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Reserve Loans and Interest Deductions

Reserve loan interest could become deductible under the right conditions.

In recent years, loans are becoming more popular with homeowners' associations as a means of smoothing out reserve funding plans for several reasons: (1) they avoid a huge, one-time special assessment that many members may not be able to afford; (2) they allow the Association to perform larger projects all at once when needed rather than spreading them out over years because of cash flow limitations; (3) they keep property values higher; (4) most importantly, they make more sense because newly-developed specialty industry banking services have created structured loan packages for homeowners' associations. Unless a bank knows the industry, it probably wouldn't understand how to structure financing within its lending guidelines, simply because the HOA business is so different from the commercial real estate market. snabblan utan UC

I receive regular inquiries from board members inquiring how the interest expense on these loans is treated for income tax purposes on the Association's tax return. Many people know that real estate-related loan interest is deductible for individuals, and several know that it's also allowable for partnerships and corporations. So the question is, is HOA loan interest treated differently only because this corporation happens to be a homeowners' association? And the answer is, maybe.

Applying this same concept to a loan for common area repairs in a homeowners' association, the suggested answer is that since the repairs are linked to assets and aren't held for business purposes, then any loan interest takes on the same characterization, and is not thought to be a deductible cost. This concept would apply whether the Association filed Form 1120 or Form 1120-H.

In a standard scenario, the Association borrows cash for particular, large jobs because it doesn't have enough money differently to make the repairs. As an example, an Association might have only $100,000 in cash reserves but requires $1,500,000 to replace roofs. The Association borrows and immediately (or at least at the very near future) spends the money it borrowed. Its $100,000 cash position is relatively unchanged but on a very temporary basis. Given these conditions, how can the thing treat on the tax returns?

When the Sec. 528 election is made, the interest on the loan to repair institution property won't be deductible from the Association. The borrowed money was used to fund nondeductible personal expenses - repairs to commonplace residential property not held for business use. This interest is incurred concerning repairs which would have otherwise been made from member evaluations (exempt function income or capital contribution). Considering these assessments would have been exempt function income, the loan presumably assumes the same status. IRC Sec. 528 (d) (1) (B) prohibits any deduction connected with exempt function income.

If the Sec. 528 election is NOT made, the Association is taxed as a regular corporation, subject to the limitations of IRC Section 277. The interest on the loan to fix association property won't be deductible by the Association. The borrowed money was used to finance nondeductible personal expenses - fixes to common residential property not held for business use. The attention is incurred concerning repairs which could have otherwise been made from penis assessments, and the interest cost becomes a portion of "member deductions" (as opposed to "nonmember deductions").

However, what if the situation are shifted slightly, as I have seen happen on many occasions? Each situation needs to be looked at carefully, as, under certain circumstances, the interest cost could be allowable. The key here is located in the very assertion from IRS that it's the function and use of this borrowing which decides deductibility.

Assume instead that the Association had $2,000,000 in reservations as opposed to $100,000 in the above example. That is more than sufficient to cover the roofing job, however, because those funds are earmarked for other projects, the Association nonetheless decides to borrow $1,500,000 for the roofing job. What has just happened is that the purpose of your loan has only changed. Though the borrowed money was used to cover the roof project, the actual aim of the loan was to keep existing cash balances. In other words, this turned into an economic decision rather than a financing decision.

The $2,000,000 in cash balances is generating taxable interest income which would not exist had the money been used to cover the roofing project. Consequently, the interest deduction on the reserve loan directly reduces net interest income (interest income less interest deduction) back down to where taxable interest income would have been had no loan be used for your roofing project. On the other hand, the differential between the interest rate earned by the Association versus the rate of interest paid may signify that there's not any net interest income at all.

This simple notion applies no matter which of those two tax types is registered. However, IRS bias will be against allowing such a deduction, because IRS agents typically look just at using the borrowed cash, not the underlying reason (purpose) for borrowing the money. Connected to Form 1120, the Appropriate citation appears to be in the now withdrawn Treasury Regulations Section 1.277-1, particular paragraphs of which are reproduced below:

    1.277-1 (d)(5) Total deductions. For purposes of this part, the total deductions a membership organization may take into account are the sum of its membership deductions and nonmembership deductions.

    1.277-1 (d)(6) Membership deductions.) Membership deductions would be the expenses, depreciation and similar items of deduction attributable to group actions. Such articles of deduction might, nevertheless, be taken into consideration only to the extent that such items are otherwise allowable as deductions under Chapter 1 of the Code (applied about whether the action giving rise to such questions was engaged in for profit).

    1.277-1 (d)(7) Nonmembership deductions. Nonmembership deductions would be the costs, depreciation and similar things allowable as deductions under Chapter 1 of this Code other than those items described in subparagraph (6) of this paragraph.

    1.277-1 (d)(8)) Allocation of deductions.) Items of deduction attributable in part to nonmembership activities and as a way to membership activities will be allocated between the two types of actions on a reasonable and consistently applied basis.

Several years ago I discussed this dilemma while at a meeting at the national IRS office at Washington, D.C., specifically with the Special Industries and Pass-throughs Group, which is that the particular group within IRS that believes tax law for this particular business. These people are extremely well-versed in association tax law, and therefore are the individuals who would either write the IRS' position on such a matter in the form of a Letter Ruling or Revenue Ruling or provide technical support for IRS lawyers in a tax litigation setting. For these reasons, I can feel comfortable with their response, even though it was informal.

The above discussion is valuable because it points out two significant issues: (1), not all the tax law matters are written in stone - there is room for interpretation; and (2) not all tax practitioners agree on all issues, nor should they.

The deduction of interest expense for a homeowners' association is a matter that, in my estimation, is not delineated in existing tax law. Looking at the exact citations as my colleagues, I will legitimately reach another conclusion. The only way this problem is eventually solved is through the issuance of guidance by the IRS or advice from the courts (and even after that, due to appeals and potential subsequent interpretations, it may not be finally resolved).

Gary Porter, CPA, RS, PRA, has been operating in the community association industry for more than 30 decades. As a CPA, he's performed thousands of institution audits and ready tens of thousands of union income tax returns. He's specialized in the planning of tax exemption applications and has successfully taken more than 70 associations tax exempt, in a cumulative tax savings of tens of thousands of dollars. He is the principal author of PPC's "Guide to Homeowners Associations" and "Homeowners Association Tax Library," which serve as the first manuals employed by CPAs in the community association industry. lana pengar direkt

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