Can painting be included in the reserve study?

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 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 even arise?  In 1993 the IRS audited approximately 15 associations in San Diego, California that created a national furor within the inudstry.  The IRS audits dealt significantly with the concept of the inclusion of painting in reserves.  The reason this became such a big deal in the industry was because of the misunderstanding that occurred related to this issue.

You must realize that the IRS has its own 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 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, it is not a capital expenditure. Consequently, the reserve contributions that most tax preparers were excluding from taxable income on 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 our position 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.