Should Painting Costs Be Included In The Reserve Fund?

For most condominium projects, painting is one of the largest expenditures that the Association will incur. Consequently, it is logical that it should be included in the Association’s reserves because it is not an annual maintenance expense. For most Associations it will occur every 7 to 15 years.
So why does this question arise? In 1993, the IRS office responsible for 15 Homeowners’ Associations in San Diego, California, created a national furor over the need to include the cost of painting in reserves. This became a very big issue in the industry, but only because of the misunderstanding that occurred related to this issue.
The IRS has its own set of rules, and that they really don’t care what the Homeowners’ Association industry thinks. The Homeowners’ Association industry generally refers to expenditures as being either “operating” or “reserve” in nature. The IRS refers to expenditures as being either noncapital or capital in nature. These two definitions are not the same, and the major area of difference is painting expense. It is common practice within the Homeowners’ Association industry to exclude reserve contributions from taxation because they are capital assessments. However, the IRS states that in order for an assessment to be classified as capital in nature, the related expenditure must qualify as being capital in nature. Unfortunately, there are numerous rulings and tax court cases which clearly state that painting is a non-annual maintenance expense and it is therefore not a capital expenditure. Consequently, the reserve contributions that were being excluded from taxable income of the Association’s tax return now become taxable income. That makes it very difficult for an Association to accumulate the necessary painting funds without incurring a huge tax liability. The easy answer to this question is to have the Association file income tax Form 1120-H and avoid this issue of capital versus noncapital expenditures that exists only on Form 1120.
It is the general position of the Reserve Industry that the tax tail should not wag the economic dog. Determination of reserves should be made based upon economic considerations, state statutes and governing document requirements. Taxes should not enter into that consideration. Consult with the Association’s tax accountant to find out ways to avoid the tax risks on this issue.