Hawaii Condo Law

There are normally two options for most community associations to file their federal tax returns. The 1120-H tax form is a special filing available only for certain homeowner associations. The 1120-H tax form is authorized under Internal Revenue Code §528 (26 U.S.C. §528). Only certain homeowner associations qualify to file an 1120-H tax form. A homeowner association qualifies if:

1. it is organized and operated to provide for the acquisition, construction, management, maintenance, and care of association property;
2. substantially all of the units (85%) must be used for residential purposes.
3. it elects to have the section apply for the taxable year;
4. no part of the net earnings of the association inures to any private shareholder or individual;
5. 60% or more of the association’s gross income consists solely of amounts received as membership dues, fees, or assessments from owners of residential units, residences or residential lots (exempt function income); and
6. 90%or more of the association’s expenditures for the taxable year are expenditures for the acquisition, construction, management, maintenance, and care of association property.

If the homeowners association qualifies under Section 528, the dues or assessments received from property owner-members of the association are exempt from taxation if the dues and assessments are used for the maintenance and improvement of its property. All non-exempt income is taxed at the 30% tax rate from the first dollar of income.

If the association does not elect to file an 1120-H tax form or is not qualified, it must file an 1120 tax form. Under Internal Revenue Code §277 (26 U.S.C. §277), the income of homeowner associations are treated the same as a corporation. Membership dues or assessments are taxable subject to applicable deductions and adjustments.

Last month, the National Association of Realtors (”NAR”) reported that condominiums are appreciating faster than single-family homes. NAR President Al Mansell, said the reputation of condos as an investment has changed dramatically. “In much of the 1980s and early 90s, condos earned a reputation for slow price growth, in many cases because there was an oversupply on the market,” he said. “With the maturation of this market segment, condos have been appreciating faster than single-family homes for the last four years. In the past, affordability was a bigger factor in condo sales – now, lifestyle choices have emerged as a driving force in their growing popularity.”

“Lifestyle choices” are what condominium associations are all about. Some people purchase a condominium unit because they chose a lifestyle where someone else maintains and repairs their home. Other people purchase a condominium unit because they chose a lifestyle where amenities are available to residents that would not be available to them if they lived outside a community association. Still other people purchase a condominium unit because they chose a lifestyle where they can rely on residents to abide by a shared set of rules and aesthetic appearance.

NAR’s pricing information is consistent with polling data. A 1999 Gallup poll showed that community association members were happy with their associations. The poll showed that 75% of association members were either extremely satisfied or very satisfied with their association. Another 20% were somewhat satisfied with their association. Not surprisingly, almost the same percentages thought their association was extremely, very and somewhat responsive. The poll also showed that 42% of community association members would not consider selling their home under any circumstances. Another 36% would consider selling at 15% above market value. While a condominium lifestyle choice is not for everyone, it is clear that they are translating into the bottom line for condominium owners.

In order to understand what a HO6 policy is, I need to explain a condominium master policy. Under Hawaii Condo Law, condominium associations are required to have property insurance that covers the common elements and all walls, floors and ceilings even if they are not a part of the common elements. In addition, most condominiums have a public liability policy that covers claims on the common elements (e.g. someone slips and falls on the common element walkway).

The policies purchased by the condominium association are sometimes referred to as a master policy. The master policy does not cover all situations and property. First, the condominium master policy do not cover personal property inside the apartment. For instance, if there is a fire, the master policy will not cover the personal property in the apartments. Second, the master policy does not cover apartment owners for liability claims inside the apartments. If your guest slips and falls in your bathroom and sues you, the master policy will not cover you or your guest. Third, most condominium master policies do not cover improvements or upgrades inside the apartment. The most that these master policies will cover is the cost to restore the apartment to the original condition even if you made changes to your apartment (presumably with Association approval). Fourth, some condominium master policies do not cover anything other than the common elements and the walls, floor and ceilings. The other parts of the condominium apartment (like the stove, kitchen cabinets, etc.) may not be covered by the condominium’s master policy. Fifth, most condominium master policies have a relatively high deductible for property claims. Deductibles of $5,000 or higher are common because insurance companies or associations want to limit the number of relatively minor claims.

If there is an incident that would normally be covered by insurance (i.e. a fire, windstorm, etc.) the condominium master policy will cover the claim but it would exclude, coverage for personal property in the apartment, upgrades to the apartment, and things other than the common elements or walls, floors and ceiling. In addition, liability inside your apartment would not be covered by the master policy. Any claims would be subject to the association’s deductible. Some people assume that the Association will cover these things even if the insurance company does not. They are wrong. The Association is not a substitute for the insurance company. If an owner doesn’t have his or her own insurance policy, they will have to pay for these types of losses out of their own pocket or try to prove that another owner was negligent. That’s where an HO6 policy comes in.

A HO6 policy is purchased by an owner of a condominium apartment and covers these items and usually has a relatively small deductible ($250 to $500). The cost of a HO6 policy is relatively small (about $200 a year) and provides important protections for apartment owners. In addition to covering things excluded from the condominium master policy, the HO6 will often cover assessments by the Association for rebuilding if there is insufficient funds because of exclusions in the master policy. More importantly, the HO6 policy will pay to defend you if someone is injured in your apartment. For this reason, it is very important for owners to have their own HO6 policy.

The Recodification will provide allow Boards to require owners to have a HO6 policy if the By-Laws give the Board this power. Associations may wish to take advantage of this provision of the Recodification. HO6 policies address a common problem for condominium associations. If water is pouring out of an apartment and damages other apartments, the master policy will not cover all the damages for the reasons I’ve already explained. The Association will not be responsible for the shortfall unless the Association is negligent. If the owner of the leaking apartment had a HO6 policy, it would protect the owners of the apartments damaged by the water. By requiring all owners to have a HO6 policy, all the members of the Association would be protected by the acts of their neighbors. Since HO6 policies are so inexpensive, it is a cost effective way of filling a gap in the coverage provided by the master policy. For that reason, condominium associations should consider adopting amendments to their By-Laws authorizing the Board to require owners to have a HO6 policy.