Determining Residential Status of Associations
By: Gary A. Porter, CPA
This article provides an analysis of what the Internal Revenue Code (IRC) requires for an association to qualify as a residential association as defined in IRC Section 528 so that the association may take advantage of Form 1120-H.
Many, if not most, associations may generally make an annual election to file Form 1120-H, under IRC Code Section 528. This allows the association to be protected from any adverse tax consequences for failure to follow the rigorous standards for filing Form 1120. The penalty, however, is that the association will be taxed at a flat rate of 30% on its taxable income. Given the large exposure some associations have had in recent years in filing Form 1120, more associations are now filing Form 1120-H, just as a safety measure. They view the extra tax cost as merely insurance to protect against a potentially much larger tax liability that could be incurred for inadvertently failing to comply with the filing requirements of Form 1120.
The association is required to separate its exempt function and taxable income for purposes of the IRC Section 528 computation. This generally results in the Association being taxed on items such as interest income, laundry and vending machine income, and fees for special services to members and nonmembers, less allowable, directly related deductions. The exempt function income will generally consist of all member assessments and other charges to members that do not represent charges for special services.
However, only those associations that meet the criteria set forth in IRC Section 528 qualify to use Form 1120-H. One of the criteria under IRC Code Section 528 (C)(2) is that substantially all of the units must be residential. All timeshare and many resort associations face a problem here, in that while the units are physically no different from the units in a non resort association, the resort association may not meet the residential tests because the units are not continuously occupied as residential units. The criteria for qualification as a residential association are set forth in various sections of the Code and Regulations. However, there are some apparent conflicts that have not yet been resolved. Regulation 1.528-4(B) requires that at least 85% of the total square footage of all units within the project be used by individuals for residential purposes as the first test for qualification as a residential association; such determination to be made based on the conditions existing on the last day of the association's taxable year. Criteria are explained for determining the impact when the unit has never been occupied, and when a unit is previously occupied. However, Regulation 1.528-4(D) states that a unit will not be considered used for residential purposes if for more than one half the days in the Association's taxable year, such units occupied by a person or series of persons, each of whom occupies the unit for less than 30 days.
Below we explore these criteria to determine the outcome as to the qualification of the association as a residential association. It is readily apparent from an understanding of the Code and Regulations that to perform a thorough analysis of the ability of a resort association to qualify as residential under IRC 528, the association must maintain statistics on the actual use of the units within the year. This may be information that is difficult to obtain, and will probably provide the greatest roadblock to an association in being able to properly analyze its situation to select the best tax filing option.
The questions below must be applied on a unit by unit basis, then aggregated for purposes of the 85% test.
A. Residential use test
1. Was unit occupied as a residence on the mast day of the association’s tax year? If yes, go to part B. If no, go to question 2.
2. If vacant, was the unit last occupied as a residence? If yes, go to part B. If no, go to question 3.
3. Has the unit been occupied for non residential purposes? If yes, the unit is nonresidential. If no, go to question 4.
4. Was the unit originally constructed as a residence? If yes, go to part B. If no, go to question 5.
5. Is the unit used for purposes auxiliary to residential use? If yes, the unit is residential. If no, the unit is nonresidential.
B. Transient use test - For more than one-half of the days of the association’s tax year, was the unit occupied by individuals occupying it for more than 30 days? If yes, the unit is residential. If no, the unit is nonresidential.
C. Residential determination (check one)
- Unit is residential
- Unit is non residential
The final test is for the association to aggregate each of the units for which it is able to gather the above information. If more than 85% of the square footage of condominium associations, or more than 85% of the lots for property owners associations, is residential, then the association will qualify as residential.
It is valuable to revisit this issue given the current activity of the IRS with respect to timeshare associations. Most timeshare associations can never meet the transient use test. However, some interval associations, such as the “quarter-share” association, may meet the transient use test, as the interval is greater than a 30 day period. The above questionnaire may be adapted for use by an association to document compliance with IRC Section 528.
The Ledger Quarterly has attempted to provide an in-depth analysis of areas of taxation that are confusing, or that cause problems for practitioners. Most of this effort focusses on Form 1120 issues, because they are the most troublesome. However, as more practitioners are turning to Form 1120-H, some of the basic 1120-H issues need to be readdressed also. The Summer 1995 issue examined IRC Section 528's 90% test. The Fall 1989 and Winter 1990 issues provided an overview of the Form 1120-H qualifications and requirements. The Summer 1989 issue addressed timely filing to preserve the option of making an election under IRC Section 528, and the guidelines of the new Concord Consumers Housing Cooperative case. In the future, we expect to take a more detailed look at IRC Section 528's 60% test.
Gary Porter, CPA began his accounting career with the national CPA firm Touche Ross in 1971. He is licensed by the California Board of Accountancy and the Nevada Board of Accountancy. Mr. Porter has restricted his practice to work only with Common Interest Realty Associations (CIRAs), including homeowners associations, condominium associations, property owners associations, timeshare associations, fractional associations, condo-hotels, commercial associations, and other associations.
Gary Porter is the creator and coauthor of Practitioners Publishing Company (PPC) Guide to Homeowners Associations and other Common Interest Realty Associations, and Homeowners Association Tax Library. Mr. Porter served as Editor of CAI’s Ledger Quarterly from 1989 through 2004 and is the author of more than 200 articles. In addition, he has had articles published in The Practical Accountant, Common Ground and numerous CAI Chapter newsletters. He has been quoted or published in The Wall Street Journal, Money Magazine, Kiplinger’s Personal Finance, and many major newspapers.
Mr. Porter is a member of Community Associations Institute (CAI), American Resort Development Associations (ARDA), and California Association of Community Managers (CACM). Mr. Porter served as national president of CAI in 1998 – 1999.