Index of Terms (non-exhaustive)
HOAs can choose to file taxes under either Section 528 (using Form 1120H) or Section 277 (using Form 1120) of the tax code (IRC), with potentially very different ramifications.
Section 528 was set up specifically for HOAs. Form 1120H is a simple one page form and all income is taxed at a flat 32%. The HOA must meet the 60% exempt function revenue test, the 90% exempt function expense test, and 85% of the sq footage of all the units must be for residential use. Taxable income is calculated from “nonexempt function income.” All “exempt function income” is non-taxable. Under Section 528, HOAs are not entitled to net operating loss deductions and there is a possibility of more income being taxed compared to electing 277.
Under Section 277, the HOA is taxed like a regular corporation and Form 1120 is more complex and has a tiered tax rate. Additionally, compliance risks are much higher. Risks include reserves being taxed, excess member income being taxed, and prepaids are income in the year paid and therefore contribute to the excess member income. Taxable income is calculated from nonmember income, all member income is considered non-taxable.
Most HOAs will file Form 1120-H under Section 528. It is an easier form and may have generally less audit risk. Filing Form1120 may make sense if the HOA has a large loss to carryover or if they are making a 70-604 election. Neither method is a “one size fits all” and the best option may change from year to year. A good HOA specialist tax accountant will compute the taxable income under both options and consider the risks versus the value of filing under each option to ensure the HOA pays the least amount of taxes while avoiding the risk of audit, penalties and back taxes.
Relevant statutes and cases: