Reserve Tax Issues

Several homeowners association income tax issues can potentially affect the reserve study.  This is because the homeowners association industry thinks in terms of operating funds and reserve funds.  However, the IRS thinks in terms of operating funds and CAPITAL funds.  To the IRS, capital funds are the large expenditures of funds that are typically described as major repairs or replacements, expenditures that add to the original life of the asset (component).

The biggest problem for associations is painting expense.  The industry lumps these costs into reserves as part of the reserve fund study.  But, the IRS does not recognize painting as a capital expenditure; to the IRS, painting is simply a non annual maintenance expense.  The IRS position is backed up by several court cases that are very specific and on point.  See article that discusses this sensitive area.

You have probably heard someone within the industry say that an association "cannot have painting in reserves because of IRS rules."  That's not true.  The association is often required by state law to include painting in the reserve study.  Common sense tells you painting should (generally) be included in the reserve study.  You just have to be careful. 

If the association files Form 1120-H, there is no tax issue with respect to painting.  If the association files Form 1120, then it has to be very careful to avoid negative tax consequences.  See article that addresses tax planning techniques to avoid, or at least minimize, this tax issue.