Rev. Rul. 88-56

1988-2 C.B. 126, 1988-27 I.R.B. 6.

                       Internal Revenue Service

                                 Revenue Ruling

                 HOMEOWNERS ASSOCIATION; EXEMPT FUNCTION INCOME

                            Published: July 5, 1988

Section 528. - Certain Homeowners Associations, 26 CFR 1.528-1: Homeowners associations.

  Homeowners association; exempt function income.  The amounts paid by a developer to a homeowners association, in settlement of a law suit for underassessments, are exempt function income to the homeowners association under section 528(d)(3) of the Code.

ISSUE

  If a homeowners association sues a developer for underassessments, are amount paid in settlement of the litigation exempt function income of the homeowners association under section 528(d)(3) of the Internal Revenue Code?

FACTS

  The taxpayer is a residential real estate management association formed to own, operate and maintain a residential real estate development. The association qualifies as a 'homeowners association' as defined in section 528(c) of the Code and has timely elected to be treated as such for each year since it was formed. The members of the association are the lot owners in the development, including the developer, who owns the unsold lots in the development. A major responsibility of the association, through its board of directors, is assessing its members, including the developer, for annual due for present and future operations, maintenance, repair, and replacement of common area improvements.

  During the development phase, the developer owned a majority of the lots and controlled the development's homeowners association. After control of the homeowners association passed to the individual lot owners, the association's board of directors determined that the developer, while in control of the association, had assessed dues at a level that was inadequate to provide for current and  future maintenance of the common area improvements in the development. The association filed a law suit against the developer for the amount that had been underassessed with respect to the lots owned by the developer during the development stage.

  To resolve the litigation, the association and the developer entered into an agreement. Under the agreement the developer agreed to pay a specified amount to the association in settlement of the association's claim.

LAW AND ANALYSIS

  Section 528(a) of the Code provides, in part, that a homeowners association  (as defined in section 528(c)) is subject to taxation only to the extent provided in section 528.

  Section 528(b) of the Code imposes a tax of 30 percent on the homeowners association taxable income of every homeowners association for each taxable year.

  Section 528(c)(1) of the Code defines a homeowners association as a condominium management association or a residential real estate management association if, among other requirements, 60 percent or more of the association's gross income for the taxable year consists solely of amounts received as membership dues, fees, or assessments from owners of residences or residential lots in the case of a residential real estate management association.

  Section 528(d)(1) of the Code generally defines homeowners association taxable income as the excess (if any) of the gross income for the taxable year (excluding any exempt function income) over the deductions allowed by chapter 1 that are directly connected with the production of the gross income (excluding exempt function income), computed with certain modifications.

  Section 528(d)(3)(B) of the Code defines 'exempt function income' as any amount received as membership dues, fees or assessments from owners of real property in the case of a residential real estate management association.

  Section 1.528-9(a) of the Income Tax Regulations provides that it is not necessary that the source of income be labeled as membership dues, fees, or assessments. What is important is that such income be derived from owners of residential units or residential lots in their capacity as owner-members rather than in some other capacity such as customers for services. Section 1.528-9(a) provides further that dues, fees, or assessments paid to an organization by a developer with respect to unfinished or finished but unsold units or lots shall be exempt function income even though the developer does not use the units or lots.

  For federal income tax purposes, the classification of amounts received in settlement of litigation is to be determined by the nature and origin of the claim. See, for example, U.S. v. Gilmore, 372 U.S. 39 (1963), 1963-1 C.B. 355. In the present situation, the amounts paid by the developer to the association pursuant to the settlement agreement presented compensation for inadequate past assessments for current and future maintenance of the common area improvements in the development. Such amounts, therefore, were paid by the developer in compensation for underassessments and, under section 1.528-9(a) of the regulations, they are properly characterized as assessments that are exempt function income.

HOLDING

  If a homeowners association sues a developer for underassessments, the amount paid in settlement of the litigation are exempt function income of the homeowners association under section 528(d)(3) of the Code.

DRAFTING INFORMATION

  The principal author of this revenue ruling is Donna Young of the Corporation Tax Division. For further information regarding this revenue ruling contact Ms. Young on (202) 566-4733 (not a toll-free call).

Rev. Rul. 88-56, 1988-2 C.B. 126, 1988-27 I.R.B. 6.