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Taxes – Association Rules for Capital Gains and Losses

Below is a look at two different aspects of association capital gains and losses that our firm has had to deal with this tax season. The concepts are interesting primarily because their tax answers are so different from what our association clients expected. Also, our clients had to do some homework before we could determine the answers.

Have you ever lost money on an investment when the market moved against you? Investment losses – nobody wants them. But when this happened recently to several associations, they told us that at least they could deduct those losses – right? Wrong! The rules for capital gains and losses for associations are different from those that apply to individuals.

On a slightly different topic, it can be easy to think it’s really a simple question when your association has a capital gain on the sale of property – but that’s only if you know the answers to these questions:

  1. Who is REALLY the taxpayer?
  2. What is the tax basis in the property sold?(This will probably surprise you.)
  3. Was this a complete or partial sale? (Didn’t see that one coming, did you?)
  4. What did you do with the sale proceeds?

We have worked with several associations already this year that have incurred capital losses on their investment activities. In each case, the associations had invested in interest rate-sensitive investment vehicles, particularly U.S. treasury bonds. Interest rates on treasury bonds have been at the lowest point ever in recent years, but have recently experienced some significant (percentage) rate increases. When this caused the value of existing low-interest bonds to plummet, these associations panicked and sold the bonds to avoid further losses. By doing so, they incurred capital losses.

Capital losses are a significant problem for associations, as they are not treated like any other form of income or expense. For corporations, the rule is that capital losses may not be used to offset other regular income, but can only be used to offset other capital gains. What this means is that an Association with a $10,000 capital loss from investment activities may generally not be able to use this loss on its tax return. The loss must be carried back three years and may be carried forward for a period of five years, but may only be used to offset past or future capital gains. For most associations, this means it is lost forever.

Moving on to capital gains, another association recently posed a question regarding a significant capital gain from the sale of common area property. Their take on the matter was that since they consider themselves to be a nonprofit organization, they should not have to pay any tax on the gain resulting from the sale of this property. They also considered it to be such a simple matter that they were going to have the association treasurer just show no gain on the Form 1120-H tax return. For this association, taxes had always been such a simple matter that they had always prepared their own tax return. This year, since they had this sale of common area property, they thought they should at least ask the question. As soon as we started asking them questions about the gain, however, they realized they were in way over their head on this one.

Before an association can properly reflect a capital gain on its tax return, its board of directors need to know the answers to the following questions:

  1. Who is REALLY the taxpayer?
  2. What is the tax basis in the property sold?
  3. Was this a complete or partial sale?
  4. What did you do with the sales proceeds?

Who is the taxpayer? While that may seem like a dumb question with an obvious answer, it’s amazing how many people can’t answer the question. If the Association is a planned development that holds title to its common area property and is selling a parcel of property to which it has title, then the answer is simple: the Association is the taxpayer. If, however, the Association is a condominium association, which generally does not hold title to its common area property, then it becomes a more complex question.

If it is determined that the Association is the titleholder of the property, then the Association is the taxpayer.

However, in the more common circumstance where the Association is simply acting as the agent for the members of the Association, then the members of the Association are the taxpayers, not the Association. If you have determined that the members of the condominium association are in fact the titleholder to the property, you are then led to the remaining questions two, three, and four above.

Tax Basis. Assuming the Association is a planned development, or a condominium association in which it is determined that the Association itself is the titleholder of record, this is a taxable transaction that must be recognized on the Association tax return. That makes the tax basis very important. There are generally only three possibilities for determining tax basis:

  1. If the Association purchased the property it later sold, the tax basis is the purchase price plus any subsequent capital improvements made to the property.
  2. If the developer transferred the property to the Association while it still retained at least 80% control of the Association, then the Association has the same basis in this property as it had in the hands of the developer, assuming that the developer did not take a deduction for this property on the developer’s tax return. And that is generally an unknowable fact, particularly 20 years down the line.
  3. If the developer transferred property to the Association at a point in time in which it no longer retained at least 80% control of the Association, that is generally considered a contribution to capital and there would be no tax basis in the property.

For a condominium association that does not hold title to the property sold, the members are the taxpayers, so this sale is NOT reported on the Association tax return. Because the Association acted as an agent for the members in facilitating the sale, however, it does have an obligation to disclose to its members the information THEY may need to report. Each member-owner is going to have a different tax basis. The Association will never know this information.

Complete or partial sale. If the sale of a common area parcel does not completely terminate the members’ interest in the Association, then it is a partial sale. In the case of a partial sale, the rule is that any net proceeds received from the sale first reduce tax basis, then are recognized as capital gains to the extent that sales proceeds exceed the tax basis (Revenue Ruling 81-152). The Association generally should be able to determine if the transaction is a complete or partial sale as it affects members.

What did you do with the money? This becomes a critical question when there is a partial sale, as the overriding assumption is that the sales proceeds will represent a reduction in basis to the members. It is not uncommon, however, for the Association to retain the proceeds to either shore up the operating budget or apply toward specific capital reserve projects. The tax treatment for the individual members depends on how the Association uses that money. There are generally three possible uses of sales proceeds:

Proceeds are distributed prorated to the members.

Proceeds are retained by the Association to be used in the operating budget.

Proceeds are retained by the Association to be used for capital reserve projects.

If the money is either refunded to the members or is held by the Association and expended for operating budget purposes, then to that extent the members will have a reduction in tax basis for their distributable share, even if they did not receive the money.

If instead the money was retained by the Association for capital reserve projects, this represents an increase in tax basis for each individual member. What that means is that if the full amount was used for capital reserve projects, there is no net tax impact to the individual members, as the sales proceeds which reduce basis are offset by the reserve contribution which increases tax basis.

Notice to members. If the Association is the taxpayer, there is no need for disclosure to members. But if the Association is a condominium project that does not hold title and is not reporting the sale, then the Association has the obligation of notification and disclosure toward the members, no matter how the proceeds are used. A word of caution: the Association should not be in the business of dispensing tax advice to its members. Our standard recommendation in this instance is that the Association should notify its members in writing that the sale has occurred, disclose the gross proceeds received, and inform how the proceeds were used. In our clients’ situations, since we are generally involved as the tax advisor at this point, we suggest that the notice to members also states that the Association’s accountant believes that this is a possible taxable event for each member, and that they should contact their own tax advisors to determine appropriate tax treatment. The notice could describe the basis issues above.

As you can see, what can seem like a very simple little question regarding the sale of the property is, in fact, a very complex tax issue that generally requires a seasoned tax professional to review and understand its possible tax impact to the Association. This is generally not the type of an issue that a board treasurer filing a tax return on behalf of the Association should handle himself or herself.

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