What Are Some Accounting and Tax Issues of a Construction Defect Settlement?

Tax Issues

There are different types of proceeds that can be received from a construction defect settlement. Some of these are as follows:

Payments in lieu of dues - These amounts are generally treated like any other assessment income. Thus, if filing as a regular corporation (form 1120) this amount would be taxable, but if filing as a homeowners association (form 1120-H) this amount would be excluded from income.

Punitive damages - These amounts would be taxable.
Interest - These amounts would be taxable.

Compensatory damages (amounts received for actual damages) - These amounts are generally excluded from tax as they are considered to be a return of capital, to the extent of the bases of the underlying assets. If there is any excess, the association will have taxable gain. However, if the excess funds can be used for other capital purposes the gain can be eliminated. Deductible capital expenses include the attorney fees and legal costs associated with the lawsuit. The tax cases on record state that the funds are set aside into a separate bank account and not commingled with operating funds

Accounting Issues
For tax purposes and accounting purposes, there is valid reason to segregate construction defect activity. Some of the items to consider:

Accumulate all pre-settlement costs into one account on the financial statements - From the onset of the potential litigation set up an account to accumulate all costs associated with the lawsuit, such as attorney fees, court costs, expert witness fees, mailing fees to homeowners, etc.

When settlement funds are received open a separate bank account(s) - Treat this money as a separate activity. If desired, the amounts accumulated in the pre-settlement stage can be repaid. Pay all expenses related to the damage from this account.

Make appropriate investments - Often the funds received are substantial. Consider the appropriate investments to make to earn interest but not jeopardize the principal. Talk to an investment advisor knowledgeable about the community association industry. There are accounts in banks and brokerage houses which allow funds to be deposited in several certificates of deposit or treasuries and yet the association receives one statement. This can make accounting for the investments easier.

Consider a job-cost system for the project - Depending on the size of the project, consider segregating the costs into the various aspects of the work. This will allow the association to monitor the actual costs spent in the different phases.

Audit Considerations
At the time of the year end audit, the CPA will be examining or reviewing the accounting records associated with the receipt and expenditure of the construction defect funds. Some of the items the CPA will be looking for will include the following:

Documentation regarding the settlement - The CPA will verify that the income received agrees with the amount of the settlement.

Verification of paid amounts - The CPA will verify amount paid to vendors using a variety of means. For material dollar amounts (and this amount is different for each audit), paid invoice and contracts will be examined. Board meeting minutes will be read to verify board approval of vendors, payments, etc. Note: WHAT THE CPA DOES NOT DO IS TO DETERMINE WHAT AMOUNTS ARE FAIR OR WHAT EXPENSES SHOULD COME FROM THE CONSTRUCTION DEFECT FUNDS VS. OPERATING OR RESERVE FUNDS.

Disclosure items for the report - The CPA will be looking for documentation, either in the minutes or from attorneys to disclose the current status of the construction to the members. Also, the CPA will be looking for conflicts of interest disclosures when the association uses “related parties”.

Reserve Study Considerations

For many condominiums in Washington there is the requirement that a reserve study be performed every three years and reviewed annually. Generally accepted auditing standards for community associations require that the CPA put reserve study information in the audit or review report, or state why it is not included. When major damage has occurred in an association and, especially, when construction has begun to rebuild the community, the reserve study is not generally useful at this point in time. However, to have a new study before the construction is substantially complete may not be valid either. Often, during this time the board uses the old study for disclosure purposes and the CPA either states that the reserve study is not included in their report as of this time or also uses the old study. When the construction is completed, a new study should be done as soon as reasonably possible.