Is Loan Interest Deductible – at the Association Level and at the Homeowner Level?

Associations are able to obtain loans and various financing from banks and other lending institutions. It has gotten a lot more common in the last few years. Thus, the question arises – is the interest deductible against interest income on the Association’s tax return? Also, homeowners want to know if their portion of the interest is deductible on their own personal tax return.

In February, 1997 the California Society of CPAs had a discussion session with the IRS and this question arose. The answer was published for members of the CSCPA. Although this would be considered to be informal communications with the IRS, it does very succinctly summarize the situation and give direct answers. It is being reprinted here for your consideration.

The “bottom line” is that individuals cannot deduct interest paid on Association loans because their property is not securing the loan. The loan is secured by assessments.

For Associations – if form 1120-H is filed, the interest expense is not deductible. If form 1120 is filed, it may be. The issue with form 1120 is whether there is interest income coming from the members as they may have financed their special assessments. Talk with your CPA about this issue.

Here is the IRS’ discussion on the matter with CSCPA:

Question- An unincorporated homeowners association assesses each homeowner to repair damage resulting from the Northridge earthquake. Rather than pay the assessments, the homeowners, as an association, take out an SBA loan. If the association liens each homeowner’s residence for a pro-rata share of the loan, would the interest paid on the loan be deductible by the individual homeowners?

Answer- Whether or not incorporated, the homeowners association will be taxed as a corporation absent an election under Sec. 528 to be taxed solely on income which is not exempt function income. If that election is not made, the interest on the loan to repair association property will be deductible by the association.

If the Sec. 528 election is made, the interest on the loan to repair association property will not be deductible by the association. This interest will be incurred with respect to repairs which would have otherwise been made from member dues. Since these dues would be exempt function income, the loan arguably takes the same status. Sec. 528 (d) (1) (B) prohibits any deduction associated with exempt function income.

Additionally, the interest will not be deductible by the members of the association. Generally, a taxpayer is allowed an interest deduction only for interest on their own debt, not on the debts of another (see Rider Corp., 84-1 USTC9171 (1984, CA). If the interest were arguably passed through by an unincorporated association, what authority would a member rely on for their deduction? There is little question that the association’s pass through would be neither a trade or business nor investment to the member. Therefore, the only character of deductible interest left would be qualified residence interest.

Repairs to association property would clearly not meet the definition of acquisition debt. Therefore, the debt would be considered equity debt. Even if sufficient equity exists in each member’s residence, is this debt secured by that residence? Sec. 1.163-10T (0) (1) holds that debt is treated as secured by a qualified residence if it is on the security of any instrument such as a mortgage, deed of trust, or land contract (a) that makes the interest of the debtor in the qualified residence specific security for the payment of the debt, (b) under which, in the event of default, the residence could be subjected to the satisfaction of the debt with the same priority as a mortgage or deed of trust in the jurisdiction in which the property is situated, and (c) that is recorded, where permitted, or is otherwise perfected in accordance with applicable State law.

Your question stated that the association will place a lien against the property of the members as a result of the loan from the SBA. Debt is not treated as secured by a qualified residence, however, if it is secured solely by virtue of a lien upon the general assets of the taxpayer or by a security interest (e.g., a mechanic’s lien or judgment lien) that attaches to the property without the debtor’s consent. If SBA has no power to force a sale of a member’s residence or default of the loan, the residence is not security for that loan. Therefore, the interest would not be deductible as qualified residence interest.

To be deductible by the association members, some statutory provision must exist which would allow the debt of the association to be allocated to its members, and be deductible by its members. Sec. 216 allows a tenant-stockholder of a cooperative housing corporation (co-op) to deduct their proportionate share of the taxes and interest paid by the co-op.

To become a co-op, the association must:

1. have only one class of stock,
2. make distributions to stockholders solely out of earnings and profits except in the case of complete liquidation,
3. allow stockholders, solely by reason of stock ownership, to occupy as a residence a home owned by the co-op, and
4. earn at least 80 percent of its gross income, in the year the stockholder is allocated interest, from the stockholders.

Sec. 1.163-10T (q) (1), of the Income Tax Regulations, includes in the definition of a residence stock held in a co-op. Any indebtedness of the co-op secured by this stock is held to be secured by the residence. Therefore, stockholders could treat this interest as qualified residence interest on their tax returns.

In summary, if the association makes the election under Sec. 528 they will not be able to deduct interest on loans made to repair association property. In addition, the members will also be unable to deduct any of this interest.

If no Sec. 528 election is made, the association will be entitled to the interest deduction. if the association acquires all real property currently owned by its members in exchange for its stock, it may qualify as a cooperative housing corporation under Sec.216. As such, the co-op may pass through to its stockholders their proportionate share of the taxes and interest paid by the co-op for the year. If the loans which generated the interest are secured by the stock of the stockholders, they will be entitled to deduct their proportionate share of the interest as qualified residence interest.