Federal Tax Law Changes in 2018 for Community Associations

Federal Tax Law Changes in 2018 for Community Associations

[ Blog/News ]

Federal Tax Law Changes in 2018 for Community Associations

Qualifying residential homeowners and condominium associations have the unique option in Federal taxation to file one of two tax forms. (This discussion does not include nonresidential, timeshare, cooperatives, commercial or exempt associations).

(Editor’s Note: This blog article first appeared in the April 2018 issue Community Associations Journal. It is a second in a two-part article. Part One appeared in the March issue.)

Federal Tax - Blue Icon Federal Tax - Orange Icon Federal Tax - Blue Icon

Community associations can file form 1120-H, U.S. Income Tax Return for Homeowners Associations or they can file form 1120, U.S. Corporation Income Tax Return. The determination as to which tax return to file is outside the scope of this analysis. However, it should be noted that if the association qualifies to file form 1120-H, this is an annual election and an association can change between the two tax returns each year.

The new Federal tax law makes no changes to form 1120-H. There is a flat tax rate on taxable income of 30%. That remains the same.

However, there is a Federal tax rate change when filing form 1120 effective January 1, 2018. 

From 2005 through 2017 there was a phased tax rate schedule as follows:

OverBut not overTax isOf amount over
$0$50,00015%$0
$50,000$75,000$7,500 + 25%$50,000
$75,000$100,00013,750 + 34%$75,000
$100,000$335,000$22,250 + 39%$100,000
$335,000$10,000,000$113,900 + 34%$335,000
$10,000,000$15,000,000$3,400,000 + 35%$10,000,000
$15,000,000$18,333,333$5,150,000 + 38%$15,000,000
$18,333,33335%$0

It is common to hear that the U.S. corporate tax rate has been 35%. However, as noted above, that is not entirely true – and especially not for most community associations. In our experience, we have found that the majority of associations have taxable income under $50,000; thus, their tax rate has been 15%.

Under the new tax law there is a permanent flat corporate rate of 21%. Thus, many community associations will actually see an increase in their tax rate from 15% to 21% when they file their 2018 1120 tax returns.

Additionally, while we are not discussing the pros and cons of filing 1120 vs. 1120-H, it should be noted that filing 1120 is a much riskier tax option and requires much more diligent accounting and financial reporting. At times, the community association has been swayed into filing form 1120 due to the 15% tax differential. However, now that the tax rate difference is 9%, (21% vs. 30%) some associations may consider the cost versus benefits and conclude that the risk is no longer worthwhile for only a 9% tax savings.

For those associations filing form 1120, there are some additional tax law changes:

  • Expensing of short-lived assets (rather than depreciating them). This is fully in effect through 2022, and then gradually phased out by 2026.
  • Elimination of net operating loss carrybacks and limitations on carryforwards.
  • Elimination of the corporate alternative minimum tax.

Quite frankly, most associations will not be affected by the above items. The large, high taxable income community associations should discuss all the new tax law ramifications with their tax preparer. However, most associations filing form 1120 are limited in their ability to use the above deductions. Nonmembership and investment income is taxable. Tax regulations (IRC Section 277) do not allow for an offset to taxable income from membership losses, including depreciation deductions. Again, this is another reason that filing form 1120 is a more complex matter than form 1120-H. End Of Article

Summary of Impact on Community Associations

  • Form 1120-H – No Change
  • Form 1120 – If taxable income under $50K, tax rate increase from 15% to 21%
  • Form 1120 – If taxable income over $50K – would need analysis based on specifics

By Gayle Cagianut, CPA

Owner, Cagianut & Company, CPA

Gayle Cagianut is the owner of Cagianut & Company (C&C), and has been a leader in the community associations industry for over 25 years. C&C now works with almost 800 associations in Washington and Idaho performing audits and tax returns. As education is a primary focus of C&C, Gayle provides numerous volunteer hours speaking and writing about accounting, auditing and tax matters specific to condominiums and homeowners association.

Gayle is a member of the Washington State Community Association Institute (WSCAI) and Washington Society of CPAs and American Institute of CPAs. She is a CAI National Faculty Member and was elected to CAI National Business Partners Council. 

A prior CAI National Author of the Year Award winner, Gayle is an original co-author for the “Guide to Homeowners Associations” for Practitioner’s Publishing Company (PPC), a national CPA manual. She is also a current contributing author/editor for a Commerce Clearing House (CCH) national CPA manual.

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Let’s Play 20 Questions: Taxes and Audits

Let’s Play 20 Questions: Taxes and Audits

[ Blog/News ]

Let’s Play 20 Questions: Taxes and Audits

One thing is certain for community associations: An annual federal tax return. Another thing MAY be certain: an annual Certified Public Accountant (CPA) audit. If this is surprising to you, read on. If this is not surprising to you, read on anyway; as community associations are so unique in their tax treatment!

(Editor’s Note: This blog article first appeared in the March 2018 issue Community Associations Journal. It is a first in a two-part article. Part two will appear in the upcoming April issue.)

Let’s test your knowledge by playing “20 Questions”!

Question Mark in Talk Bubble Icon Green  Question Mark in Talk Bubble Icon Orange  Question Mark in Talk Bubble Icon Blue

Are associations required to file an annual federal tax return?

Answer Mark in Talk Bubble Icon GreenYES. Associations are required to file annually, even if they do not have taxable income. The return is required from the date of inception, even if assessments are not yet billed.

What type of tax return do associations file?

Answer Mark in Talk Bubble Icon GreenMost associations file a form 1120-H return, which is a special return for this industry. Some associations file a form 1120 return, which is the regular corporate return. This industry is unique in the tax law since most associations may “flip flop” back and forth each year between an 1120-H and an 1120. Some associations (such as commercial associations, and associations that don’t meet certain tests) are required to file an 1120 return. A few associations are considered a Non-Profit for tax purposes and file a form 990 tax return. This is rare and has stringent/narrow requirements.

Do associations pay tax?

Answer Mark in Talk Bubble Icon GreenYES. For the 1120-H return, they pay 30% tax on net “non-exempt function income.” Examples would be interest/investment income on all accounts, income from non-members (such as cell tower income or rental of an association owned unit), and “user fees” from members. For the 1120 return, Associations pay graduated corporate tax rates on net membership income and net non-membership income. These can be very complex issues, so it is always best to have an industry CPA advise on the best tax return choice and prepare the return for the association.

Is there a way to avoid tax?

Answer Mark in Talk Bubble Icon GreenIf the Association has interest/investment income, or income from non-members, other than the standard exemption available, it is difficult to avoid paying any tax. There are strategies to minimize tax. The association should work with their CPA on appropriate deductions that may be taken against the taxable income. If there is other taxable income, keep good accounting records of the potential direct expenses related to the production of income. Additionally, if the association qualifies for 1120 tax return filing, some tax rates are below the 30% “flat tax” for the 1120-H return. As noted above, the 1120 return is recommended in limited circumstances due to the requirements, and higher IRS audit risk.

What are some of the requirements to file an 1120 tax return?

Answer Mark in Talk Bubble Icon GreenIf the Association thinks they are planning on filing an 1120 tax return, they should consult with their CPA as this gets very complex, quickly. Generally, the association needs to follow strict accounting requirements including segregation of operating and reserve cash, and “fund accounting” is preferable. The Association should adopt and adhere to a budget that agrees with the reserve study, have minimal “transfers between funds”, document repayment plans for “due between funds” and be aware of the capital and non-capital items in the reserve study. They also need to have the association membership approve the “70-604” tax election.

What is the “70-604” tax election?

Answer Mark in Talk Bubble Icon GreenThis is a federal tax election only, and does not impact the books. As noted above, if the association files an 1120 tax return, the “net membership income” is taxable. The 70-604 allows the net membership income to be deferred from year one to year two. Since the 70-604 cannot be used two years in a row, this is only a deferral of tax. IF the association still has net membership income remaining at the end of year two, if an 1120 return is again filed, and no offsetting membership losses exist, the net membership income is taxable. Our firm recommends that each association approve the 70-604 each year at the annual meeting, regardless of the type of return filed. This is because it is not known (until the return filing) which form will be appropriate, and if an 1120 is necessary, the 70-604 may be needed. It also provides extra “IRS audit insurance”, regardless of the form filed each year. Again, this election is approved by the membership, not the board.

Is transferring monies to reserves the same as the “70-604?”

Answer Mark in Talk Bubble Icon GreenNo. Should be two separate motions.

When is the tax return due to the IRS?

Answer Mark in Talk Bubble Icon GreenThe return is due 3.5 months after the year end. For calendar year associations, this is April 15. There is an extension available, however any tax due must be paid by the tax return original due date.

What is an audit?

Answer Mark in Talk Bubble Icon OrangeAn independent CPA is engaged by the association to determine if the year end financial statements are materially correct, in accordance with Generally Accepted Accounting Principles (GAAP) and that adequate financial statement disclosures have been presented. The CPA should not be connected to the association in any way. “Materiality” is a matter of CPA judgment, however it means the CPA does not look at every transaction. Examples of “disclosures” would be litigation, special assessments, contingencies, FDIC limitation exceeded, and significant events occurring after year end but before the date of the Auditors’ Report.

Is our association required to have an annual audit?

Answer Mark in Talk Bubble Icon OrangeThis depends on the body of Washington law (RCW) that governs the association, and the size of the association. Please read the noted RCW for more clarification and consult your attorney if unclear.

  • “New Act” Condominiums (Created after 7/1/90 -RCW 64.34.372) Condominiums with 50 or more audits must be audited annually. Condominiums with less than 50 units have an annual audit requirement, however, there are annual waiver provisions.
  • “Old Act” Condominiums: (Created before 7/1/90) Generally, the requirements default to the New Act Condominiums provisions, however, if the governing documents require an annual audit, then an audit is required, regardless of the number of units.
  • Homeowners Associations (RCW 64.38.045) Associations with annual assessments of $50,000 or more must be audited annually, however, there are annual waiver provisions.

Additionally, there is an audit requirement for New Act Condominiums upon the legal transition from developer control. (RCW 64.34.312)

When is an audit recommended, regardless of the requirements?

Answer Mark in Talk Bubble Icon OrangeBecause the board is charged with governance of the association, they need to think through carefully whether the waiver of an audit is advised. Some of the reasons to have an audit include:

  • The CPA may also issue a “Report of Internal Control.” This contains recommendations that protect the board and association.
  • Provides significant disclosures to current and future owners.
  • Construction defect settlements.
  • Insurance proceeds/settlements.
  • Large special assessments.
  • Large construction projects.
  • Change in management companies.

If there is suspected fraud, a separate “forensic audit” may be appropriate.

What is needed in an audit?

Answer Mark in Talk Bubble Icon OrangeThe auditor will ask for the financial records and reports for both the audit year and subsequent year. If it is a new client, the auditor will ask for the financial records of the prior year end. Additionally, the auditor will also ask for governing documents, reserve studies, tax returns, budgets, and board minutes.

How long will the audit take?

Answer Mark in Talk Bubble Icon OrangeIn our firm, IF all information is provided when requested, the process is about six to eight weeks.

Who receives the audited financial statements?

Answer Mark in Talk Bubble Icon OrangeThe Auditors’ Report is addressed to the association board and membership. Other users include future owners (in the re-sale certificate) and current or possible association lenders. (The “Report of Internal Control” is addressed to the association board and management.)

What do we do if an audit discloses an issue?

Answer Mark in Talk Bubble Icon OrangeDiscuss the audit results with your management company and CPA, if you don’t understand the issue. Then, the board should discuss their plans to rectify the issue, and document this in the board minutes.

Are there more questions?

Answer Mark in Talk Bubble Icon BluePossibly, this article has raised more questions for you, than answered. Consult your association CPA, as there are numerous exceptions/details that are beyond the scope of this article.

 

Was this really 20 questions?

Answer Mark in Talk Bubble Icon BlueNo. Apparently the CPA cannot count. End Of Article

By Catherine Kuhn, CPA

Owner, Cagianut & Company, CPA

Catherine Kuhn, CPA, manages the Bellevue office of Cagianut & Company, CPA, which is devoted exclusively to serving the financial needs of over 800 Community Associations in Washington. C&C has over 25 years of experience in serving Community Associations and currently has 18 employees. Prior to joining Cagianut & Company in 2006, Cathy was a partner in a large Bellevue CPA firm and served clients in various industries there for 20 years. Cathy teaches classes and writes articles for WSCAI. In addition to being “Mom” to 2 active teenagers, she serves as Treasurer of the Newport High School Girls Basketball Booster Club, and a financial volunteer for Bellevue Young Life.

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