Saving an Association $60,000 in taxes based on a chance conversation
By: Gary A. Porter, CPA
One of the nicest parts of any CAI national conference is the opportunity to interact with others that have the same interests and problems that you have. Sometimes, the most valuable information you receive is not in one of the formal educational sessions, but is obtained through casual conversation with others during the conference.
I had an opportunity at a recent CAI national conference in to help out a manager that had a relatively rare transaction with a very large tax impact. The manager was wondering if there was any possible way to reduce this huge tax obligation. I was able to offer some help, because this is the third time I have dealt with a very similar situation, so it was not new to me.
The tax situation
The manager’s association was just getting ready to close escrow on the sale of a (former) manager’s unit, and had just been advised by the association’s CPA that the gain on sale would create a $60,000 tax liability. Upon my questioning the manager on the key tax issues, she informed me that the association had spent a significant amount of money on repairs and maintenance during the year, and that is the reason they decided to sell the unit (no manager had used it for several years, it had been rented out to produce income for the association). She also informed me that the condo association, and not the unit owners, was on title to the unit. This is the most critical issue.
My advice was that the association should defer the sale for a very brief period of time, if possible (the manager said that was possible). My opinion was that the excessive maintenance expenses during the current year had probably created a large membership loss. The plan, therefore, was to convert the taxable nonmember gain into membership income (as opposed to taxable nonmember income) and use it to offset the large member loss. Net result? No taxable income created by the sale of the unit. I explained that the association had probably spent enough money on common area repairs to incur a substantial member loss, if Form 1120 were filed. That being the case, the association could absorb a significant member income without reaching the point where there would be taxable net member income (this under new Revenue Ruling 2003-73).
The mechanics of achieving the desired result required that the association sell the unit to an existing member of the association, thereby converting nonmember income into member income. That member could then later complete the sale to the third party without gain, based on the price he/she paid to the association, and the taxable gain could be avoided by both the association and the member. IRS Private letter ruling 9637007 is directly on point is describing this situation. Obviously, several things must be in place for this to work:
- there must be a large member loss to absorb the gain,
- you must have a member willing to participate in the transaction, and
- you must have sufficient passage of time to avoid this appearing to be a "step" transaction.
The final result
I was contacted by the association’s CPA shortly after the conference and provided them with the necessary citations so that they could research the issues to confirm my advice. The final result was that they did restructure the transaction and expect to close escrow shortly on the sale and completely avoid any taxable gain. That conference was worth $60,000 to that association.
But the results could have been different had title vested in the condominium owners rather than the association. See below.
Key issue – Who is the taxpayer?
As stated earlier, the key issue is who has title to the unit being sold?
If title vests at the association, the above-described plan can work under the right circumstances.
If, however, the members of the association hold title to the unit as part of the common area, then the association is probably not be the taxpayer, but is simply acting as an agent for the members. IRS private letter ruling 199934013 addressed this exact issue. In that ruling, the IRS held that since the unit owners held title, they were the taxpayer, and the association was acting strictly in the capacity of an agent, and the association's only responsibility was to report out the gain to the owners.
In many similar situations in California during the last few years, I have rendered opinions that such proceeds (pro-rata share of gain on sale or insurance recovery) represent first, a reduction in basis to the unit owners, and second, taxable gain to the extent that the proceeds exceed their basis. I normally write the letter that accompanies the check distributing the proceeds, and advise each member in the letter to seek their own tax counsel on this matter. The last thing the association wants to do is be cast in the role of a tax advisor. The best course is to provide general guidance and rules from the association’s CPA, and tell the members to consult their own tax advisors. But, you must provide them with enough information to reach a conclusion based on the information provided.
Other twists and turns
If the unit owner is the taxpayer, what happens if the association retains the proceeds from the sale? That’s exactly what happens much of the time, as the sale is often triggered by the association’s need for cash. The answer is, it depends on what the association does with the money. (I feel like a used car salesman when I say “it depends”, but, it is true.)
If the association retains the proceeds and uses them for operating fund working capital, then each of the members will have a pro-rata reduction of tax basis, or potentially, taxable income. That will depend upon each unit owner’s tax basis, and that is information that the association cannot even know. Heck, the unit owners probably don’t even know.
If the association retains the proceeds for “capital” reserves such as a roof (but not painting), or capital repairs, then the units owners have no tax impact and no reduction in tax basis. The reason for this is that that the pro-rata share of gain, which represents a reduction of tax basis to the unit owners, is offset by an equal and corresponding increase in tax basis caused by the “capital contribution” by the unit owners to the reserves of the association. Revenue Ruling 81-152 provides direct guidance on this calculation.
The moral of the story
Tax law can be very tricky, as you can see from the above, particularly when you’re involved with a condominium association. Transactions are not always as straightforward as they appear. But, by knowing the law, and structuring your transaction to comply with existing rulings, you can achieve significant tax savings.