Non-Exempt Function Income for HOAs: Deductions and the 30% Rate

Any money a homeowners association takes in outside member assessments is generally non-exempt function income for HOAs, and under Internal Revenue Code Section 528 it is taxed at a flat 30% after allowable deductions.¹ That covers bank interest, investment dividends, cell tower and billboard leases, laundry revenue, fees from non-members, and most per-use charges for the clubhouse or pool. Member dues and assessments stay on the exempt side and are not taxed. The classification work is where boards tend to slip, and misclassifying a revenue stream either overpays the IRS or underpays it and invites a penalty.

What Counts as Non-Exempt Income

Exempt function income is narrow. It covers only amounts received as membership dues, fees, or assessments from owners in their capacity as members.² Everything else is non-exempt. The Treasury regulations spell out several categories that do not qualify:

Interest on bank accounts, money market funds, certificates of deposit, and reserve or sinking fund accounts, plus any dividends from an investment portfolio.
Amounts received from people who are not members, including fees paid by non-members to use the pool, tennis courts, or clubhouse.
Fees charged to members for short-term use of association facilities, such as renting the clubhouse for an evening.
Payments for work performed on privately owned property rather than association property.
Transportation fees collected from members for rides to shopping areas, workplaces, or other destinations.

Cell tower leases, billboard rentals, and laundry income from outside users all fall squarely into this bucket. They are payments from outside parties for commercial use of association property, and how the money is booked internally does not change the tax classification.²

The Annual-Fee Exception

One exception matters in practice. A fee a member pays for special use of an association facility is normally non-exempt, but the regulations treat it as exempt function income if two conditions are both met: the fee is not charged more than once in any 12-month period, and the privilege lasts for the full 12-month period (or the portion of the year the facility is in use).²

An annual pool membership paid by a homeowner qualifies. A $50 fee to rent the clubhouse for a birthday party does not. The dividing line is duration, not dollars. Boards that convert per-use charges into annual access fees can shift that revenue to the exempt column, but only if the fee genuinely buys year-round access rather than a repackaged single rental.

Deductions Against Non-Exempt Income

Tax is not owed on the full non-exempt revenue figure. Expenses directly connected to producing that income are deductible.¹ If the clubhouse is rented to non-members, the cleaning, utilities, insurance, and maintenance costs tied to those rentals reduce the taxable amount. Management fees paid to oversee the investment accounts offset investment income. The requirement is a direct link between the expense and the revenue it produced.

General operating costs that benefit the whole community — landscape maintenance, security, common-area lighting — cannot be deducted against non-exempt income. Those costs belong to the exempt function.

Splitting Dual-Use Expenses

Most associations have staff and facilities that serve both sides. A community manager who spends part of her time on the investment portfolio and part on member services creates an allocation question. The regulations require shared expenses to be split between exempt and non-exempt functions on a reasonable basis, and the non-exempt portion is then deductible. The regulations give a plain example: a manager earning $10,000 who spends 10% of her time on activities producing non-exempt income generates $1,000 of deductible expense.³ Time logs, usage records, and square-footage calculations are all reasonable methods; whichever the board picks needs to be documented and applied the same way each year.

The $100 Specific Deduction

After all directly connected expenses come off, the association gets a flat $100 deduction on top.¹ It is not indexed for inflation and it applies regardless of how much non-exempt income was earned. For an HOA whose only non-exempt income is a few hundred dollars of bank interest, this deduction alone can wipe out most of the tax.

The 30% Rate and When Form 1120 Beats It

Associations filing Form 1120-H pay 30% on their homeowners association taxable income. Timeshare associations pay 32%.¹ Those rates apply only to non-exempt income after deductions, never to member assessments.

An association that does not elect Section 528 files a regular corporate return on Form 1120, where the federal rate is 21%. The IRS itself tells associations to run the numbers under both forms and file whichever produces the lower total tax.⁴ The trade-off is complexity. Form 1120 pulls the association into Section 277 rules for membership organizations, where excess member income can be deferred under Revenue Ruling 70-604 with a membership vote and capital contributions can be excluded if properly earmarked and segregated. The clean exempt versus non-exempt split of Section 528 goes away. For an HOA whose only non-exempt income is modest bank interest, Form 1120-H is almost always simpler and cheaper. For an association with substantial commercial revenue, the 21% Form 1120 rate deserves a real comparison.

The Qualification Tests Before You File 1120-H

Filing Form 1120-H is an annual election, and three tests must be met that year:¹

At least 60% of gross income comes from membership dues, fees, or assessments paid by unit or lot owners.
At least 90% of expenditures go toward acquiring, building, managing, maintaining, or caring for association property.
For a condominium association, substantially all units are used as residences; for a residential real estate management association, substantially all lots or buildings are restricted to residential use.

The 60% income test is the one that catches boards out. If investment balances or non-member rental income grow fast enough, non-exempt revenue can push past 40% of gross income and disqualify the association from Section 528 for that year. Watch the ratio during the year, not at tax time.

Deadlines and Late Elections

The return is due on the 15th day of the fourth month after the end of the association’s tax year, which is April 15 for calendar-year associations. Form 7004 gets an automatic extension if filed by the original due date.⁴ Because the election is annual, the board can switch between Form 1120-H and Form 1120 from one year to the next.

One practical benefit of the Section 528 election: the quarterly estimated tax rules that apply to regular corporations do not apply to associations filing Form 1120-H, regardless of the tax owed.⁴ An association on Form 1120 may have to make those payments.

If the deadline slips and the election is missed, it is not automatically lost. Treasury Regulation Section 301.9100-2 gives an automatic 12-month extension to make the election, provided the association files Form 1120-H within 12 months of the original due date, including any extensions previously granted.⁵ Even when no tax is owed, filing is still the mechanism that makes the election; skipping it leaves the association treated as an ordinary corporation for the year.

1
Office of the Law Revision Counsel. 26 USC 528 – Certain Homeowners Associations
2
eCFR. 26 CFR 1.528-9 – Exempt Function Income
3
eCFR. 26 CFR 1.528-10 – Special Rules for Computation of Homeowners Association Taxable Income and Tax
4
Internal Revenue Service. Instructions for Form 1120-H
5
U.S. Government Publishing Office. 26 CFR 301.9100-2 – Automatic Extensions