assessments contributing to a substantial capital reserve could be classified as prior year member income, which would then be taxable income and might not satisfy the requirements for deferral under Rev. Rul. 70-604.
The accounting and tax treatment for commercial condominium management associations, or similar organizations, is complex and often overlooked, since it is commonly but incorrectly assumed that such organizations are tax-exempt. As such, a deeper look into the topics and guidelines discussed in this article could prevent potential adjustments under audit examination.