Academy/Taxes, Audits & Financial Compliance
Interest income
The reserve fund label doesn't change what the IRS sees.
Interest your association earns on operating and reserve funds is always taxable income, whether it files Form 1120-H or Form 1120. It never counts as exempt function income, even when the interest comes from a reserve fund earmarked for property maintenance. Only interest that is independently tax-exempt, such as from certain municipal bonds, escapes this.
Interest doesn't qualify as exempt function income
Exempt function income means dues, fees, or assessments a member owes simply for being a member, not for using anything. Interest works differently: it's what the bank or investment pays the association for holding money, and no member's ownership creates a liability to pay it. That's why it can never be exempt function income, no matter which account it sits in.
The IRS instructions for Form 1120-H list interest earned on reserve or sinking funds by name as an item that does not qualify as exempt function income. It gets reported and taxed as ordinary non-exempt income.
Reserve fund interest isn't protected either
This is where boards get surprised. The reserve fund exists to pay for the roof, the pavement, the pool resurfacing, so it feels like "property money" that shouldn't be taxed. But the IRS taxes the interest that reserve money earns, not the reserve balance itself. Setting money aside for a capital project does not shield the interest that money generates while it sits in the account.
The only interest an association can exclude is interest that is independently tax-exempt, for example from certain municipal obligations. Whether a specific investment your association holds qualifies, and whether your state separately taxes that same interest, depends on the security and your state's own rules. Confirm both with your CPA before assuming an exclusion applies.
How the interest actually gets taxed
On Form 1120-H, taxable interest is reported on its own line and included in the association's taxable income, then reduced by a flat $100 specific deduction. The association cannot use a net operating loss from a prior year to offset it. What's left is taxed at a flat rate.
"The taxable income of a homeowners association that files its tax return on Form 1120-H is taxed at a flat rate of 30% for condominium management associations and residential real estate management associations. The tax rate for timeshare associations is 32%."
Source: Instructions for Form 1120-H (2025), IRS
File Form 1120 instead, and that same interest is taxed at the regular 21% corporate rate alongside the rest of the association's taxable income, with normal corporate deductions available. Which form produces less tax depends on the numbers for that specific year.
Check yourself
Answer before you read the explanation, recalling it is what makes it stick.
Your treasurer says the $18,000 earned on the reserve account this year isn't taxable, since it's set aside for the roof replacement. Is the treasurer right?
An association files Form 1120-H and earns $2,400 in taxable interest on its operating account, with no other non-exempt income. How does that interest get treated?
Which of these is the only kind of interest an association can exclude from its taxable income entirely?
Sources
- Instructions for Form 1120-H (2025), IRS
- 26 U.S.C. Section 528, Certain Homeowners Associations, Legal Information Institute, Cornell Law School
Taxes, Audits & Financial Compliance
Next, see how interest fits into the bigger non-exempt income picture your association has to track.
Whether your state also taxes this interest, and whether a specific investment qualifies as independently tax-exempt, varies by state and by the security your association holds.