The Internal Revenue Service (“IRS”) excludes from an association’s taxable income those amounts which are properly kept and used for capital contributions. In several significant Revenue Rulings, the IRS considered special assessments for major repairs and replacements to be capital contributions in addition to capital contributions to reserve funds from annual assessments.
For assessments to be classified as capital contributions, the association must comply with the following criteria in the Revenue Rulings:
- Notify unit owners in advance that a specific portion of their assessments represents capital contributions to the association. This can be accomplished by including the reserve fund contributions as a line item in the annual budget.
- Designate reserve fund contributions for specific future capital expenditures. This can be accomplished by having a reserve study conducted. The reserve study should list the funds required for each expected future capital expenditure. Associations that are currently setting aside funds for future capital expenditures and have not conducted a reserve study would not meet this requirement.
- Monies earmarked for reserves should be utilized only for the major repair and replacement of assets and not for other purposes.
- Segregate reserve funds from operating funds. This means separate bank accounts must be established for reserve funds and might prohibit inter-fund borrowing.
- Maintenance items such as painting, staining, and caulking are not considered capital replacements for tax purposes.
Associations can further reduce their tax liability by proper ly planning before year-end with the assistance of a Certified Public Accountant or other tax professional. In many instances, excess operating funds may be transferred to reserves and excluded from taxable income if there is a reserve study in place which is not fully funded. Investment choices also affect an association’s tax liabilities. All investment income is taxable at the federal level except for income generated from municipal bonds or other tax exempt governmental obligations.
Taxes are an area in which board members usually require professional assistance to fulfill their fiduciary duty to make informed decisions.