Can an association – a homeowners’ association (“HOA”) or condominium association – receive tax-exempt status from the Internal Revenue Service (“IRS”). In short, maybe.
There are three avenues for an association to qualify for tax-exempt status. These different paths are referred to by the section of the Tax code that provides the tax exemption, and include:
Each comes with distinct advantages and qualifications, and is discussed in turn.
Tax exemption based on Section 501(c)(4)
Generally, the Internal Revenue Code (“IRC”) 501(c)(4) provides a stricter standard for a associations to qualify for exemption than IRC 501(c)(7) or 528. The standard for qualifying as a tax-exempt 501(c)(4) is that the organization must operate for the benefit of the general public, i.e., it must provide a community benefit. The position of the IRS regarding the exemption of associations under IRC 501(c)(4) is set-forth in a number of revenue rulings. The principal factor barring exemption in this area is the degree of private benefit served by the operation of the particular homeowners’ organization.
Illustrative of this point is Commissioner v. Lake Forest, Inc., 305 F. 2d 814 (1962). That case involved a nonprofit membership housing cooperative that provided low-cost housing to its members. In denying exemption, the court stated that the organization was not organized exclusively for the promotion of social welfare. The court found that although its activities were available to all citizens eligible for membership, “its contribution is neither to the public at large nor of a public character.” The court looked to the benefits provided and not to the number of persons who received benefits through membership. Specifically, the court looked to whether the public at large or simply the association itself benefitted.
Exemption under 501(c)(4) is the most difficult determination to receive because an applicant must limit the degree of private benefit served by the operation of a particular HOA to qualify. This balancing act between public versus private benefit isn’t simply a numbers game. As illustrated in the Lake Forest case, the IRS evaluates the type of benefits provided, not the number of people who received the benefit. In fact, the size of the organization is almost irrelevant. The IRS will look to facts such as:
- Is the association a traditional HOA, or is it a Condominium Association. The essential nature and structure of condominium ownership, involving common ownership and maintenance of property, did not qualify for exemption under IRC 501(c)(4).
- The organization must
- serve a “community” that bears a reasonably recognizable relationship to an area ordinarily identified as governmental;
- must not conduct activities directed to the exterior maintenance of private residences; and,
- the common areas or facilities it owns and maintains must be for the use and enjoyment of the general public
- Does the association restrict access to common sidewalks, green spaces, or streets. If yes, it does not qualify for exemption.
You should recognize that the disqualifying points put for by the IRS – maintenance of exteriors of private residences – is exactly the reason why most associations exist in the first place. Further, it specifically excludes condominiums, the most common and fastest growing type of associations. Condominiums association are associations where individual unit owners have joint ownership of the building and land – e.g. a condominium where all residents own part of the mail room and pay fees for maintaining it. In a traditional HOA, the association itself, or a single member/resident, owns property that is maintained commonly – e.g. a single-family neighborhood where fees go to maintenance of roads not jointly owned by the residents.
Given the ownership nature of condominiums, it is impossible to avoid substantial private benefit to member/resident. Given all of these requirements, it is rare that an association meets 501(c)(4) exemptions.
Tax exemption based on Section 501(c)(7)
As an (easier) alternative to tax exemption under IRC 501(c)(4), an association whose primary function is to own and maintain certain recreational areas and facilities may elect exemption as a social club under IRC 501(c)(7) rather than under IRC 501(c)(4).
This is more desirable for associations that seek to restrict use of its recreational facilities to members but offers little community benefit. Section 501(c)(7), however, also comes with a disqualification that pushes out most associations. The association:
- it cannot own or maintain residential properties that are not part of its social facilities;
- cannot administer and enforce covenants for preserving the architecture and appearance of the housing development; and
- it cannot provide the development with fire and police protection.
Again, these disqualifications are typically an essential component of associations and disqualify most organizations.
Tax Exemption under IRC 528
IRC 528 was enacted under the provisions of the Tax Reform Act of 1976, to provide associations with another alternative to tax exemption. A history of the IRS’s rulings on associations gives the impression IRC 528 was created because associations have such difficulty meeting exemption under 501(c)(4) and 501(c)(7).
IRC 528 exempts from income tax any dues or assessments received by qualified associations from property owner-members of the organization, where these dues and assessments are used for the maintenance and improvement of its property.
All associations described in IRC 528 may qualify for this sort of quasi-exempt status by election. In other words, IRC 528, is an election an association must affirmatively meet and file for every year. 528 is not a tax-exempt determination.
IRC 528 defines a qualified “homeowners’ association” as an organization that is a condominium management association or a residential real estate management association if:
- it is organized and operated to provide for the acquisition, construction, management, maintenance, and care of association property;
- it elects to have the section apply for the taxable year;
- no part of the net earnings of the association inures to any private shareholder or individual;
- 60 percent or more of the association’s gross income consists solely of amounts received as membership dues, fees, or assessments from owners of residential units, residences or residential lots (exempt function income); and,
- 90 percent or more of the association’s expenditures for the taxable year are expenditures for the acquisition, construction, management, maintenance, and care of association property.
IRC 528 broadens the type of associations that qualify for the election beyond what could qualify under 501(c)(4) or (7). It encompasses associations, condominiums, real estate management groups, and even timeshares. The key benefit to IRC 528 is this broadness. IRC 528 reflects Congress’ view that it is not appropriate to tax the revenues of an association of homeowners who act together if an individual homeowner acting alone would not be taxed on the same activity.
Obtaining tax-exempt status for an association from the IRS is a complex process with limited options. The most challenging route is through 501(c)(4) exemption, which requires a careful balance between public and private benefit. This option is rarely suitable for most associations due to their nature and purpose. An alternative is seeking exemption under 501(c)(7) as a social club, but it comes with disqualifications that may exclude many associations. Lastly, IRC 528 provides a more inclusive option, allowing various types of associations to qualify for quasi-exempt status by election. Despite its advantages, the decision to elect IRC 528 must be made annually. Overall, associations face significant hurdles in obtaining tax-exempt status, and the available avenues require careful consideration of their specific circumstances and objectives.
This blog is for educational purposes only and does not constitute legal advice. This article, or contacting Apex, does not in any way form an attorney-client relationship. Speak to a licensed attorney if you need help or advice in how to dissolve your organization. If you have any questions or would like to learn more, please contact Coleman Scroggins at Coleman@apexlg.com or visit our website and blog.