Starting and Operating 2-4 Unit Condominium Homeowners Associations In California
This article provides step-by-step instructions for starting and operating an unincorporated condominium homeowners association for a 2-4 unit property in California. It addresses the following frequently asked questions:
- Is a condominium homeowners association (“HOA”) association necessary for a 2-4 unit building?
- How does one create a condominium homeowners association?
- When and how must the HOA register and file forms with governmental agencies?
- What tax returns must it file and what taxes must it pay?
- When should the HOA have its first owner meeting, and what should it do at the meeting?
- How does the HOA call and conduct an owner meeting?
- How should the HOA create its budget and collect owner dues and assessments?
- What records must the HOA keep and what reports must it make to its members?
- How can the HOA fine and discipline owners and otherwise enforce its rules?
California law requires that all condominium properties, regardless of size, have a homeowners association. The HOA carries out the obligations of the condominium owners as imposed by its governing documents and applicable law. The primary obligations are maintaining the common areas, establishing and collecting assessments, conducting meetings, and enforcing the rules.
A common misconception is that no homeowners association exists until the owners create a corporation or some other sort of “official” entity. In fact, an association begins to exist automatically on the day that the name on the title to one condominium is different than the name on the title to another condominium. Filing an official formation document, such as Articles of Incorporation, (to create an incorporated HOA) or Articles of Association (to create an unincorporated HOA) is optional, and a condo association that files neither is still considered to be a formal legal entity. Most 2-4 unit condominium associations in California remain unincorporated. California law gives condominium owners in unincorporated associations a unlimited liability protection provided the association carries $2M of liability insurance. In addition, it is relatively easy for 2-4 unit associations to open bank accounts and obtain utilities and insurance, so the additional cost and paperwork burdens of incorporating, although relatively light, outweigh the benefits.
When and how must a 2-4 unit condominium homeowners association register and file forms with governmental agencies?
- Establishing Authority: In California, an unincorporated homeowners association may file Articles of Organization with the Secretary of State or, alternatively, a statement specifying who has authority to accept legal papers on its behalf. California also allows an unincorporated homeowners association to record a Statement of Authority with the County Recorder of the county where the condominiums are located in which it reveals who has the authority to sign checks and contracts on its behalf. All of these filings are optional, and most 2-4 unit California homeowners associations find them to be unnecessary.
- Obtaining A Tax ID: A tax identification number (commonly known as an “Employer Identification Number” or “EIN”) is a number that identifies the association for tax purposes. To get an EIN, the owners simply ask the internal revenue service to issue one. The request can be made online, in which case the number is issued instantaneously. In California, incorporated homeowners associations are required to have an EIN, but it is unclear whether this is necessary for unincorporated associations. A 2-4 unit homeowners association must weigh the benefits of getting one against the burdens of having one. On one hand, the tax ID will make it possible to open a bank account without using the tax ID of the owner or manager. On the other hand, it may force the homeowners association to file tax exemption requests and tax returns that it would not otherwise file (see discussion below).
- Establishing Nonprofit Tax Status: An unincorporated condominium homeowners association qualifies as a nonprofit organization that is exempt from income and franchise taxes, but the law is unclear as to whether filings or applications are required to establish tax-exempt status. The most conservative route is to file for both federal and California exemptions, and this is strongly advised if the HOA has obtained an EIN. Note, however, that these filings create ongoing annual obligations and, in our experience, there do not seem to be any consequences for not formally seeking the exemptions. If the association wishes to formally establish federal tax-exempt status, it must file a Form 1120H with the IRS by the 15th day of the third month after the end of each tax year. If the association wishes to formally establish California tax-exempt status, it must file a Form 3500 with the California Franchise Tax Board 90 days before the end of the first year the HOA exists. Unlike the federal Form 1120H, the 3500 is a one-time filing and need not be repeated each year; however, filing the Form 3500 creates an annual filing burden on homeowners associations with average owner dues collections of more than $25,000 (see discussion below).
- Annual Registration: Unincorporated California homeowners associations (regardless of their level of informality) are required to file a Form SI-CID with the Secretary of State once every two years in July.
What tax returns must a 2-4 unit condominium homeowners association file and what taxes must the HOA pay?
Tax filing requirements for unincorporated and informal homeowners associations are not clear. Many of these associations file no returns and suffer no consequence. However, this approach is risky if the HOA obtains an Employer Identification Number, which creates awareness that the HOA exists and an expectation that it will file a return. If the HOA has an EIN, it is best to file returns to avoid the risk of penalties. At the federal level, the return is filed using Form 1120, which is due annually by the 15th day of the third month after the end of each tax year. No federal tax will be due so long as the only income the HOA receives is owner dues, and so long as it uses all of this income to pay operating expenses and accumulate reserves. At the California state level, an association that has obtained an EIN, or wishes to proceed conservatively, should first file a Form 3500 (as discussed above) to establish its California tax-exempt status. The Form 3500 is a one-time filing. Unincorporated homeowners associations that have obtained tax-exempt status then annually file a Form 100 if they receive more than $100 in income from sources other than owner dues and assessments, and a Form 199 if their income (including owner dues) is $25,000 or more. These filings are due by the 15th day of the fifth month after the end of each tax year. Note that the need to file Form 199 does not mean that tax is due, and no tax will be due so long as the only income the homeowners association receives is owner dues, and so long as it uses all of this income to pay operating expenses and accumulate reserves.
When should a homeowners association have its first meeting, and what should it do during that meeting?
A homeowners association should have its first owner meeting as soon as possible after at least two condos are owned by different people. Here is a list of items that should be discussed and resolved at the first homeowners association owner meeting:
Item 1: Establishing Management
Every condominium homeowners association, including one consisting of only two members, should have a plan under which a specific person is responsible for ensuring that the basic duties of the HOA are fulfilled: (i) creating the annual budget including a repair/replacement reserve contribution; (ii) collecting and depositing owner dues, paying bills and keeping records; (iii) coordinating common area cleaning and repair; and (iv) complying with the requirements and formalities imposed by California law such as running meetings and reporting to owners. The easiest way to fulfill these responsibilities is to hire a qualified homeowners association manager or management company. At its first meeting, the association should decide whether it will hire a manager and, if so, how the manager will be selected. A specific owner should be charged with the task of obtaining management proposals, along with a deadline for presenting these to the other owner(s). If the association chooses not hire a manager, it should carefully delineate exactly who among the owners will be responsible for each of the above-listed tasks, and record its decisions in the minutes.
Item 2: Complying With Filing and Taxation Requirements
An owner or manager should be assigned the task of satisfying association filing and taxation requirements (discussed in detail above) or hiring a professional to do so. Keep in mind that postponing this task can expose the association to monetary penalties.
Item 3: Opening Bank Accounts
California law requires that every condominium property, including those with only two units, have at least two bank accounts: one for its operating expenses (such as insurance, shared utilities, and management costs), and a separate one for its repair/replacement reserves. If either or both accounts do not exist at the time of the first owner meeting, an owner or manager should be assigned the task of opening them. (See the discussion above concerning tax ID numbers.)
Item 4: Adopting the Operating Budget, Maintenance Reserves, and Assessments
California law requires that every condominium property, including those with only two units, have a budget and repair/replacement reserves. If no budget exists at the time of the first meeting, an owner or manager should be assigned the task of creating a proper one. (For more details, see the discussion of budget preparation and owner dues below.)
Item 5: Confirming Association Insurance
An owner or manager should be assigned the task of obtaining homeowners association insurance or, if insurance is already in place, verifying that it satisfies the requirements of the condominium documents and applicable law. Building insurance that predates condominium conversion will need to be replaced. The following aspects of the HOA insurance policies should be checked:
- Expiration dates, to make sure the insurance is in effect and timely renewed;
- Names of the insured party or parties, to make sure the HOA is properly named; some condominium documents also require that each owner be a named insured on each HOA policy;
- Items covered on the casualty policy, to make sure that all parts of the building are covered either under the HOA policy or under the individual policies carried by the owners; the HOA should specifically confirm that its casualty policy covers all of the elements that it is responsible to repair and replace;
- Limits of liability coverage to make sure they comply with both the HOA documents and the law; and
- Limits of casualty coverage, particularly those relating to replacement costs and building code upgrades.
Item 6: Establishing Collection Procedures and Fines/Penalties
California law requires that every condominium property, including those with only two units, adopt policies regarding assessment collection and owner discipline, and to circulate such information to owners. Some recommendations for policies are discussed below. At its first meeting, the association should discuss and adopt assessment and discipline policies and record its decisions in the minutes. A manager or owner should be appointed to circulate a written statement of the policies to all owners.
Do not assume that, just because the HOA is very small, it does not need to observe meeting formalities imposed by law and by its governing documents. If the association does not follow proper procedures, an owner who is unhappy with its decisions will be able to legally challenge the validity of those decisions (even if the unhappy owner came to the meeting and/or participated in the decision-making process). The CC&Rs will contain requirements for calling and conducting an owner meeting, including: (i) the number of days advance notice that must be given and the way the notice must be transmitted; (ii) whether or not an agenda must be given with the notice and whether matters not included in the agenda can be discussed or decided; (iii) the level of attendance required to conduct business (also called the “quorum” requirement); (iv) how owners not able to be physically present at the meeting can participate; (v) the number or percentage of votes required to make various types of decisions; (vi) whether and how decisions can be made without a formal meeting; and (vii) how records (or “minutes”) of the meeting must be kept and transmitted to the owners. Every homeowners association must satisfy the minimum meeting and voting formality requirements imposed by California law regardless of how few condominiums the property contains and regardless of what its governing documents state; and if the documents impose requirements that are more stringent than those imposed by law, the HOA must comply with the requirements in its documents.
California has recently enacted extremely complex and burdensome requirements for owner meetings at which governing documents will be amended, or exclusive usage rights to common area will be granted to a particular owner or owners. The Association must designate either one or three election inspectors to supervise the vote. These inspectors may be owners. Voting must be by secret written ballot sent 30 days before the voting deadline. The ballot may not identify the owner by name, unit number, or otherwise. It must be sent with two pre-addressed envelopes and instructions. The ballot must be inserted into one envelope that is then sealed and inserted into the second envelope. On the second envelope, the voter prints and signs his/her name, and provides his/her address and unit number. The voter then mails or hand delivers the second envelope to the election inspector(s), who must count them in an open meeting of the board or owners. The ballots must be retained for one year and available for review by owners. There is no exemption from these requirements for smaller associations, and failure to follow them allows a court to void the election results and impose monetary penalty on the association.
A homeowners association operating budget consists of two components: the operating expenses, including annually recurring costs such as insurance, management, common area utilities, janitorial costs etc.; and the repair/replacement reserves, which is money collected in advance for eventual repair, refurbishment and replacement of the portions of the property that the HOA is responsible to maintain. Both budget components must be based on facts about the specific property for which the budget is prepared rather than on industry statistics or generalized averages or, worse, “educated guessing”. The best practice for establishing the repair/replacement reserve component of the budget is:
- List all association-maintained components for which refurbishment or replacement will be needed in 30 years or less;
- List the estimated cost of refurbishment or replacement for each component;
- List the number of years before the item is expected to need refurbishment or replacement;
- Divide each component’s estimated refurbishment/replacement cost by the number of years, which will tell you how much to collect for the item each year; and
- Add the annual collection for each item to determine the total annual reserve collection.
California law requires that every condominium property, including those with only two units, conduct a detailed reserve study at least once every three years that includes all of the elements described above along with a plan for funding the reserves, and review the most recent study and funding plan annually to determine if changed circumstances or new information require revisions. California law requires homeowners associations to send each owner a copy of the operating budget and dues calculation, along with a disclosure relating to the reserves, between 30 and 90 days before the beginning of the HOA’s fiscal year. California recently developed a fill-in form for this disclosure that can be found in California Civil Code Section 1365.2.5. Replacement /reserve funds must be kept in a separate bank account, and cannot be used to pay for operating expenses except in very limited circumstances.
California law requires every homeowners association to have a written policy for collecting delinquent dues and assessments, and to send a copy of its policy to each owner every year. California law prohibits an owner from withholding a dues or assessment payment on the grounds that the owner is entitled to recover money or damages from the homeowner association, but permits an owner to dispute an assessment on other bases either in small claims court or by demanding a meeting with all owners.
California law allows the homeowners association to record a “lien” against the non-paying owner’s lot or condominium, an inexpensive and quick procedure that ensures that the association will automatically receive its money when the property is sold, and gives the HOA preferred repayment status if the defaulting owner files bankruptcy. A decision to record a lien must be made at a meeting open to all owners. At least 30 days before recording a lien against a delinquent owner’s property, the association must send a notice by certified mail that includes a variety of specific information and language. Recording a lien is a particularly useful homeowners association remedy when the defaulting homeowner is “under water”, meaning that the value of his/her unit is less than the balance owed on the mortgage. While filing the lien will not trigger immediate payment, it will increase the likelihood that the HOA will be paid eventually, while avoiding the need for the HOA to take over the defaulting owner’s mortgage. Keep in mind, however, that if the owner defaults on the mortgage and the bank forecloses, the homeowners association’s lien will be wiped out, and it will not be legally entitled to recover the defaulting owner’s debt from the lender or from the new owner.
California law also allows the homeowners association to trigger a process under which the non-paying owner’s property is sold on the open market, provided that the defaulting owner gets to keep any amount of the sale price left after paying costs of sale, mortgages, legal fees, and debts and penalties to the HOA. This forced sale process, called a “foreclosure”, is non-judicial, meaning that the homeowners association does not need to go to court at any point during the sale process. A homeowners association that wants to collect unpaid dues or assessments through non-judicial foreclosure typically hires a trustee or foreclosure service to handle the sale and collection process. Note that a foreclosure is only useful if the value of the defaulting owner’s lot or condominium is significantly greater than the amount of the mortgage; otherwise, the proceeds from the forced sale, after payment of costs and mortgage, may not be sufficient to repay the owner’s debt to the HOA. Also note that liens and non-judicial sales are allowed for delinquent assessments, interest, late fees, collection costs (including attorney fees), and interest, but are not allowed on for fines and penalties imposed for rule violations.
California law imposes the following recordkeeping and reporting requirements on every condominium property, including those with only two units:
- Annual budget and repair/replacement calculation
- Bank records including reconciliations
- Tax returns and regulatory filings
- Meeting notices and minutes
- Member list, including the names, addresses and contact information of each owner
- Insurance policies
- Agreements with service providers including any association manager
- Annually: Budget including repair/replacement calculation, and statement of dues
- Annually or more frequently: Report of income and expenses
- Annually: Summary of insurance coverage and/or copies of policies
- Annually: Copy of HOA dispute resolution procedures
- Annually: Copy of HOA assessment collection policy
- Annually: Copy of HOA alteration approval procedure
- Annually: Schedule of HOA fines and penalties
- Regularly: Meeting minutes
Homeowners association documents may supplement these requirements, but may not diminish or eliminate them.
California law permits homeowners associations to impose fines and penalties, but only provided the HOA adopts a schedule in advance, and sends a copy to each owner each time a fine or penalty is established or adjusted. Fines or penalties cannot be the basis for a lien or non-judicial foreclosure, but can be collected through legal action, including a forced sale supervised by a court.
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About The Author
SirkinLaw APC has been creating homeowner association documents, advising owners, and mediating association disputes, for more than twenty years. Andy Sirkin was co-author of 10 editions of The Condominium Bluebook, and his expertise in preparing governing documents is recognized throughout California. SirkinLaw APC governing documents continue to be the ones other firms emulate, and Realtors, lenders and buyers strongly prefer. This leadership results from constant improvement and innovation that makes our documents easier to read and understand, as well as more efficient and less expensive to enforce.