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.
- Residential use test
- 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.
- If vacant, was the unit last occupied as a residence? If yes, go to part B. If no, go to question 3.
- Has the unit been occupied for nonresidential purposes? If yes, the unit is nonresidential. If no, go to question 4.
- Was the unit originally constructed as a residence? If yes, go to part B. If no, go to question 5.
- Is the unit used for purposes auxiliary to residential use? If yes, the unit is residential. If no, the unit is nonresidential.
- 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.
The above questionnaire may be adapted for use by an association to document compliance with IRC Section 528.
Timeshare associations were granted the ability to file Form 1120-H without regard to the residential status discussed above due to a change in the tax law in 1998. Prior to that date, timeshare could not meet the residential test and could not file Form 1120-H.