Deductible expenses on Form 1120-H are limited to costs with a proximate and primary relationship to producing the association’s non-exempt function income, meaning revenue that does not come from member dues, fees, or assessments. Ordinary community costs like landscaping, pool upkeep, and common-area repairs generally do not qualify, because they support exempt member activity rather than taxable outside revenue. Since non-exempt income is taxed at a flat 30% (32% for timeshare associations), every legitimate deduction counts, and getting them right depends on how carefully the association separates its two income streams and the expenses attached to each.1Internal Revenue Service. Instructions for Form 1120-H
The Two-Bucket Rule Behind Every Deduction
Form 1120-H splits an HOA’s money into exempt function income and non-exempt function income. Exempt function income is what owners pay in their capacity as owner-members: monthly assessments, special assessments, reserve fund contributions. That income is excluded from taxable income entirely, and the expenses that support it are not deductible on the return.2Office of the Law Revision Counsel. 26 USC 528 – Certain Homeowners Associations
Non-exempt function income is everything else. Bank interest, reserve fund investment earnings, cell tower lease payments, vending and laundry revenue, rental income from non-members, and fees charged to the public for using amenities all land in this bucket. Fees from a resident who rents the clubhouse for a private party or buys a guest pass also count here, because the resident is paying as a customer, not as an owner-member.3eCFR. 26 CFR Part 1 – Homeowners Associations
Deductions attach only to the second bucket. A deductible expense on Form 1120-H has to clear two hurdles: it must qualify as a deduction under the regular tax code, and it must be directly connected with producing non-exempt function income. The regulation defines “directly connected” as having a proximate and primary relationship to producing that taxable income.4eCFR. 26 CFR 1.528-10 – Special Rules for Computation of Homeowners Association Taxable Income and Tax
Expenses That Qualify
The deductible categories are narrower than most boards expect. They cluster around the small handful of activities that actually generate outside revenue.
Investment-related costs. Bank fees on interest-bearing accounts, investment advisory fees, safe deposit box rentals, and similar costs tied to managing the accounts that produce taxable interest are deductible against that interest income.
Rental expenses. When the HOA rents its clubhouse or common areas to non-members, the utilities consumed during rental periods, advertising aimed at outside renters, cleaning and repair costs tied to non-member use, and insurance riders specific to the rental activity are all deductible against the rental income.
Depreciation. Depreciation on assets or portions of facilities used to produce non-exempt income is deductible, provided the depreciation is directly connected to that income-producing activity.4eCFR. 26 CFR 1.528-10 – Special Rules for Computation of Homeowners Association Taxable Income and Tax
State and local taxes and license fees. These are deductible when directly connected with producing non-exempt income. Federal income taxes are not deductible.1Internal Revenue Service. Instructions for Form 1120-H
Professional fees. The portion of accounting, legal, or tax preparation fees attributable to the non-exempt side of the association’s finances is deductible. The portion attributable to member operations is not.
Deductions in each category cannot exceed the non-exempt income they relate to. An HOA earning $3,000 in clubhouse rentals cannot deduct $5,000 of rental-related expenses and apply the excess against interest income from an unrelated source.
Allocating Shared Expenses
Most real HOA expenses do not sit cleanly in one bucket. An administrative assistant handles both member accounts and non-member rental bookings. A utility bill covers a building used by residents and outside renters. An accounting fee covers the whole return. The regulations require these shared costs to be split between exempt and non-exempt functions on a reasonable basis.4eCFR. 26 CFR 1.528-10 – Special Rules for Computation of Homeowners Association Taxable Income and Tax
What counts as reasonable depends on the expense. For personnel costs, time records or a documented percentage of effort spent on non-exempt activities are the strongest support. For facility costs, square footage or hours of use dedicated to the income-producing activity works well. The IRS does not prescribe a single method, but the association has to explain and defend whatever approach it uses. This is where deductions most often get lost in an audit: without documentation showing how the split was calculated, the IRS can disallow the entire allocation.
What Cannot Be Deducted
Two categories are off the table on Form 1120-H no matter how directly they connect to non-exempt income.
Net operating losses. If allowable deductions exceed non-exempt income in a given year, taxable income is simply zero and the excess deductions vanish. There is no carryforward or carryback. An HOA with a large one-time investment expense in one year and substantial non-exempt income the next cannot use one to offset the other.1Internal Revenue Service. Instructions for Form 1120-H
Special corporate deductions. The deductions under Part VIII of Subchapter B of the Internal Revenue Code, most notably the dividends received deduction that regular C corporations can claim, are not available on Form 1120-H.1Internal Revenue Service. Instructions for Form 1120-H
Also worth naming plainly, because boards often assume otherwise: routine community expenses like landscaping, pool service, common-area repairs, and management fees tied to member operations are not deductible on Form 1120-H. They support exempt function activity, and the income supporting them was already excluded from the return.
How Deductions Flow Into the Tax Calculation
Once deductible expenses are identified and any shared costs allocated, the arithmetic is short. Start with total non-exempt function income, subtract all allowable deductions directly connected to that income, then subtract the $100 specific deduction the statute provides.2Office of the Law Revision Counsel. 26 USC 528 – Certain Homeowners Associations Multiply what remains by 30% (32% for timeshare associations) to get the tax.1Internal Revenue Service. Instructions for Form 1120-H
A worked example. An HOA collects $12,000 in interest and $3,000 in clubhouse rental fees from non-members, for $15,000 in total non-exempt income. It can document $4,900 in directly connected expenses, including bank fees, a share of the accountant’s bill, and utilities during rental periods. Taxable income is $15,000 minus $4,900 minus the $100 specific deduction, or $10,000. Tax owed is $3,000.
One additional point on the calculation: capital gains from selling association assets are taxed at the same 30% flat rate rather than at the lower capital gains rates available on other corporate returns.5Internal Revenue Service. Instructions for Form 1120-H Deductions tied to producing that gain follow the same directly-connected standard as every other expense on the return.