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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-KSB



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ANNUAL REPORT PURSUANT TO SECTION 13
OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934



For the fiscal year ended December 31, 2004



Commission File No. 333-106501



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KH FUNDING COMPANY

(Name of small business issuer in its charter)



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|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Maryland                                                       |  | 52-1886133                          
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification No.)



10801 Lockwood
Drive, Suite 370

Silver Spring, Maryland 20901

(Address of principal executive offices, including Zip Code)



(301) 592-8100

Registrants telephone number, including area code



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|                                                      |  |                 
|----------------------------------------------------- |  | ----------------
|Securities registered under Section 12(b) of the Act: |  | None            
|Securities registered under Section 12(g) of the Act: |  | None            
|                                                      |  | (Title of class)



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Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the
past 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No ̈



Check if there is no disclosure of delinquent filers in response to Item 405 of Regulation S-B contained in this form, and
no disclosure will be contained, to the best of Registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-KSB or any amendment to this Form 10-KSB. ̈



Registrants revenues for its most recent fiscal year were $ 2,429,570



On March 15, 2005, the aggregate market value of the voting and non-voting common equity held by nonaffiliates (computed by reference to the last price at
which the common equity was sold) was $6,263,890.



On
March 15, 2005, the number of outstanding shares of Registrants common stock was 2,505,556.



Documents Incorporated by Reference



Portions of Registrants definitive Proxy Statement filed with the Securities and Exchange Commission in connection with its 2005 Annual Meeting are
incorporated into Part III of this Report.



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PART I



INTRODUCTORY STATEMENT



The information contained in this report pertains to the registrant, KH Funding Company. References to the Company, KH Funding or
we, our and us refers to KH Funding Company.



FORWARD-LOOKING STATEMENTS



Some of the
statements contained in this annual report discuss future expectations, and other forward-looking information. Those statements are subject to known and unknown risks, uncertainties and other factors that could cause the actual results
to differ materially from those contemplated by the statements. The forward-looking information is based on various factors and was derived using numerous assumptions. In some cases, you can identify these so-called forward-looking
statements by words like may, will, should, expects, plans, anticipates, believes, estimates, predicts, potential, or
continue or the negative of those words and other comparable words. You should be aware that those statements only reflect our predictions. Actual events or results may differ substantially. Important factors that could cause our actual
results to be materially different from the forward-looking statements are disclosed under the heading DESCRIPTION OF BUSINESS - Risk Factors.



ITEM 1. DESCRIPTION OF BUSINESS



KH Funding Company (www.khfunding.com) conducts both mortgage and investment banking operations from its headquarters in Silver Spring, Maryland. Its
primary business activities consist of originating, acquiring and servicing mortgage loans, and issuing interest-bearing debt securities to investors. We emphasize the direct origination of small commercial real estate mortgage loans and investment
property residential mortgage loans. We purchase first and second trust residential loans nationwide from other lenders and banks.



Our net income depends largely upon our net interest income, which is the difference between interest income from loans and investments, referred to as
interest-earning assets, and interest expense on investor notes and other borrowed funds, referred to as interest-bearing liabilities. Our net interest income may be affected by general economic conditions, policies established by regulatory
authorities and competition.



Operations



We operate from an office building in Silver Spring, Maryland. On a daily
basis we perform the record keeping and administer the assets of KH Funding Company for the benefit of KH Fundings stockholders and note holders. This is done in the same way as a commercial bank administers its assets for the benefit of its
stockholders and depositors.



Our assets of $26.22 million as
of December 31, 2004 consist of cash, mortgage notes, real property and marketable securities. In the normal course of business we collect the income generated by the assets; receive funds from investors; handle the redemption of debentures; and
maintain and track the receipts, disbursements and balances on escrow accounts established by the borrowers.



The following table sets forth certain information relating to KH Funding Company for the five years ended December 31, 2004. The average yield and cost
of funds are derived by dividing interest income or interest expense by the average balance of notes receivable or notes payable, respectively, for the years shown. All categories are at note rates and exclude fee income and expense.



|     |  |               |   |  |               |   |  |                         |  
|---- |  | ------------- | - |  | ------------- | - |  | ----------------------- | -
|Year |  | Average Yield |   |  | Cost of Funds |   |  | Net InterestRate Spread |  
|2000 |  | 11.96         | % |  | 8.43          | % |  | 3.53                    | %
|2001 |  | 11.94         | % |  | 7.86          | % |  | 4.08                    | %
|2002 |  | 11.00         | % |  | 6.40          | % |  | 4.60                    | %
|2003 |  | 10.74         | % |  | 6.00          | % |  | 4.74                    | %
|2004 |  | 10.89         | % |  | 5.69          | % |  | 5.20                    | %



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Our sale to investors of one-day demand notes with checking account access has helped us to lower our
cost of funds because these notes earn below the average rate of interest on our other investor notes. Also helping to lower our cost of funds was the turnover in the one and three-year investor notes that matured in 2004. These have largely been
reinvested in one, three and five-year notes that pay less interest to the investor than the investor was earning on the maturing note. The rates paid on our one-day and 30-day demand notes are changed according to changes in the federal funds
target rate.



Technology



KH Funding uses state-of-the-art software and hardware. We maintain an
off-site secondary location which has full back-up operability with up-to-date information. The software we use to track our loan portfolio is commercially in use by over 300 other subscribers. Our investment account software was made to our
specifications by a contractor that does work for the Department of Housing and Urban Development.



Customer Service



We
provide monthly statements and timely, personal service to our investors, which has always cultivated a good word-of-mouth referral system. We have developed and made available to our investors on-line access to their accounts at
www.khfunding.com. The web site allows investors to view their account information at anytime, such as account balances, maturity dates and recent transactions. Access to the web site will allow investors to complete transfers from one account to
another account, order wire transfers, and request withdrawals.



Business
Strategy



Our business strategy is to grow and enhance our
profitability by increasing our activity of investing in mortgage and business loans. The additional funds necessary to carry through with this strategy will be obtained through the sale of debentures and capital stock.



We intend to continue maintaining our assets and our strict collection
procedures for any problem assets. We expect to realize more operating efficiencies and cost controls as we invest the proceeds from future offerings, as we do not expect significant additional personnel or facilities will be needed to handle the
investing and administration of the increase in funds.



Market Area and
Credit Risk Concentration.



Our lending activities are
concentrated primarily in the Washington, DC and Baltimore, MD metropolitan areas. We also purchase residential mortgage loans from banks and other lenders in other states. As of December 31, 2004, our average loan size was $94,000. Our larger
loans, above $250,000, are made with a strong emphasis on collateral-based underwriting as opposed to credit scoring only or primarily.



Competition



KH Funding Company faces significant competition both in making loans and in attracting investor funds. Our competition for loans comes principally from
commercial banks, mortgage companies, insurance companies and other financial service companies; often these are smaller local independent loan companies or individuals. Our competition for investor funds has historically come from competitors
offering uninsured products, such as the mutual fund industry, securities and brokerage firms and insurance companies, as well as insured money market accounts and certificates of deposit at commercial banks.



We are finding that in making loans, and acquiring loans, more and larger
institutions are becoming our competitors. This trend is not material at this point as there is a sufficient amount of quality product available from smaller lenders and banks that operate at our level. However, if this trend continues, it is
possible that a larger institution that wants our assets could acquire us, or we could choose to align ourselves with a larger institution to enjoy a lower cost of funds.



We are confident going forward that we will continue to be able to attract investors to our investment products. Our one,
three and five-year term investments are priced at a rate that is normally more than 200 basis points (2%) above insured investments for a similar term at commercial banks. Our daily and thirty-day liquidity



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products are competitively priced with other uninsured investments that have similar features such as checking withdrawal. The holders of one-day demand
Notes are provided checking accounts to access their funds (this feature is not offered to South Carolina residents). The checking account privileges are exclusively for funds invested in KH Funding notes and allow the holders of one-day demand
notes to execute redemption or investment requests conveniently, quickly and with less expense than by wire transfer or the mail. The holder may write a check against the account, which reduces the note balance. The holder may add to their
investment by making deposits at the bank through which the checking accounts are provided.



Lending Activities



Our
loan portfolio consists primarily of first and second trust loans that we have originated or acquired from other lenders. We also own several business line-of-credit and fixed-term loans that we have directly originated. A small portion of our
portfolio contains loans for consumer purposes such as auto and personal loans, and a few loans secured by assets such as stock.



We rely on community contacts as well as referrals from existing customers, attorneys and real estate professionals to generate business within our
lending area. In addition, we have developed a list of note brokers, banks and lenders nationwide that sell us loans.



We have developed underwriting policies to control the inherent risks in the origination and acquisition of loans. The policies address approval limits,
loan-to-value ratios, appraisal requirements, debt service coverage ratios, loan concentration limits and other matters relevant to loan underwriting.



First Trust Lending.



Direct Origination. We primarily originate first trust loans for investment (rented) residential real estate, and small commercial properties. We
generally have a loan-to-value (LTV) of 80%, or less. Credit scores of the borrowers generally range in the mid 600s. Credit scores are determined by complex computer programs which take into consideration many factors. There are three
companies that are the primary providers of credit reports and credit scores for individuals. We generally obtain credit reports and/or credit scores from all three companies, and are a member of one, Equifax. Credit scores range from the 400s to
the 800s. The lower the score, the lower the quality of credit or creditworthiness of the individual. Credit scores from 580 to mid-600s will generally indicate a C/C+ borrower, mid-600s to 680 is an B-/B/B+
borrower, high-600s to low-700s is an A- borrower and 720 or higher is an A borrower. Lenders adopt different guidelines for acceptability regarding credit scores. For us a credit score of 580 to the 800s (the highest score
possible) is within the range of acceptability in order to make or acquire a loan, however, we prefer the credit score to be in the mid-600s and above. The borrowers with a score below the mid-600s must provide us with a reason, or reasons, which
mitigate the below mid-600s score.



Acquired Loans. The
first trust loans we acquire nationwide are generally 90% LTV, or less, and the loans are made to sub-prime borrowers. The interest rates are usually 9.5% to 11.5%. The majority of these loans are for lower-priced properties.



Second Trust Lending.



Direct Origination. The majority of our stand-alone, second trust
loans, in which we do not have a first trust on the property, are on owner-occupied properties and the borrowers are consolidating debts. The average LTV is up to 100%. The borrowers credit scores generally start at 580 and average in the low
600s. We are no longer originating this type of loan.



Acquired loans. We limit the total LTV for these second trust loans to 100%. We formerly purchased loans with LTVs of up to 125%. However, we discontinued that practice in 2000. We also greatly curtailed purchasing stand-alone second
trusts in 2000, as we would prefer to also own the first trust when a loan has a combined LTV of more than 90%. However, with a credit score in the low to mid 600s, and up, we will still purchase stand-alone second trusts.



Business Lending. We directly originate loans to small businesses. We
do not acquire loans made to small businesses. Most of the loans we make are for businesses generating less than $1,000,000 in gross revenue. If the business owns real estate we will put a lien on the property(ies) owned by the business. If the
business does not own real estate we will usually place a lien on the primary residence of the owner(s) of the business. We prefer to extend



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credit facilities to a business only when the equity in the real estate we have a lien on exceeds the loan amount. We are more collateral-sensitive when
making business loans than we are cash flow sensitive. In other words, if we are considering a loan for a development stage or start-up business and we find the business plan or the results of operations for the business borrower to be
reasonably acceptable, and the credit score of the borrower to be at the high end of our range of acceptability, then we will make the loan provided we are well secured with real estate collateral. Generally, the cash flow will not be present at the
time the loan is closed, but will be expected to develop with the use of the loan proceeds. However, we do require that the borrower(s) have good credit and a reasonable ability to repay the loan. In the instances where a business has accounts
receivable as a primary source of repayment we will put a lien on the accounts receivable.



Other Assets Lending. Some of the loans in our portfolio are not secured by real estate or business assets. Automobiles and investor notes secure the majority of these loans. These loans are generally made to
borrowers with whom we have a long-standing relationship.



Unsecured Lending. Less than one percent of our loan portfolio contains unsecured loans. The majority of these loans are for small amounts, under $5,000, made to borrowers with whom we have a long-standing relationship, or borrowers
referred to us by other customers. A few of these loans are to borrowers with whom we originally held a collateralized loan, but the collateral has been foreclosed upon.



The following table sets forth the composition of our loan portfolio by collateral type in dollar amounts for the periods
indicated:



|                                           |  |                         |            |      |   |           
|------------------------------------------ |  | ----------------------- | ---------- | ---- | - | ----------
|                                           |  | Year Ended December 31,
|Loans By Collateral Type                   |  | 2004                    |            | 2003
|Collateralized by First Trust Mortgages    |  | $                       | 4,251,283  |      | $ | 5,140,758 
|Collateralized by Business Assets          |  |                         | 4,424,112  |      |   | 3,610,143 
|Collateralized by Investment Property      |  |                         | 9,543,663  |      |   | 5,285,001 
|Other Assets (Auto, Stock)                 |  |                         | 1,013,265  |      |   | 145,539   
|Residential Real Estate Second Trust       |  |                         | 1,116,984  |      |   | 1,073,275 
|Other Loans                                |  |                         | 150,870    |      |   | 167,708   
|                                           |  |                         |            |      |   |           
|Total Loans Before Allowance for Loan Loss |  | $                       | 20,500,177 |      | $ | 15,922,424
|                                           |  |                         |            |      |   |           



Loan Approval
Procedures and Authority. The Chief Executive Officer may approve any loan up to and including $500,000. The Chief Executive Officer and another member of our Board of Directors must approve all loans over $500,000.



The Company has no internal appraisers and as such it relies on independent
appraisers to determine the value of collateral underlying a loan. For commercial property mortgage loans, in addition to an independent appraisal, we generally require an environmental site assessment to be performed. We also require title and
hazard insurance on all first and second trust mortgage loans. In addition, we may require borrowers to make payments to a mortgage escrow account for the payment of property taxes.



Non-Performing Assets



Non-accrual loans include loans 90 days or more past due, and other loans which have been identified by management as presenting uncertainty with respect
to the collectible portion of interest or principal. There is no recognition of interest earnings on non-accrual loans.



Loans are placed on non-accrual status either when reasonable doubt exists as to the full and timely collection of interest and principal, or when a loan
becomes past due 90 days or more and there are no extraordinary circumstances indicating payments on the loan will continue.



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Allowance for Loan Losses



We maintain an allowance for loan losses. Charges to loan loss expense, and recoveries of loans previously written-off,
increase the allowance. Write-off of a loan decreases the allowance. The adequacy of the allowance is periodically reviewed and adjusted by management based upon past experience, the value of the underlying collateral for specific loans, known or
inherent risks in the loan portfolio and current economic conditions.



The most common known risk in the loan portfolio is a non-performing or impaired loan (i.e., the loan is more than 90 days late and the possibility of collection is remote). If KH Funding has specific knowledge or some other reason to
consider a loan impaired, management reviews the loan to determine if an impairment loss is required. Collections on the loan reduce the balance of the impaired asset.



If the non-accrual loan asset begins performing again it is reclassified as a performing asset and will accrue interest
retroactively from the last date interest had been previously accrued.



If the impaired asset is only partially recovered, or if after all legal remedies have been exhausted no recovery, or no additional recovery, is available, then the un-recoverable portion is written off against the loan loss allowance and
the balance of the loan loss allowance is decreased by the amount of the loan being written-off.



Our historical loan loss experience:



|     |  |             |            |                               |   |         |  |      |  
|---- |  | ----------- | ---------- | ----------------------------- | - | ------- |  | ---- | -
|Year |  | Total Loans |            | Write- Offs Net of Recoveries |   | Percent | 
|2000 |  | $           | 9,611,228  |                               | $ | 85,287  |  | 0.89 | %
|2001 |  | $           | 13,406,940 |                               | $ | 104,964 |  | 0.80 | %
|2002 |  | $           | 16,126,909 |                               | $ | 139,069 |  | 0.86 | %
|2003 |  | $           | 15,922,424 |                               | $ | 111,278 |  | 0.70 | %
|2004 |  | $           | 20,500,177 |                               | $ | 244,389 |  | 1.19 | %



At December 31,
non-performing assets were as follows:



|                                                   |  |      |           |      |   |          
|-------------------------------------------------- |  | ---- | --------- | ---- | - | ---------
|                                                   |  | 2004 |           | 2003
|Loans on non-accrual status                        |  | $    | 583,351   |      | $ | 441,474  
|Real estate held for sale                          |  |      | 0.00      |      |   | 150,482  
|                                                   |  |      |           |      |   |          
|                                                   |  | $    | 583,351   |      | $ | 591,956  
|                                                   |  |      |           |      |   |          
|Loans 90 days past due and still accruing interest |  | $    | 2,109,236 |      | $ | 2,282,688
|                                                   |  |      |           |      |   |          



All of the loans 90
days past-due and still accruing interest are adequately collateralized and management does not anticipate loss of principal or accrued interest receivable on these loans.



Governmental Regulations



Our operations may become subject to future federal and state laws and regulations relating to banking or lending operations. These regulations may:



| |  |  | require us to obtain and maintain additional licenses and qualifications
| | - |  | ------------------------------------------------------------------------



| |  |  | limit the interest rates, fees and other charges that we are allowed to collect;
| | - |  | --------------------------------------------------------------------------------



| |  |  | limit or prescribe other terms of our loan arrangements with borrowers; or
| | - |  | --------------------------------------------------------------------------



| |  |  | subject us to potential claims, defenses and other obligations.
| | - |  | ---------------------------------------------------------------



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Although we believe that we are currently in compliance with statutes and regulations applicable to our
business, there can be no assurance that we will be able to maintain compliance with existing or future governmental regulations. The failure to comply with any current or subsequently enacted statutes and regulations could result in the suspension
or termination of our applicable laws and would have a materially adverse effect on us. Furthermore, the adoption of additional statutes and regulations, changes in the interpretation and enforcement of current statutes and regulations, or the
expansion of our business into jurisdictions that have adopted more stringent regulatory requirements than those in which we currently conduct business could limit our activities in the future or significantly increase the cost of regulatory
compliance.



In addition, certain environmental regulations my
affect our operations. For example, our ability to foreclose on the real estate collateralizing our loans may be limited by environmental laws which pertain primarily to commercial properties that require a current or previous owner or operator of
real property to investigate and clean up hazardous or toxic substances or chemical releases on the property. In addition, the owner or operator may be held liable to a governmental entity or to third parties for property damage, personal injury,
investigation and cleanup costs relating to the contaminated property. While we would not knowingly make a loan collateralized by real property that was contaminated, it is possible that the environmental contamination would not be discovered until
after we had made the loan.



Insurance



We maintain the following types of insurance for the benefit of KH Funding:



| |  |  | Bankers Bond: fidelity and theft coverage of $500,000
| | - |  | -----------------------------------------------------



| |  |  | Mortgage Impairment: covers losses to properties when the borrowers policy has expired
| | - |  | --------------------------------------------------------------------------------------



| |  |  | Property Damage-Vacant Properties: covers losses to properties immediately after we take title, if they are vacant
| | - |  | ------------------------------------------------------------------------------------------------------------------



| |  |  | Liability Coverage-Vacant Properties: covers liability losses to individuals at vacant properties after we take title
| | - |  | ---------------------------------------------------------------------------------------------------------------------



| |  |  | Key Man Life: $2.7 million payable to KH Funding in the event of the death of Robert L. Harris
| | - |  | ----------------------------------------------------------------------------------------------



| |  |  | Key Man Disability: $12,000 per month payable for one year to KH Funding in the event of the disability of Robert L. Harris
| | - |  | ---------------------------------------------------------------------------------------------------------------------------



| |  |  | Umbrella Liability: $2 million in excess liability coverage above any primary liability coverage that we maintain
| | - |  | -----------------------------------------------------------------------------------------------------------------



| |  |  | Landlord Policies for Individual Rental Properties: basic insurance for rented properties
| | - |  | -----------------------------------------------------------------------------------------



| |  |  | Health Insurance: maintained for the benefit of the employees
| | - |  | -------------------------------------------------------------



| |  |  | Business Owners Policy: comprehensive business and liability coverage
| | - |  | ---------------------------------------------------------------------



Personnel



At December 31, 2004 we had four full-time employees and, four part-time employees. We consider our relationships with our employees to be good.



Risk Related to Our Business



Our assessment of the quality of loans we acquire may be inaccurate which could adversely
affect our profitability.



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Before we purchase or originate loans, we perform an evaluation of the loans in order to determine
whether they are eligible for our portfolio. There is no guarantee that the initial analysis of the loans will reflect actual future results which, if unfavorable, could adversely affect our profitability. See Our BusinessLending
Activities.



If all of the remedies for recovering a defaulted loan
that we own are inadequate, it could have a materially adverse effect on our financial results.



We may fail to collect funds from originated and acquired loans. Our ability to fully recover amounts due under the originated and acquired loans may be
adversely affected by, among other things:



| |  |  | the financial failure of the borrowers;
| | - |  | ---------------------------------------



| |  |  | the purchase of fraudulent loans;
| | - |  | ---------------------------------



| |  |  | misrepresentations by a broker, bank or other lender;
| | - |  | -----------------------------------------------------



| |  |  | third-party disputes; and
| | - |  | -------------------------



| |  |  | third-party claims with respect to security interests.
| | - |  | ------------------------------------------------------



Any of these events could require us to seek enforcement of a borrowers guarantee, which could prove to be inadequate to fully collect the loans.
Therefore, we cannot assure you that we will not experience losses on acquired or originated loans in the future. These potential future losses may be significant, may vary from current estimates or historical results and could exceed the amount of
the balance budgeted to our loan losses. We do not maintain insurance covering such losses. In addition, the amount of provisions for loan losses may be either greater or less than actual future write-offs of the loans relating to these provisions.
Any of these events could have a materially adverse effect on our business. See Our BusinessAllowance for Loan Losses.



Our lack of diversified operations and investments increases our exposure to risk of loss.



Primarily our operations consist of, and our income is derived from, investing in mortgage loans that we purchase from
brokers, banks and other lenders and making loans to small businesses and individuals. In addition, we invest excess cash in investment grade debt securities issued by financial companies that we hold for liquidity and investment purposes. Further,
we hold as investments many of the properties on which we foreclose. Most of these properties are held as rental investments. This lack of diversification, of investing only in loans, and to a lesser degree in bonds and real estate, increases our
exposure to the risk of loss if a substantial number of loans become uncollectible. This increases the risk that uncollectible loans could materially affect our financial results.



A change in market interest rates may result in a reduction in our profits and impair our ability to repay the Notes.



Rapid changes, either upward or downward, in interest rates may adversely
affect our profits. Any future rise in interest rates may:



| |  |  | reduce customer demand for our products;
| | - |  | ----------------------------------------



| |  |  | widen investor spread requirements;
| | - |  | -----------------------------------



| |  |  | change loan prepayment rates;
| | - |  | -----------------------------



| |  |  | increase our cost of funds;
| | - |  | ---------------------------



| |  |  | reduce the spread between the rate of interest we receive on loans and interest rates we must pay under our outstanding debt securities; and
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | limit our access to borrowings in the capital markets.
| | - |  | ------------------------------------------------------



We are subject to risks associated with decreases in interest rates to the extent that we have issued fixed rate debt securities with scheduled maturities
of over one year. At December 31, 2004 we had $8,518,043 million debt securities with scheduled maturities greater than one year. If market interest rates decrease in the future, the rates paid on our long term debt securities could exceed the
current market rate paid for similar instruments which could result in a reduction in our profitability which could impair our ability to redeem the debt securities.



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If we are not able to sustain the levels of loan originations that we experienced in the past, our future profits may
be reduced and our ability to redeem the Notes may be impaired.



It is necessary for us to continue adding loans to our investment portfolio because we need to re-invest proceeds of loan payoffs as they are received. We will also need to invest in more mortgages as we grow in size. Our ability to sustain
the level of loan originations needed depends upon a variety of factors outside our control, including:



| |  |  | interest rates;
| | - |  | ---------------



| |  |  | economic conditions in our primary market area;
| | - |  | -----------------------------------------------



| |  |  | decline in real estate values;
| | - |  | ------------------------------



| |  |  | competition; and
| | - |  | ----------------



| |  |  | regulatory restrictions.
| | - |  | ------------------------



In a rising interest rate environment, we would expect our ability to originate loans at interest rates that will maintain our current level of
profitability will be easier compared to a falling or stable interest rate environment. If we are unable to sustain our levels of growth, our profits may be reduced and our ability to repay the debt securities upon maturity impaired.



Our lending activities are concentrated in the Washington/Baltimore metropolitan areas, so
we are subject to the economic conditions of those areas.



Our lending activities are concentrated in the Washington, D.C. and Baltimore, Maryland metropolitan areas. Therefore, any negative changes that could arise in the economy of those areas could have a negative effect on our business.



We are dependent on our senior management team and, if we are not able to
retain them, it could have a materially adverse effect on us.



We are dependent upon the continued services and experience of our senior management team, including Robert L. Harris, our Chief Executive Officer and President, Louise B. Sehman, our Chief Financial Officer, Secretary and Treasurer, James
E. Parker, a Vice President, and Ronald L. Nicholson, a Vice President. We depend on the services of Messrs. Harris and Parker and Ms. Sehman and other members of our senior management team to, among other things, continue our growth strategies and
maintain and develop our client relationships. We have no employment agreements with any of our employees. The loss of the services of any of our senior management or any of our other key employees would disrupt our operations and would delay our
planned growth while we worked to replace those employees. We maintain key person life insurance on Robert L. Harris only. As a result, if any of our other key employees were to die or become unable to provide services for us, our
operations would be disrupted and we would have no means of recovering any resulting losses. In addition, if Mr. Harris were to die or become unable to provide services for us, there is no assurance that the insurance proceeds would be sufficient to
recover any resulting losses.



We have notes payable and notes receivable
with certain of our officers, directors and principal stockholders. This might cause such persons to have a conflict of interest.



As of December 31, 2004, some of our officers, directors and stockholders held notes payable totaling $5,851,281. Although such persons equity
ownership encourages them to act in the best interests of all stockholders, circumstances could arise where such persons, particularly those that are members of our Board of Directors, will be in a position of allocating available cash in a manner
that may not be in the best interests of other stockholders. In addition, as of December 31, 2004, certain loans held by KH Funding to some of our officers, directors and stockholders totaled $1,833,611. Although we believe that each of these
transactions were on terms as



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favorable as could have been obtained from an unrelated party, they could create, or appear to create, potential conflicts of interest which may not
necessarily be resolved in our favor. This could have a material adverse effect on our business, operating results and financial condition. See, Certain Relationships and Related Transactions.



We do not have a compensation committee.



Currently, we do not have a compensation committee and we do not know if or when such a
committee will be formed. In the meantime, our Board of Directors governs decisions regarding compensation. Our Board of Directors is not entirely comprised of independent members. See Management.



ITEM 2. DESCRIPTION OF PROPERTY



The real estate we own is generally acquired at foreclosure or through a
deed-in-lieu of foreclosure. The more expensive properties on which we foreclose are sold as soon as possible. Generally, with the lower and medium priced single-family residential properties we acquire through foreclosure, we rent them out and
continue ownership for a short period. Often these properties have a rental value that is high relative to fair market value. If so, we have an opportunity to maximize profits from an ultimate sale by finding a good tenant, making cosmetic and
appliance upgrades, and then selling the property for, hopefully, a higher market value than may have been realized by a quick sale. In order to determine the fair market value of a foreclosed property we obtain an Opinion of Value from a licensed
real estate professional.



We currently own real estate in
several states, including:



| |  |  | one rental property in Capitol Heights, Maryland
| | - |  | ------------------------------------------------



| |  |  | one rental property in Gainesville, Georgia
| | - |  | -------------------------------------------



| |  |  | one rental property in Grand Prairie, Texas
| | - |  | -------------------------------------------



| |  |  | two rental properties in Schenectady, New York
| | - |  | ----------------------------------------------



| |  |  | five rental properties in Montgomery, Alabama
| | - |  | ---------------------------------------------



| |  |  | one rental property in Waco, Texas
| | - |  | ----------------------------------



| |  |  | two rental properties in Leander, Texas
| | - |  | ---------------------------------------



ITEM 3. LEGAL PROCEEDINGS



We are involved periodically in various claims and lawsuits that arise in connection with our financial services business. We believe that these routine
legal proceedings, in the aggregate, are not material to our financial condition and results of operations.



ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS



No matters were submitted to a vote of the shareholders during the fourth quarter of 2004.



10



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PART II



ITEM 5. MARKET FOR COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES



Market, Holders and Dividends



Our common stock is not listed on a public trading market. As of March 15,
2005 we had 52 stockholders of record holding 2,505,556 shares. In each of the last two fiscal years we have paid an annual dividend on our common stock of $0.15 per share and do anticipate paying dividends on our common stock in the foreseeable
future.



Equity Compensation Plan Information



The following table sets forth information as of March 15, 2005 with respect
to the compensation plans under which equity securities of the Company are authorized for issuance.



|                                                               |  |                                                                      |  |                                                          |      |                                                                                                                                      |        
|-------------------------------------------------------------- |  | -------------------------------------------------------------------- |  | -------------------------------------------------------- | ---- | ------------------------------------------------------------------------------------------------------------------------------------ | -------
|                                                               |  | EQUITY COMPENSATION PLAN INFORMATION                                
|Plan category                                                  |  | (a) Number of shares to be issued uponexercise of outstandingoptions |  | (b) Weighted-average Exercise priceof Outstandingoptions |      | (c) Number of sharesremaining available for future issuanceunder equity compensationplans
(excluding shares reflected in column (a))
|Equity compensation plans approved by security holders (1)     |  | 0                                                                    |  | $                                                        | 0.00 |                                                                                                                                      | 100,000
|Equity compensation plans not approved by security holders (2) |  | 311,250                                                              |  | $                                                        | 2.00 |                                                                                                                                      | n/a    
|Total                                                          |  | 311,250                                                              |  | $                                                        | 2.00 |                                                                                                                                      | 100,000

---

|(1) | The Equity compensation plan approved by stockholders is the 1998 Stock Incentive Plan (the 1998 Plan).
|--- | ---------------------------------------------------------------------------------------------------------

|(2) | The Companys only equity compensation plan has been approved by its stockholders.
|--- | ----------------------------------------------------------------------------------



Recent Sales of Unregistered Securities



We did not sell any shares of our Common Stock in 2004.



Repurchase of Securities



We did not repurchase any of our Common Stock during the fourth quarter of 2004.



11



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ITEM 6. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION



This discussion may contain statements that could be deemed forward-looking
statements within the meaning of Section 21E of the Securities Exchange Act of 1934 and the Private Securities Litigation Reform Act, which statements are inherently subject to risks and uncertainties. Forward-looking statements are statements that
include projections, predictions, expectations or beliefs and future events or results or otherwise are not statements of historical fact. Such statements are often characterized by the use of qualifying words (and their derivatives) such as
expect, believe, estimate, plan, project, anticipate, or other statements concerning opinions or judgment of KH Funding and its management about future events. Factors that
could influence the accuracy of such forward-looking statements include, but are not limited to, the financial success or changing strategies of KH Fundings customers, actions of government regulators, the level of market interest rates, and
general economic conditions. See FORWARD LOOKING STATEMENTS.



Critical Accounting Policies



The Securities and Exchange
Commission (SEC) recently issued guidelines on the disclosure of critical accounting policies. The SEC defines critical accounting policies as those that require application of managements most difficult, subjective or complex
judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain and may change in subsequent periods.



Our significant accounting policies are disclosed in the footnotes to the financial statements. Management believes the following significant accounting policies also are
considered critical accounting policies:



Loan impairment
 A loan is considered impaired when, based on available information or current events, it is probable that we will be unable to collect scheduled payments of principal and interest when due according to the contractual terms of the loan
agreement. Factors considered in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment
shortfalls generally are not considered impaired. We measure impairment on a loan by loan basis using the present value of expected future cash flows discounted at the loans effective interest rate, the loans obtainable market value, or
the fair value of the collateral if the loan is collateral-dependent. However, impairment is based on the fair value of the collateral if it is determined that foreclosure is probable.



Allowance for loan losses  We periodically evaluate the adequacy of the allowance for loan losses based on past loan
loss experience, known and inherent risks in the portfolio, adverse situations that might affect the borrowers ability to repay, the estimated value of any underlying collateral, and current economic conditions. While we use information
available in establishing the allowance for loan losses, evaluation assessments are inherently subjective and future adjustments to the allowance may be necessary if economic conditions differ substantially from the assumptions used in making the
evaluation. The allowance for loan losses is a material estimate that is particularly susceptible to significant change in the near term.



Overview



KH Funding Companys primary business activities consist of originating, acquiring and servicing mortgage loans, and issuing interest-bearing debt
securities to investors. KH Funding Companys business operations are conducted solely from its headquarters in Silver Spring, Maryland.



KH Funding has over 500 investors who have purchased its corporate notes dating back to 1990. The note purchasers have been attracted primarily through
word-of-mouth referrals. The proceeds from the sale of Notes are used to make redemptions to existing note holders and for investment in real estate mortgage loans, business loans, investment grade debt securities and real property. We emphasize the
direct origination of small commercial real estate mortgage loans and investment property residential mortgage loans. We purchase first and second trust residential loans nationwide from other lenders and banks.



12



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Our net income depends largely upon our net interest income, which is the difference between interest
income from loans and investments, referred to as interest-earning assets, and interest expense on investor notes and other borrowed funds, referred to as interest-bearing liabilities. Our net interest income is significantly affected by general
economic conditions, policies established by regulatory authorities and competition.



Recent Developments



Broker-Dealers.The Company has been expanding the wholesale distribution for its investment products by engaging in strategic alliances with several major financial services firms throughout the country. We currently have signed selling agreements with two
NASD Broker-Dealers with a network of over 170 registered representatives in the Midwest and West. These alliances give us the ability to sell our Investment Debt Securities through a network of financial consultants in defined geographic locations.
To date, our wholesale distribution plan has been very successful, establishing close to 300 new investment accounts providing over $8,000,000 in funds to KH Funding. We plan to further increase our wholesale network, and are currently in
negotiations with several NASD member Broker Dealers interested in distributing our notes in parts of the United States where we are not currently represented.



Sub-S Corporate Status. During the preparation of the 2003 income tax returns for the company, it was discovered that during 2003 stock in the
company was transferred to shareholders who were ineligible to be S corporation shareholders. The effect of such a transfer is to terminate the S election on the date of the transfer. However, the Internal Revenue Service has a process by which they
will allow the S election to continue based on inadvertent terminations. We submitted a formal request to the Internal Revenue Service for such treatment, and on November 18, 2004 our request was approved. Therefore, our S election was
unaffected.



Comparison of Financial Condition at December 31, 2004 and 2003



Assets. Total assets increased $3.13 million, to
$26.22 million at December 31, 2004, from $23.09 million at December 31, 2003. The size of the gross loan portfolio increased to $20.50 million from $15.92 million. Investments available for sale decreased from $2,520,949 to $658,248.



As of December 31, 2004 and 2003 non-accrual loans totaled $583,351 and
$441,474, respectively. The increase of $141,877 is represented by first trust loans on which the Company anticipates little or no loss.



As of December 31, 2004 and 2003, there were loans of $2,109,236 and $2,282,688, respectively, more than ninety days past due on the books of the Company
that continue to earn interest. These loans are well collateralized and the borrowers are making regular payments.



Liabilities. Total liabilities increased $3.62 million or 16.9% to $25.03 million at December 31, 2004, from $21.41 million at December 31, 2003.
The increase was largely the result of increases in notes payable to investors due to our increased marketing efforts and affiliations with brokers.



Equity. Total stockholders equity decreased to $1,195,852 or 28.9% in 2004 from $1,681,913 in 2003 due to an operating loss in 2004 and
dividends paid to shareholders.



Comparison of Operating Results for Years
ended December 31, 2004 and 2003



The average yield earned
on loans receivable increased to 10.89% in 2004 from 10.74% in 2003. The increase was due to more aggressive pricing by the Company on both the loans it originates directly and loans it acquires.



The average rate paid on investor accounts decreased to 5.69% in 2004 from
6.00% in 2003. The net result was an increase in net interest rate spread, which was 5.20% for 2004 as compared to 4.74% in 2003. The net interest rate spread is at note rates and excludes fee income and expense.



Net (Loss) Income. Net loss for the year ended December 31, 2004 was
$97,473 compared to net income of $4,166 for the year ended December 31, 2003. The decrease was attributed to costs associated with the debt offering and increased professional fees.



13



---

Interest Income. Total interest income was $2.27 million in 2004 compared to $1.97 million in
2003. The additional income resulted from growth in our loan portfolio and in higher average balance of investments available for sale in 2004 than 2003. The interest income for all periods includes point and fee income, interest earned on bank
investments and marketable securities.



Interest
Expense. Interest expense was $1.30 million in 2004, an increase from the $1.27 million for 2003. The additional expense resulted from an increase in investor accounts, and loan participations, which are treated as financings. The average rate
paid on investor accounts decreased to 5.69% in 2004 from 6.00% in 2003. The interest expense includes fees paid for loan purchases. There was one participating loan at December 31, 2003 and 2004.



Provision for Loan Losses. The provisions for loan losses was $266,700
in 2004 and $146,379 in 2003. We recovered one previously written-off loan of $4,800 in 2004 and $4,815 in 2003. At year-end our impaired loans were $583,351 in 2004 and $441,474 in 2003. Our allowance for loan losses was $233,311 at the end of 2004
and $211,000 at the end of 2003.



Non-Interest Income.
We had non-interest income was $121,637 in 2004 and $89,987 in 2003. The increase was principally the result of gains on the sale of real estate owned, partially offset by recognized impairment losses on investment securities.



Non-Interest Expense. Non-interest expense increased to $929,365 in
2004 from $634,249 in 2003. The increase was the result of increased salary expense, professional fees, and offering costs.



Income Taxes. KH Funding Company is a Subchapter S corporation under the Internal Revenue code and accordingly no items appear for income taxes.



Liquidity and Capital Resources



KH Funding Companys primary sources of capital are the proceeds from
the sale of investor notes to investors, principal and interest payments on loans, sales of participation interests in loans and rental income. While maturities and scheduled amortization of loans and investments are predictable sources of funds,
the sale of investor notes and mortgage loan prepayments are greatly influenced by interest rate trends, economic conditions and competition. Our One Day Demand Notes are a major cause of turnover in our cash positions.



The table below illustrates the sales of investor notes versus redemptions
for the years indicated:



|     |  |            |            |                |   |            |  |        |  
|---- |  | ---------- | ---------- | -------------- | - | ---------- |  | ------ | -
|Year |  | Notes Sold |            | Notes Redeemed |   | Percentage | 
|2000 |  | $          | 10,367,351 |                | $ | 10,661,308 |  | 102.84 | %
|2001 |  | $          | 14,418,456 |                | $ | 11,280,177 |  | 78.23  | %
|2002 |  | $          | 22,926,619 |                | $ | 18,681,654 |  | 81.47  | %
|2003 |  | $          | 26,630,166 |                | $ | 24,697,770 |  | 92.74  | %
|2004 |  | $          | 49,008,102 |                | $ | 44,786,895 |  | 91.39  | %



During the past few
years, the combination of generally low interest rates on deposit products at commercial banks, the poor performance of the stock market, our public offering for notes, and increasing referrals from customers have positioned KH Funding to experience
solid growth in the number of new investors attracted to its investment products. Based on its monitoring of historic trends and its current pricing strategy for investor accounts, management believes KH Funding Company will retain a large portion
of its existing investors and will experience a significant increase of funds from new investors in the future.



14



---

The maturities of notes payable at December 31, 2004 is as follows:



|                         |  |   |           
|------------------------ |  | - | ----------
|Year ending December 31, |  |  
|2005                     |  | $ | 16,299,360
|2006                     |  |   | 2,670,997 
|2007                     |  |   | 3,330,398 
|2008                     |  |   | 1,010,740 
|2009                     |  |   | 1,425,702 
|2010                     |  |   | 80,206    
|                         |  |   |           
|                         |  | $ | 24,817,403
|                         |  |   |           



Redemption of Notes
Payable.Management believes that the risk of not being able to fund redemption requests only exists if the requests for redemption exceed the amount of readily available cash, i.e., if our liquidity is insufficient to fund redemptions. Upon the
sale of a note payable, the funds for redemption are immediately available. Of course, part of our investment strategy is to invest funds that are invested with us for a longer period into higher yielding, less liquid investments, such as mortgages;
nevertheless, the funds are still available, just not immediately. Only holders of one-day demand notes can ask for funds sooner than thirty days, and we make an effort to keep funds available for these requests. Only holders of thirty-day demand
notes can ask for funds sooner than 90 days, and if the funds will not be available within thirty days, we will sell some of our mortgage loans (notes receivables) to have the funds available to meet requests for funds from these note holders. All
other types of notes, that is the term notes of one, three and five years, are redeemable upon maturity, or prior to maturity on 90 days advance notice, subject to a penalty. If necessary, we will sell loans (notes receivables) in bulk to fund
redemption requests from note holders.



The Company strives to
maintain sufficient liquidity to meet all redemption requests. We normally hold 10% to 20% of our assets in cash and cash equivalents to fund redemptions of one-day accounts. This amount has always been sufficient for us to meet our obligations.
Also, if required, we are able to sell loans within 30 days to raise cash to meet redemption requests from 30-day account holders or within 90 days to meet early redemption requests from term account note holders. The majority of our loan assets are
classified as available for sale to meet liquidity demands, if necessary.



Plan to Raise Additional Capital. We intend to continue to expand our operations through future public offerings of debt by the Company and select, contracted Broker-Dealers, and sales of capital stock.
However, there is no assurance that such transactions will occur or be successful.



We also expect that we will be able to attract more investors who are interested in our longer-term fixed rate notes. We are now offering trust services for IRA accounts through our Trust Services Department. We
intend to expand these services and believe that IRA investors generally look for investments of a long-term nature, which complements our preferred mode of investing.



Use of Capital Proceeds. Capital received by us in prior years has been used to fund new loans. However, rather than
directly originating new loans, in the last five years we have purchased ever-larger portions of loans that have been added to our portfolio. The loans are purchased nationwide from brokers, banks and other lenders, usually at a discount, in
wholesale bulk purchases. We will continue to expand this wholesale component of our operations and have it be a major part of our loan acquisition strategy.



We anticipate that our operations will shift to acquiring larger percentages of loans at the wholesale level. This increased wholesale component will
enable us to expand our operations and increase our net profit with a limited amount of additional expense because we anticipate that only a minimal expansion of our administrative functions will be needed to support an increased wholesale
component.



We intend to use our future excess capital to
purchase more liquid, marketable loans and to increase the volume of loans we purchase. To increase our investment and portfolio activity, we plan to identify and utilize additional brokers, lenders and banks as sources for our loan acquisitions.



Known Trends, Events or Uncertainties



Impact of Inflation and Interest Rates. The financial statements of
KH Funding and notes thereto, presented elsewhere herein, have been prepared in accordance with accounting principles generally accepted in the United States of America, which require the measurement of financial position and operating results in
terms of historical



15



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dollars without considering the change in the relative purchasing power of money over time and due to inflation. The impact of inflation is generally to
increase the value of underlying collateral for the loans made by KH Funding to its borrowers. Unlike typical industrial companies, nearly all the assets and liabilities of KH Funding are monetary in nature. As a result, interest rates have a
greater impact on KH Fundings performance than the effects of inflation generally.



Recent Accounting Pronouncements



In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards, or SFAS, No. 153, Exchanges of Nonmonetary Assets, an amendment of APB Opinion
No.29, Accounting for Nonmonetary Transactions. This statement amends the principle that exchanges of nonmonetary assets should be measured based on the fair value of the assets exchanged and more broadly provides for exceptions regarding
exchanges of nonmonetary assets that do not have commercial substance. This Statement is effective for nonmonetary asset changes occurring in fiscal periods beginning after June 15, 2005. The adoption of this standard is not expected to have a
material impact on financial condition, results of operations, or liquidity.



In December 2004, FASB issued SFAS No. 123R, Share-Based Payment, which is a revision of SFAS No. 123, Accounting for Stock Issued for Employees. SFAS No. 123R requires that all share-based
payments to employees, including grants of employee stock options, be valued at fair value on the grant date and be expensed over the applicable vesting period. SFAS No. 123R is effective for the Company on January 1, 2006. The Company will
transition to SFAS No. 123R using the modified prospective application. Under the modified prospective application, compensation costs will be recognized in the financial statements for all new share-based payments granted
after January 1, 2006. Additionally, the Company will recognize compensation costs for the portion of previously granted awards for which the requisite service has not been rendered (nonvested awards) that are outstanding as of July 1,
2005 over the remaining requisite service period of the awards. The compensation expense to be recognized for the nonvested awards will be based on the fair value of the awards. The Company is in the process of analyzing the effects of the impact of
this standard on its operations.



In November 2003 the
Emerging Issues Task Force (EITF) of the FASB issued EITF Abstract 03-1, The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments (EITF 03-1) effective for fiscal year ending after
December 15, 2003. The abstract provides guidelines on the meaning of other than-temporary impairment and its application to investments in addition to requiring quantitative and qualitative disclosures in the financial statements. The Company has
implemented the guidelines of this Consensus. The adoption of this Consensus did not have any impact on the Companys financial condition, results of operations, or liquidity.



16



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Summary Financial Data



You should consider our summary financial information set forth below together with the more detailed financial statements,
including the related notes, and Managements Discussion and Analysis of Financial Condition and Results of Operation included elsewhere in this report.



|                                     |  |                         |           |   |      |   |           |  |      |           |  |      |           |   |  |   |          
|------------------------------------ |  | ----------------------- | --------- | - | ---- | - | --------- |  | ---- | --------- |  | ---- | --------- | - |  | - | ---------
|                                     |  | Year Ended December 31,
|                                     |  | 2004                    |           |   | 2003 |   | 2002      |  | 2001 |           |  | 2000
|Statement of Operations Data:        |  |                         |           |   |      |   |           |  |      |           |  |      |           |   |  |   |          
|Revenue:                             |  |                         |           |   |      |   |           |  |      |           |  |      |           |   |  |   |          
|Interest and Fees on Loans           |  | $                       | 2,006,449 |   |      | $ | 1,826,202 |  | $    | 1,757,153 |  | $    | 1,463,789 |   |  | $ | 1,245,557
|Other Income(1)                      |  |                         | 390,121   |   |      |   | 232,299   |  |      | 106,504   |  |      | 105,800   |   |  |   | 19,561   
|Total Revenue(2)                     |  |                         | 2,396,570 |   |      |   | 2,058,501 |  |      | 1,863,657 |  |      | 1,569,589 |   |  |   | 1,265,118
|Provision for Loan Losses            |  |                         | 266,700   |   |      |   | 146,379   |  |      | 144,165   |  |      | 158,000   |   |  |   | 53,000   
|Expenses:                            |  |                         |           |   |      |   |           |  |      |           |  |      |           |   |  |   |          
|Interest                             |  |                         | 1,297,978 |   |      |   | 1,273,677 |  |      | 1,173,985 |  |      | 1,007,521 |   |  |   | 812,560  
|Non-Interest                         |  |                         | 929,265   |   |      |   | 634,279   |  |      | 516,431   |  |      | 440,364   |   |  |   | 337,632  
|Total Expenses(3)                    |  |                         | 2,494,043 |   |      |   | 1,907,956 |  |      | 1,690,416 |  |      | 1,447,885 |   |  |   | 1,150,192
|Net Income (Loss)                    |  |                         | (97,473   | ) |      |   | 4,166     |  |      | 29,076    |  |      | (36,296   | ) |  |   | 61,926   
|Per Common Share Data:               |  |                         |           |   |      |   |           |  |      |           |  |      |           |   |  |   |          
|Basic Earnings (Loss) Per Share(4)   |  |                         | (0.04     | ) |      |   | - 0 -     |  |      | 0.02      |  |      | (0.02     | ) |  |   | 0.04     
|Diluted Earnings (Loss) Per Share(5) |  |                         | (0.04     | ) |      |   | - 0 -     |  |      | 0.01      |  |      | (0.02     | ) |  |   | 0.03     

---

|(1) | Consists of all Non-Interest Income plus Interest on Bank Accounts, Interest on Investments-Marketable Securities and Other Interest.
|--- | -------------------------------------------------------------------------------------------------------------------------------------

|(2) | The sum of Interest and Fees on Loans plus Other Income as explained above in (1).
|--- | ----------------------------------------------------------------------------------

|(3) | The sum of Interest Expense plus Non-Interest Expense.
|--- | ------------------------------------------------------

|(4) | Using average of beginning and ending balance of number of shares and annual earnings, shown in cents per share.
|--- | ----------------------------------------------------------------------------------------------------------------

|(5) | Using average of beginning and ending balance of number of shares and number of outstanding options, and annual earnings-cents per share.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------



17



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|                                                                      |  |                         |            |    |      |   |            |      |  |   |            |   |  |      |            |    |  |   |            |  
|--------------------------------------------------------------------- |  | ----------------------- | ---------- | -- | ---- | - | ---------- | ---- |  | - | ---------- | - |  | ---- | ---------- | -- |  | - | ---------- | -
|                                                                      |  | Year Ended December 31, |           
|                                                                      |  | 2004                    |            |    | 2003 |   |            | 2002 |  |   | 2001       |   |  | 2000 |           
|Balance Sheet Data:                                                   |  |                         |            |    |      |   |            |      |  |   |            |   |  |      |            |    |  |   |            |  
|Cash and Marketable Securities                                        |  | $                       | 3,325,093  |    |      | $ | 4,169,911  |      |  | $ | 2,371,931  |   |  | $    | 357,957    |    |  | $ | 416,939    |  
|                                                                      |  |                         |            |    |     
|Loans Receivable                                                      |  |                         | 20,144,798 |    |      |   | 15,590,526 |      |  |   | 15,830,293 |   |  |      | 13,036,199 |    |  |   | 9,611,228  |  
|Real Estate Owned                                                     |  |                         | 709,973    |    |      |   | 1,014,254  |      |  |   | 1,011,424  |   |  |      | 1,198,681  |    |  |   | 321,521    |  
|Other Assets(1)                                                       |  |                         | 2,039,085  |    |      |   | 2,280,217  |      |  |   | 676,560    |   |  |      | 423,112    |    |  |   | 346,293    |  
|Total assets                                                          |  |                         | 26,221,949 |    |      |   | 23,090,908 |      |  |   | 19,890,208 |   |  |      | 15,015,949 |    |  |   | 10,695,981 |  
|Notes Payable                                                         |  |                         | 24,817,403 |    |      |   | 19,980,673 |      |  |   | 17,482,519 |   |  |      | 12,789,068 |    |  |   | 9,253,739  |  
|Participation Loans                                                   |  |                         | 107,248    |    |      |   | 105,636    |      |  |   | 1,077,730  |   |  |      | 1,024,115  |    |  |   | 0          |  
|Other Liabilities(2)                                                  |  |                         | 101,446    |    |      |   | 1,322,686  |      |  |   | 358,902    |   |  |      | 422,654    |    |  |   | 360,067    |  
|Total Liabilities                                                     |  |                         | 25,026,097 |    |      |   | 21,408,995 |      |  |   | 18,919,151 |   |  |      | 14,235,837 |    |  |   | 9,613,806  |  
|Stockholders Equity                                                   |  |                         | 1,195,852  |    |      |   | 1,681,913  |      |  |   | 971,057    |   |  |      | 780,112    |    |  |   | 1,082,175  |  
|                                                                      |  |                         |            |    |     
|Other Financial Data:                                                 |  |                         |            |    |      |   |            |      |  |   |            |   |  |      |            |    |  |   |            |  
|                                                                      |  |                         |            |    |     
|Return on Average Assets(3)                                           |  |                         | (0.40      | )% |      |   | 0.02       | %    |  |   | 0.17       | % |  |      | (0.28      | )% |  |   | 0.59       | %
|Return on Average Equity(4)                                           |  |                         | (6.77      | )% |      |   | 0.31       | %    |  |   | 3.32       | % |  |      | (3.90      | )% |  |   | 5.66       | %
|Stockholders Equity to Total Assets                                  |  |                         | 4.56       | %  |      |   | 7.28       | %    |  |   | 5.1        | % |  |      | 5.2        | %  |  |   | 10.1       | %
|                                                                      |  |                         |            |    |     
|Loan Portfolio:                                                       |  |                         |            |    |      |   |            |      |  |   |            |   |  |      |            |    |  |   |            |  
|                                                                      |  |                         |            |    |     
|Principal Funded During Period                                        |  | $                       | 12,841,741 |    |      | $ | 6,875,053  |      |  | $ | 7,168,744  |   |  | $    | 9,563,367  |    |  | $ | 2,536,066  |  
|Principal Received During Period                                      |  | $                       | 8,005,490  |    |      | $ | 6,970,257  |      |  | $ | 3,730,793  |   |  | $    | 5,062,451  |    |  | $ | 2,174,071  |  
|Average Interest Rate For Period                                      |  |                         | 10.89      | %  |      |   | 10.74      | %    |  |   | 11.00      | % |  |      | 11.94      | %  |  |   | 11.96      | %
|Loan Charge-offs as a Percent of Total Portfolio at End of Period(5) |  |                         | 1.40       | %  |      |   | 0.73       | %    |  |   | 0.88       | % |  |      | 0.81       | %  |  |   | 0.89       | %
|                                                                      |  |                         |            |    |     
|Notes Payable:                                                        |  |                         |            |    |      |   |            |      |  |   |            |   |  |      |            |    |  |   |            |  
|Sale of Notes During Period                                           |  | $                       | 49,008,102 |    |      | $ | 26,630,166 |      |  | $ | 22,926,619 |   |  | $    | 14,418,456 |    |  | $ | 10,367,351 |  
|Redemption of Notes During Period                                     |  | $                       | 44,786,895 |    |      | $ | 24,697,770 |      |  | $ | 18,681,654 |   |  | $    | 11,280,177 |    |  | $ | 10,661,308 |  
|Average Interest Rate For Period                                      |  |                         | 5.69       | %  |      |   | 6.0        | %    |  |   | 6.40       | % |  |      | 7.86       | %  |  |   | 8.43       | %

---

|(1) | Consists of the sum of the following: Accrued Interest, Prepaid Expenses, Other Receivables, Investments-Other, Property and Equipment-Net, and Other Assets.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------

|(2) | Consists of the sum of the following: Borrowings, Accounts Payable and Accrued Expenses, and Escrows.
|--- | -----------------------------------------------------------------------------------------------------

|(3) | Using average of beginning and ending balances for assets, and earnings for period (annualized)
|--- | -----------------------------------------------------------------------------------------------

|(4) | Using average of beginning and ending balances for equity, and earnings for period (annualized)
|--- | -----------------------------------------------------------------------------------------------

|(5) | Annualized
|--- | ----------



18



---

ITEM 7. FINANCIAL STATEMENTS



Index to Financial
Statements



|                                                                                             |  |      
|-------------------------------------------------------------------------------------------- |  | -----
|Report of Independent Registered Public Accounting Firm                                      |  | 20   
|                                                                                             | 
|Audited Financial Statements:                                                                |  |      
|                                                                                             | 
|Balance Sheets as of December 31, 2004 and 2003                                              |  | 21   
|                                                                                             | 
|Statements of Operations for the years ended December 31, 2004 and 2003                      |  | 22   
|                                                                                             | 
|Statements of Changes in Stockholders Equity for the years ended December 31, 2004 and 2003 |  | 23   
|                                                                                             | 
|Statements of Cash Flows for the years ended December 31, 2004 and 2003                      |  | 24   
|                                                                                             | 
|Notes to Financial Statements for years ended December 31, 2004 and 2003                     |  | 25-36



19



---

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM



Board of Directors and Stockholders

KH Funding Company

Silver Spring, Maryland



We have audited the
accompanying balance sheets of KH Funding Company (the Company) as of December 31, 2004 and 2003, and the related statements of operations, changes in stockholders equity and cash flows for the years then ended. These financial statements are
the responsibility of the Companys management. Our responsibility is to express an opinion on these financial statements based on our audits.



We conducted our audits in accordance with standards of the Public Company Accounting Oversight Board (United States). Those standards require that we
plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for
our opinion.



In our opinion, the financial statements referred
to above present fairly, in all material respects, the financial position of KH Funding Company as of December 31, 2004 and 2003, and the results of its operations and cash flows for the years then ended in conformity with accounting principles
generally accepted in the United States of America.



/s/ Stegman & Company



Baltimore, Maryland

April 11, 2005



20



---

KH Funding Company



Balance Sheets as of



|                                                                                                                                         |  |      |            |   |      |   |            |  
|---------------------------------------------------------------------------------------------------------------------------------------- |  | ---- | ---------- | - | ---- | - | ---------- | -
|December 31,                                                                                                                             |  | 2004 |            |   | 2003 |  
|Assets                                                                                                                                   |  |      |            |   |      |   |            |  
|Cash                                                                                                                                     |  | $    | 2,669,845  |   |      | $ | 1,684,962  |  
|Investments available for sale:                                                                                                          |  |      |            |   |      |   |            |  
|Marketable securities - at fair value                                                                                                    |  |      | 658,248    |   |      |   | 2,520,949  |  
|Other                                                                                                                                    |  |      | 158,872    |   |      |   | 191,872    |  
|Loans, less allowance for loan losses of (2004) $233,311 and (2003) $211,000                                                             |  |      | 20,144,798 |   |      |   | 15,590,526 |  
|Accrued interest receivable                                                                                                              |  |      | 853,448    |   |      |   | 554,650    |  
|Other receivables                                                                                                                        |  |      | 537,737    |   |      |   | 1,126,791  |  
|Prepaid expenses                                                                                                                         |  |      | 445,470    |   |      |   | 359,121    |  
|Property and equipmentnet                                                                                                               |  |      | 33,755     |   |      |   | 39,122     |  
|Real estate owned:                                                                                                                       |  |      |            |   |      |   |            |  
|Rental property                                                                                                                          |  |      | 709,973    |   |      |   | 863,772    |  
|Held for resale                                                                                                                          |  |      |           |   |      |   | 150,482    |  
|Other assets                                                                                                                             |  |      | 9,803      |   |      |   | 8,661      |  
|                                                                                                                                         |  |      |            |   |      |   |            |  
|Total Assets                                                                                                                             |  | $    | 26,221,949 |   |      | $ | 23,090,908 |  
|                                                                                                                                         |  |      |            |   |      |   |            |  
|Liabilities and Stockholders Equity                                                                                                     |  |      |            |   |      |   |            |  
|                                                                                                                                         |  |     
|Liabilities                                                                                                                              |  |      |            |   |      |   |            |  
|Notes and accrued interest payable                                                                                                       |  | $    | 24,817,403 |   |      | $ | 19,980,673 |  
|Other loans payable                                                                                                                      |  |      | 66,200     |   |      |   | 1,300,200  |  
|Participation loans                                                                                                                      |  |      | 107,248    |   |      |   | 105,636    |  
|Accounts payable and accrued payroll liabilities                                                                                         |  |      | 1,900      |   |      |   | 2,562      |  
|Escrows and security deposits                                                                                                            |  |      | 33,346     |   |      |   | 19,924     |  
|                                                                                                                                         |  |      |            |   |      |   |            |  
|Total Liabilities                                                                                                                        |  |      | 25,026,097 |   |      |   | 21,408,995 |  
|                                                                                                                                         |  |      |            |   |      |   |            |  
|Stockholders Equity                                                                                                                     |  |      |            |   |      |   |            |  
|Common stock (5,000,000 shares authorized; 2,505,556 shares (2004) and 2,485,066 shares (2003), issued and outstanding; $0.01 par
value) |  |      | 25,056     |   |      |   | 24,851     |  
|Paid-in capital                                                                                                                          |  |      | 1,750,443  |   |      |   | 2,102,765  |  
|Accumulated deficit                                                                                                                      |  |      | (385,373   | ) |      |   | (287,900   | )
|Less subscription note receivable                                                                                                        |  |      | (185,450   | ) |      |   | (185,450   | )
|Accumulated other comprehensive (loss) income                                                                                            |  |      | (8,824     | ) |      |   | 27,647     |  
|                                                                                                                                         |  |      |            |   |      |   |            |  
|Total Stockholders Equity                                                                                                               |  |      | 1,195,852  |   |      |   | 1,681,913  |  
|                                                                                                                                         |  |      |            |   |      |   |            |  
|Total Liabilities and Stockholders Equity                                                                                               |  | $    | 26,221,949 |   |      | $ | 23,090,908 |  
|                                                                                                                                         |  |      |            |   |      |   |            |  



The accompanying
notes are an integral part of these statements.



21



---

KH Funding Company



Statements of Operations for
the years ended December 31, 2004 and 2003



|                                                  |  |      |           |   |      |   |          
|------------------------------------------------- |  | ---- | --------- | - | ---- | - | ---------
|December 31,                                      |  | 2004 |           |   | 2003
|Interest Income                                   |  |      |           |   |      |   |          
|Interest and fees on loans                        |  | $    | 2,006,449 |   |      | $ | 1,826,202
|Interest on bank accounts                         |  |      | 10,066    |   |      |   | 8,440    
|Interest on investments-marketable securities     |  |      | 127,719   |   |      |   | 72,794   
|Other interest                                    |  |      | 130,699   |   |      |   | 61,078   
|                                                  |  |      |           |   |      |   |          
|Total interest income                             |  |      | 2,274,933 |   |      |   | 1,968,514
|                                                  |  |      |           |   |      |   |          
|Interest Expense                                  |  |      |           |   |      |   |          
|Interest and fees on borrowings                   |  |      | 1,283,407 |   |      |   | 1,196,449
|Interest on participations                        |  |      | 14,571    |   |      |   | 77,228   
|                                                  |  |      |           |   |      |   |          
|Total interest expense                            |  |      | 1,297,978 |   |      |   | 1,273,677
|                                                  |  |      |           |   |      |   |          
|Net interest income                               |  |      | 976,955   |   |      |   | 694,837  
|                                                  |  |     
|Provision for Loan Losses                         |  |      | 266,700   |   |      |   | 146,379  
|                                                  |  |      |           |   |      |   |          
|Net interest income after provision for loan loss |  |      | 710,255   |   |      |   | 548,458  
|                                                  |  |      |           |   |      |   |          
|Non-interest Income                               |  |      |           |   |      |   |          
|Rental income                                     |  |      | 71,351    |   |      |   | 74,339   
|Gain on sale of real estate owned                 |  |      | 53,868    |   |      |   |         
|Gain on sale of securities                        |  |      | 18,576    |   |      |   | 6,702    
|Recognized loss on impairment of securities       |  |      | (33,000   | ) |      |   |         
|Other                                             |  |      | 10,842    |   |      |   | 8,946    
|                                                  |  |      |           |   |      |   |          
|Total non-interest income                         |  |      | 121,637   |   |      |   | 89,987   
|                                                  |  |      |           |   |      |   |          
|Non-interest Expense                              |  |      |           |   |      |   |          
|Salaries and wages                                |  |      | 301,984   |   |      |   | 257,941  
|Professional fees                                 |  |      | 176,894   |   |      |   | 70,645   
|Offering costs                                    |  |      | 132,376   |   |      |   | 16,800   
|Administration                                    |  |      | 73,272    |   |      |   | 53,552   
|Real estate maintenance                           |  |      | 35,940    |   |      |   | 54,356   
|Insurance                                         |  |      | 65,600    |   |      |   | 52,376   
|Depreciation                                      |  |      | 46,250    |   |      |   | 49,322   
|Rent                                              |  |      | 43,001    |   |      |   | 40,967   
|Bank charges                                      |  |      | 23,374    |   |      |   | 22,730   
|Other                                             |  |      | 30,674    |   |      |   | 15,590   
|                                                  |  |      |           |   |      |   |          
|Total non-interest expense                        |  |      | 929,365   |   |      |   | 634,279  
|                                                  |  |      |           |   |      |   |          
|Net (Loss) Income                                 |  | $    | (97,473   | ) |      | $ | 4,166    
|                                                  |  |      |           |   |      |   |          
|Basic (loss) earnings per share                   |  | $    | (0.04     | ) |      | $ | 0.00     
|Diluted (loss) earnings per share                 |  | $    | (0.04     | ) |      | $ | 0.00     
|Cash dividends paid per common share              |  | $    | 0.15      |   |      | $ | 0.15     



The accompanying
notes are an integral part of these statements.



22



---

KH Funding Company



Statements of Changes in
Stockholders Equity



For the years ended December 31, 2004 and 2003



|                                                |  |              |   |  |                 |        |   |                     |   |           |                                  |  |   |                                              |   |  |                            |          |   |  |   |         |   |  |   |           |  
|----------------------------------------------- |  | ------------ | - |  | --------------- | ------ | - | ------------------- | - | --------- | -------------------------------- |  | - | -------------------------------------------- | - |  | -------------------------- | -------- | - |  | - | ------- | - |  | - | --------- | -
|                                                |  | Common Stock |   |  | Paid-in Capital |        |   | Accumulated Deficit |   |           | Subscriptionsand Note Receivable |  |   | Accumulated OtherComprehensive (Loss) Income |   |  | Total Stockholders Equity |         
|                                                |  | Shares       |   |  | Amount          |        |   |                     |   |           |                                 
|Balance at December 31, 2002                    |  | 1,992,506    |   |  | $               | 19,925 |   |                     | $ | 1,432,546 |                                  |  | $ | (292,066                                     | ) |  | $                          | (185,450 | ) |  | $ | (3,898  | ) |  | $ | 971,057   |  
|                                                |  |              |   |  |                 |        |  
|Additional Stock Issued                         |  | 502,660      |   |  |                 | 5,027  |   |                     |   | 1,000,013 |                                  |  |   | 0                                            |   |  |                            | 0        |   |  |   | 0       |   |  |   | 1,005,040 |  
|Stock Redeemed                                  |  | (10,100      | ) |  |                 | (101   | ) |                     |   | (23,539   | )                                |  |   | 0                                            |   |  |                            | 0        |   |  |   | 0       |   |  |   | (23,640   | )
|                                                |  |              |   |  |                 |        |  
|Dividend Declared $.15 per share                |  | 0            |   |  |                 | 0      |   |                     |   | (306,255  | )                                |  |   | 0                                            |   |  |                            | 0        |   |  |   | 0       |   |  |   | (306,255  | )
|                                                |  |              |   |  |                 |        |  
|Comprehensive Income:                           |  |              |   |  |                 |        |   |                     |   |           |                                  |  |   |                                              |   |  |                            |          |   |  |   |         |   |  |   |           |  
|Net income for the year ended December 31, 2003 |  | 0            |   |  |                 | 0      |   |                     |   | 0         |                                  |  |   | 4,166                                        |   |  |                            | 0        |   |  |   | 0       |   |  |   | 4,166     |  
|Change in market value of investments           |  | 0            |   |  |                 | 0      |   |                     |   | 0         |                                  |  |   | 0                                            |   |  |                            | 0        |   |  |   | 31,545  |   |  |   | 31,545    |  
|                                                |  |              |   |  |                 |        |   |                     |   |           |                                  |  |   |                                              |   |  |                            |          |   |  |   |         |   |  |   |           |  
|Total Comprehensive Income, 2003                |  |              |   |  |                 |        |   |                     |   |           |                                  |  |   |                                              |   |  |                            |          |   |  |   |         |   |  |   | 35,711    |  
|                                                |  |              |   |  |                 |        |   |                     |   |           |                                  |  |   |                                              |   |  |                            |          |   |  |   |         |   |  |   |           |  
|Balance at December 31, 2003                    |  | 2,485,066    |   |  | $               | 24,851 |   |                     | $ | 2,102,765 |                                  |  | $ | (287,900                                     | ) |  | $                          | (185,450 | ) |  | $ | 27,647  |   |  | $ | 1,681,913 |  
|                                                |  |              |   |  |                 |        |  
|Additional Stock Issued                         |  | 22,298       |   |  |                 | 223    |   |                     |   | 24,858    |                                  |  |   | 0                                            |   |  |                            | 0        |   |  |   | 0       |   |  |   | 25,081    |  
|Stock Redeemed                                  |  | (1,808       | ) |  |                 | (18    | ) |                     |   | (4,083    | )                                |  |   | 0                                            |   |  |                            | 0        |   |  |   | 0       |   |  |   | (4,101    | )
|                                                |  |              |   |  |                 |        |  
|Dividend Declared $.15 per share                |  | 0            |   |  |                 | 0      |   |                     |   | (373,097  | )                                |  |   | 0                                            |   |  |                            | 0        |   |  |   | 0       |   |  |   | (373,097  | )
|                                                |  |              |   |  |                 |        |  
|Comprehensive Income:                           |  |              |   |  |                 |        |   |                     |   |           |                                  |  |   |                                              |   |  |                            |          |   |  |   |         |   |  |   |           |  
|Net income for the year ended December 31, 2004 |  | 0            |   |  |                 | 0      |   |                     |   | 0         |                                  |  |   | (97,473                                      | ) |  |                            | 0        |   |  |   | 0       |   |  |   | (97,473   | )
|Change in market value of investments           |  | 0            |   |  |                 | 0      |   |                     |   | 0         |                                  |  |   | 0                                            |   |  |                            | 0        |   |  |   | (36,471 | ) |  |   | (36,471   | )
|                                                |  |              |   |  |                 |        |   |                     |   |           |                                  |  |   |                                              |   |  |                            |          |   |  |   |         |   |  |   |           |  
|Total Comprehensive Income, 2004                |  |              |   |  |                 |        |   |                     |   |           |                                  |  |   |                                              |   |  |                            |          |   |  |   |         |   |  |   | (133,944  | )
|                                                |  |              |   |  |                 |        |   |                     |   |           |                                  |  |   |                                              |   |  |                            |          |   |  |   |         |   |  |   |           |  
|Balance at December 31, 2004                    |  | 2,505,556    |   |  | $               | 25,056 |   |                     | $ | 1,750,443 |                                  |  | $ | (385,373                                     | ) |  | $                          | (185,450 | ) |  | $ | (8,824  | ) |  | $ | 1,195,852 |  
|                                                |  |              |   |  |                 |        |   |                     |   |           |                                  |  |   |                                              |   |  |                            |          |   |  |   |         |   |  |   |           |  



The accompanying
notes are an integral part of these statements.



23



---

KH Funding Company



Statements of Cash Flows



|                                                                          |  |      |             |   |      |   |             |  
|------------------------------------------------------------------------- |  | ---- | ----------- | - | ---- | - | ----------- | -
|Years ended December 31,                                                  |  | 2004 |             |   | 2003 |  
|Increase (Decrease) in Cash                                               |  |      |             |   |      |   |             |  
|                                                                          |  |     
|Reconciliation of Net Income to Net Cash from Operating Activities        |  |      |             |   |      |   |             |  
|Net (loss) income                                                         |  | $    | (97,473     | ) |      | $ | 4,166       |  
|Adjustments to reconcile net income to net cash from operating activities |  |      |             |   |      |   |             |  
|Depreciation                                                              |  |      | 46,250      |   |      |   | 49,322      |  
|Amortization of loan fees                                                 |  |      | (59,219     | ) |      |   | (47,084     | )
|Provision for loan losses                                                 |  |      | 266,700     |   |      |   | 146,379     |  
|Gain on sale of securities                                                |  |      | (18,576     | ) |      |   | (6,702      | )
|Increase (decrease) in Accrued Late Charges                               |  |      | 3,171       |   |      |   | (11,115     | )
|Gain on sale of real estate owned                                         |  |      | (53,868     | ) |      |   | 0           |  
|Principal repayments from borrowers                                       |  |      | 8,005,490   |   |      |   | 6,970,257   |  
|Loans made to borrowers                                                   |  |      | (12,841,741 | ) |      |   | (6,875,053  | )
|Increase in prepaid expenses                                              |  |      | (86,349     | ) |      |   | (192,446    | )
|Recognized loss on impairment of investments                              |  |      | 33,000      |   |      |   | 5,352       |  
|Recovery of prior write-off                                               |  |      | 4,800       |   |      |   | 4,815       |  
|Increase in interest receivable                                           |  |      | (298,798    | ) |      |   | (278,042    | )
|Increase in interest payable (included in notes payable)                  |  |      | 615,523     |   |      |   | 565,757     |  
|Decrease in accounts payable and accrued payroll liabilities              |  |      | (662        | ) |      |   | (6,202      | )
|                                                                          |  |      |             |   |      |   |             |  
|Net Cash (Used) Provided by Operating Activities                          |  | $    | (4,481,752  | ) |      | $ | 329,404     |  
|                                                                          |  |      |             |   |      |   |             |  
|Cash Flows from Investing Activities                                      |  |      |             |   |      |   |             |  
|Purchase of marketable securities and other investments                   |  |      | (603,673    | ) |      |   | (2,973,144  | )
|Proceeds from sale of marketable securities and other investments         |  |      | 2,484,950   |   |      |   | 1,154,076   |  
|Payments for other receivables                                            |  |      | (410,946    | ) |      |   | (21,753     | )
|Purchase of Fixed Assets                                                  |  |      | (15,683     | ) |      |   | (3,445      | )
|Proceeds from sale of real estate owned                                   |  |      | 363,006     |   |      |   | 40,000      |  
|Payments on real estate owned                                             |  |      | 0           |   |      |   | (21,925     | )
|Other assets                                                              |  |      | (1,142      | ) |      |   | 1,891       |  
|                                                                          |  |      |             |   |      |   |             |  
|Net Cash Provided by/(Used in) Investing Activities                       |  |      | 1,816,512   |   |      |   | (1,824,300  | )
|                                                                          |  |      |             |   |      |   |             |  
|Cash Flows from Financing Activities                                      |  |      |             |   |      |   |             |  
|Proceeds from investor notes                                              |  |      | 49,008,102  |   |      |   | 26,630,166  |  
|Principal payments on investor notes                                      |  |      | (44,786,895 | ) |      |   | (24,697,770 | )
|Proceeds from Common Stock                                                |  |      | 1,025,081   |   |      |   | 5,040       |  
|Increase (decrease) in participation loans                                |  |      | 1,611       |   |      |   | (972,094    | )
|Payments on borrowings                                                    |  |      | (1,234,000  | ) |      |   | 966,323     |  
|Payment of dividends                                                      |  |      | (373,097    | ) |      |   | (306,255    | )
|Redemption of Common Stock                                                |  |      | (4,101      | ) |      |   | (23,641     | )
|Increase in escrow and security deposits                                  |  |      | 13,422      |   |      |   | 3,663       |  
|                                                                          |  |      |             |   |      |   |             |  
|Net Cash Provided by Financing Activities                                 |  |      | 3,650,123   |   |      |   | 1,605,432   |  
|                                                                          |  |      |             |   |      |   |             |  
|Net Increase in Cash                                                      |  |      | 984,883     |   |      |   | 110,536     |  
|                                                                          |  |     
|Cash, beginning of year                                                   |  |      | 1,684,962   |   |      |   | 1,574,426   |  
|                                                                          |  |      |             |   |      |   |             |  
|Cash, end of year                                                         |  | $    | 2,669,845   |   |      | $ | 1,684,962   |  
|                                                                          |  |      |             |   |      |   |             |  
|Supplemental cash flows information                                       |  |      |             |   |      |   |             |  
|Interest paid                                                             |  | $    | 619,992     |   |      |   | 565,590     |  
|Transfer of loans to other real state owned                               |  | $    | 66,528      |   |      | $ | 55,267      |  



The accompanying
notes are an integral part of these statements.



24



---

KH Funding Company



Notes to Financial Statements



For the Years Ended December 31, 2004 and 2003



NOTE ASUMMARY OF SIGNIFICANT POLICIES



Nature of Operation



KH Funding Company (the Company) operated as a general partnership from its
founding in December 1990 until July 1, 1994, at which date it incorporated. The Company is an authorized mortgage lender in the State of Maryland, and provides lending services in the Washington, DC metropolitan area, primarily to small businesses
and individuals and also purchases mortgage loans nationwide. The lending services the Company provides include originating, buying and selling loans and in-house servicing of its loans. The Company is currently not servicing loans it sells except
for certain participation loans.



Loans Receivable and
Allowance for Loan Losses



Loans receivable are stated
as unpaid principal balance net of any deferred fees and payments in process, less the allowance for loan losses.



Interest income from notes receivable is recognized using the interest method whereby interest income is recognized based upon the effective rate based
upon outstanding principal. Loan fees are amortized in income over the established life of related loan or five years, whichever is shorter. The allowance for loan losses is increased for charges to income and decreased for charge-offs (net of
recoveries). Managements periodic evaluation of the adequacy of the allowance is based on the Companys past loan loss experience, known or inherent risks in the portfolio, adverse situations which may affect the borrowers ability
to repay, the estimated value of underlying collateral and current economic conditions. It is reasonably possible that the Companys allowance for loan losses could change in the near term.



Loans that are delinquent for more than three months are evaluated for
collectibility and placed in non-accrual status when management determines that future earnings on that loan may be impaired. While in non-accrual status, collections on loans, if any, are recorded as collection of loan principal and no interest is
recorded.



Income Taxes



The Company has elected under Subchapter S of the Internal Revenue Code to
be treated as an S Corporation for tax purposes, and accordingly, items of income and loss are taxed to the shareholders. Therefore, no provision for income taxes is necessary.



Property and Equipment



Property and equipment are stated at cost and depreciated over the estimated useful lives of three to 30 years, primarily
using the straight-line method for financial statement purposes.



The unamortized costs of approximately $347,000 as of December 31, 2004 for the public debt offering are being amortized over the expected average life of the related debt proceeds of thirty-six months from the date incurred.



Investment Available for Sale



Most of the Companys investments are considered available for sale
instruments and are recorded in compliance with Statement of Financial Accounting Standards (SFAS) No. 115, Accounting for Certain Investments in Debt and Equity Securities. The cost of securities sold is determined by the specific
identification method. Purchase premiums and discounts are recognized in interest income using the interest method over the term of the securities. Net unrealized holding gains and losses are reported as accumulated other comprehensive income, a
separate component of stockholders equity. Declines in the fair value of individual available-for-sale securities below their cost that are other than temporary result in a write-down of the individual security to its fair market value;
write-downs are reflected in earnings as a realized loss on available-for-sale securities. Factors affecting the determination of whether an other-than-temporary impairment has occurred include a downgrading of the security by a rating agency, a
significant deterioration in the financial condition of the issuer, or that management would not have the intent or ability to hold a security for a period of time sufficient to allow for any anticipated recovery in fair value.



25



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KH Funding Company



Notes to Financial Statements



For the Years Ended December 31, 2004 and 2003



NOTE ASUMMARY OF SIGNIFICANT POLICIESContinued



Earnings Per Share



Basic earnings per share is derived by dividing net income available to common stockholders by the weighted-average number of common shares outstanding and does not include the effect of any potentially dilutive
common stock equivalents. Diluted earnings per share is derived by dividing net income by the weighted-average number of shares outstanding, adjusted for the dilutive effect of outstanding stock options. For this calculation the effect of 311,250
options have been excluded for 2004 as their effect is antidilutive.



|                                                 |  |      |           |   |      |   |          
|------------------------------------------------ |  | ---- | --------- | - | ---- | - | ---------
|For the year ended December 31,                  |  | 2004 |           |   | 2003
|Basic:                                           |  |      |           |   |      |   |          
|Net (loss) income (attributable to common stock) |  | $    | (97,473   | ) |      | $ | 4,166    
|Average common shares outstanding                |  |      | 2,495,311 |   |      |   | 2,238,786
|Basic earnings per share                         |  | $    | (0.04     | ) |      | $ |         
|                                                 |  |     
|Diluted:                                         |  |      |           |   |      |   |          
|Net (loss) income (attributable to common stock) |  | $    | (97,473   | ) |      | $ | 4,166    
|Average common shares outstanding                |  |      | 2,495,311 |   |      |   | 2,238,786
|Dilutive effect of stock options                 |  |      |          |   |      |   | 10,000   
|Average common shares outstanding  diluted      |  |      | 2,500,181 |   |      |   | 2,248,786
|Diluted earnings per share                       |  |      | (0.04     | ) |      | $ |         



Stock Based
Compensation



SFAS No. 123, Accounting for
Stock-Based Compensation, as amended by SFAS No. 148, requires that stock-based compensation be accounted for on the fair-value method as described in SFAS No. 123, or on the intrinsic value-based method of Accounting Principles Board (APB)
Opinion No. 25, whereby if options are priced at or above the fair value on the date of grant, no compensation expense is recognized by the Company as a result of the options. If the intrinsic value-based method is used, proforma net income must be
disclosed as if the fair value-based method had been applied. The Company continues to account for its employee stock options in accordance with APB Opinion No. 25.



Fair value of options are computed using the Minimum Value Method. A risk-free rate of 3.58% and 3.08% was used for 2004 and
2003, respectively, and a 5-year expected life of the options was used for both years. Zero volatility was used as the Companys shares are not publicly listed or traded. A dividend of $0.15 per share per year paid quarterly is assumed.



The following table summarizes information and presents the
tabular information required under FAS 148. The Company is an S Corporation and there is no tax effect on the numbers presented in this table.



26



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KH Funding Company



Notes to Financial Statements



For the Years Ended December 31, 2004 and 2003



|                                                                    |  |      |          |   |      |   |      
|------------------------------------------------------------------- |  | ---- | -------- | - | ---- | - | -----
|For the years ended December 31,                                    |  | 2004 |          |   | 2003
|Net (loss) income  as reported                                     |  | $    | (97,473  | ) |      | $ | 4,166
|Deduct  total stock-based compensation determined under fair value |  |      |          |   |      |   |      
|                                                                    |  |     
|Based method for all awards                                         |  | $    | (117,967 | ) |      | $ |     
|                                                                    |  |      |          |   |      |   |      
|Pro forma net (loss) income                                         |  | $    | (215,440 | ) |      | $ | 4,166
|                                                                    |  |      |          |   |      |   |      
|Loss per share:                                                     |  |      |          |   |      |   |      
|Basic  as reported                                                 |  | $    | (.04     | ) |      | $ |     
|Basic  pro forma                                                   |  | $    | (.09     | ) |      | $ |     
|Diluted  as reported                                               |  | $    | (.04     | ) |      | $ |     
|Diluted  pro forma                                                 |  | $    | (.09     | ) |      | $ |     



Real Estate
Owned



Real estate owned represents property acquired
by foreclosure, deed in lieu of foreclosure or purchase and is initially recorded at the lower of cost or fair market value at the date of acquisition. Costs relating to the improvements of the property are capitalized. Holding costs are charged to
expense as incurred. Subsequent to the foreclosure the property is advertised for rent or sale. Management makes the determination of whether to hold, rent or to sell the property on a case-by-case basis. Buildings for rental property are
depreciated over 30.5 years.



Statement of Cash
Flows



For purposes of the statement of cash flows,
the Company considers all highly liquid debt instruments with maturity of three months or less to be cash equivalents.



Use of Estimates in Preparing Financial Statements



In preparing financial statements in conformity with accounting principles generally accepted in the United States of America, management is required
to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and revenue and expenses during the reporting period. Actual
results could differ from those estimates.



Comprehensive
Income



Comprehensive income includes all changes in
stockholders equity during a period, except those relating to investments by and distributions to stockholders. Our comprehensive income consists of net earnings and unrealized gains and losses on investments available-for-sale. Accumulated
other comprehensive income is displayed as a separate component of stockholders equity.



Reclassification



Certain reclassifications have been made to the 2003 financial statements to conform with the 2004 presentation.



27



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KH Funding Company



Notes to Financial Statements



For the Years Ended December 31, 2004 and 2003



NOTE B - LOANS RECEIVABLE



Loans receivable
consist of 204 collateralized loans and 7 uncollateralized loans for 2004 and 235 collateralized loans and 8 uncollateralized loans for 2003. The loans receivable originate from various individuals and businesses ranging in balance from $501 to
$993,999 for 2004 and $147 to $706,442 for 2003, bearing interest rates ranging from 3 percent to 24 percent in 2004 and from 3 percent to 24 percent in 2003, with a weighted-average yield of 10.89 percent and 10.74 percent, respectively.
Uncollateralized loans constitute approximately 0.7 percent and 0.9 percent of the gross loan value at December 31, 2004 and 2003, respectively.



Loans Receivable by Collateral Type



The Companys loans receivable portfolio consists of the following by type of loans at December 31:



|                                      |  |        |            |   |        |   |            |  
|------------------------------------- |  | ------ | ---------- | - | ------ | - | ---------- | -
|                                      |  | 2004   |            |   | 2003   |  
|Primary Collateral Type               |  | Amount |            |   | Amount |  
|Residential Real Estate First Trust   |  | $      | 4,251,283  |   |        | $ | 5,140,758  |  
|Collateralized by Business Assets     |  |        | 4,424,12   |   |        |   | 3,610,141  |  
|Collateralized by Investment Property |  |        | 9,543,663  |   |        |   | 5,285,001  |  
|Residential Real Estate Second Trust  |  |        | 1,116,984  |   |        |   | 1,073,275  |  
|Other Assets (Auto, Stock)            |  |        | 1,013,265  |   |        |   | 45,539     |  
|Other Loans                           |  |        | 150,870    |   |        |   | 167,708    |  
|                                      |  |        |            |   |        |   |            |  
|Total loans receivable, gross         |  | $      | 20,500,177 |   |        | $ | 15,922,424 |  
|                                      |  |       
|Plus late charges allowed             |  |        | 20,627     |   |        |   | 23,797     |  
|Less/plus unposed payments            |  |        | (22,488    | ) |        |   | 4,693      |  
|Less unamortized loan fees            |  |        | (120,207   | ) |        |   | (149,388   | )
|Less allowance for loan losses        |  |        | (233,311   | ) |        |   | (211,000   | )
|                                      |  |        |            |   |        |   |            |  
|Total loans receivable, net           |  | $      | 20,144,798 |   |        | $ | 15,590,526 |  
|                                      |  |        |            |   |        |   |            |  



Maturities as of
December 31, 2004, are as follows:



|                         |  |   |           
|------------------------ |  | - | ----------
|Year ending December 31, |  |  
|2005                     |  | $ | 11,062,696
|2006                     |  |   | 2,101,356 
|2007                     |  |   | 1,519,677 
|2008                     |  |   | 583,699   
|2009                     |  |   | 1,057,065 
|2010 and thereafter      |  |   | 4,175,684 
|                         |  |   |           
|Total loansgross        |  |   | 20,500,177
|                         |  |   |           



The carrying values of the loans
receivable approximate their fair value.



28



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KH Funding Company



Notes to Financial Statements



For the Years Ended December 31, 2004 and 2003



NOTE B - LOANS RECEIVABLE - continued



Analysis of the allowance for loan loss is as follows:



|                                         |  |      |          |   |      |   |          |  
|---------------------------------------- |  | ---- | -------- | - | ---- | - | -------- | -
|Year ending December 31,                 |  | 2004 |          |   | 2003 |  
|Beginning balance                        |  | $    | 211,000  |   |      | $ | 175,899  |  
|Provision for loan losses                |  |      | 266,700  |   |      |   | 146,379  |  
|Loans charged off                        |  |      | (249,189 | ) |      |   | (116,093 | )
|Recovery of loans previously charged off |  |      | 4,800    |   |      |   | 4,815    |  
|                                         |  |      |          |   |      |   |          |  
|                                         |  | $    | 233,311  |   |      | $ | 211,000  |  
|                                         |  |      |          |   |      |   |          |  



Loans in non-accrual status totaled
$583,351 and $441,474 at December 31, 2004 and 2003, respectively.



As of
December 31, 2004 and 2003, the Company had loans of $2,109,236 and $2,282,688, respectively, which were more than ninety days late and for which the company continues to accrue interest. The Company has collateral for these loans and management
believes that both the principal and interest is collectible.



Analysis of
impaired loans and associated reserves:



|                                                                                                                  |  |          |         |          |   |        
|----------------------------------------------------------------------------------------------------------------- |  | -------- | ------- | -------- | - | -------
|                                                                                                                  |  | 12/31/04 |         | 12/31/03
|Total recorded investment in impaired loans at the end of the period                                              |  | $        | 583,351 |          | $ | 441,474
|Amount of that recorded investment for which there is a related allowance for credit losses                       |  | $        | 516,126 |          | $ | 163,631
|Amount of related allowance for credit losses associated with such investment                                     |  | $        | 175,117 |          | $ | 120,307
|Amount of that recorded investment for which there is no related allowance for credit losses                      |  | $        | 67,225  |          | $ | 277,843
|                                                                                                                  |  |         
|                                                                                                                  |  | 12/31/04 |         | 12/31/03
|The average recorded investment in impaired loans during the period.                                              |  | $        | 512,412 |          | $ | 308,436
|The related amount of interest income recognized within that period when the loans were impaired.                 |  | $        | -0-     |          | $ | -0-    
|The amount of income recognized using a cash basis during the time within that period that the loan was impaired. |  | $        | -0-     |          | $ | -0-    



At December 31, 2004
the Company had outstanding loan balances to one borrower and its affiliated entities of $2,978,000 which represented 15% of loans outstanding at that date. Management believes that this concentration is adequately collateralized with first deeds of
trust on related real estate.



29



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KH Funding Company



Notes to Financial Statements



For the Years Ended December 31, 2004 and 2003



NOTE CNOTES PAYABLE, INTEREST EXPENSE AND TYPES OF NOTES



Information related to notes payable at December 31, 2004 and 2003 is as follows:



|                                         |  |      |            |   |      |   |            |  
|---------------------------------------- |  | ---- | ---------- | - | ---- | - | ---------- | -
|                                         |  | 2004 |            |   | 2003 |  
|Number of notes payable                  |  |      | 518        |   |      |   | 309        |  
|Highest balance                          |  | $    | 1,355,265  |   |      | $ | 2,138,712  |  
|Lowest balance                           |  | $    | 102        |   |      | $ | 20         |  
|Lowest interest rate                     |  |      | 4.00       | % |      |   | 3.20       | %
|Highest interest rate                    |  |      | 9.85       | % |      |   | 9.875      | %
|Weighted average interest rate           |  |      | 5.69       | % |      |   | 6.0        | %
|Number of accounts greater than $100,000 |  |      | 52         |   |      |   | 39         |  
|Value of accounts over $100,000          |  | $    | 16,153,262 |   |      | $ | 15,114,067 |  



The fair value of all
notes payable is estimated to be $24,661,572 at December 31, 2004 and $19,947,114 at December 31, 2003. This estimate is based on discounted cash flow using the most recent interest rate for loans, and assuming a mid-year payoff of such notes in the
year due. Notes payable are collateralized by the loans receivable. Maturities as of December 31, 2004, are as follows:



|                         |  |   |           
|------------------------ |  | - | ----------
|Year ending December 31, |  |  
|2005                     |  | $ | 16,299,360
|2006                     |  |   | 2,670,997 
|2007                     |  |   | 3,330,398 
|2008                     |  |   | 1,010,740 
|2009                     |  |   | 1,425,702 
|2010                     |  |   | 80,206    
|                         |  |   |           
|                         |  | $ | 24,817,403
|                         |  |   |           



The maturity date is
considered to be the date on which the note first becomes a demand note. Included in the due-in-2005 category is $3,975,296 on one-day demand accounts, which the creditor can withdraw by check and $5,311,854 that requires a 30-day notice before
withdrawal can be made.



The Company has three classes of
notes payable, Series II, III and IV notes. Series II notes were sold in private offerings by the Company from inception through November 2, 2003. On November 3, 2003 the Company registered a Public Offering with the Securities and Exchange
Commission. Subsequent to the November 3, 2003 offering the Company registered a second Public Offering with the Securities and Exchange Commission on August 2, 2004. The Series III and IV notes were sold under the public offerings. The Series III
notes are senior to all other debt of the company and are secured with a priority lien on the assets of the Company. The Series IV notes join the Series II notes in right of payment and both are subordinate to senior debt of the Company.



As of December 31, 2004, notes payable outstanding by class of securities
is as follows:



|           |  |                                    |  |   |           
|---------- |  | ---------------------------------- |  | - | ----------
|Series II  |  | Privately issued subordinated debt |  | $ | 7,726,567 
|Series III |  | Publicly issued senior debt        |  |   | 14,263,633
|Series IV  |  | Publicly issued subordinated debt  |  |   | 2,827,203 
|           |  |                                    |  |   |           
|           |  |                                    |  | $ | 24,817,403
|           |  |                                    |  |   |           



30



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KH Funding Company



Notes to Financial Statements



For the Years Ended December 31, 2004 and 2003



NOTE CNOTES PAYABLE, INTEREST EXPENSE AND TYPES OF NOTES - continued



For the year ended December 31, 2004 and 2003, interest expense totaled $1,224,076 and $1,134,445, respectively, and interest paid totaled $619,992 and $565,590, respectively.



NOTE DMARKETABLE SECURITIES



Marketable securities consists of the following at December 31:



|                  |  |                 |         |        |   |                             |  |   |                 |   |        |   |                             |  |   |           |  |   |       
|----------------- |  | --------------- | ------- | ------ | - | --------------------------- |  | - | --------------- | - | ------ | - | --------------------------- |  | - | --------- |  | - | ------
|                  |  |                 |         | 2004   |   |                             |  |   |                 |   | 2003   |   |                            
|                  |  | Amortized Costs |         | Market |   | Gross Unrealized Gain(loss) |  |   | Amortized Costs |   | Market |   | Gross Unrealized Gain(loss)
|Corporate Bonds   |  | $               | 632,211 |        | $ | 623,287                     |  | $ | (8,824          | ) |        | $ | 2,453,924                   |  | $ | 2,481,572 |  | $ | 27,647
|Money Market Fund |  |                 | 34,862  |        |   | 34,861                      |  |   |                |   |        |   | 39,377                      |  |   | 39,377    |  |   |      
|Totals            |  | $               | 667,073 |        | $ | 658,248                     |  | $ | (8,824          | ) |        | $ | 2,449,281                   |  | $ | 2,520,949 |  | $ | 27,647



All of the corporate
bonds outstanding at December 31, 2004 mature in between one and five years.



Information related to the sale of marketable securities during the years ended December 31, 2004 and 2003 is as follows:



|               |  |      |           |   |      |   |           |  
|-------------- |  | ---- | --------- | - | ---- | - | --------- | -
|               |  | 2004 |           |   | 2003 |  
|Gross proceeds |  | $    | 2,484,950 |   |      | $ | 1,154,076 |  
|Gross gains    |  | $    | 21,795    |   |      | $ | 9,243     |  
|Gross losses   |  | $    | (3,219    | ) |      | $ | (2,541    | )



NOTE E  OTHER INVESTMENTS



The Company has invested excess funds in a number of development stage
companies. Because the Company maintains a minority position in these investments and cannot exert control the investments are accounted for under the cost method of accounting whereby only cash transactions effect the carrying value. There is no
readily determinable market value for these investments. Management periodically reviews their status to determine if there has been any impairment to their value.



During 2004, the Company determined that one of these investments was worthless and recognized an impairment loss of $33,000. The carrying
value of other investments was $158,872 and $191,872 at December 31, 2004 and 2003, respectively.



NOTE FWARRANTS, OPTIONS AND OTHER STOCK ISSUED



Stock Option Plans



The Company
has granted stock options to employees, shareholders and board members. All options granted vest on the day they are granted. The Company has the following stock options outstanding:



Original Shareholder OptionsThe five original shareholders were granted options on July 1, 1994, to purchase additional shares
of common stock up to 50 percent of their original purchase at $1.00 per share. Granted options allowed the purchase of an additional 235,500 shares of common stock. All of these options were exercised before December 31, 2004.



31



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KH Funding Company



Notes to Financial Statements



For the Years Ended December 31, 2004 and 2003



Other Stock OptionsDuring fiscal year 1999 the Company granted options to purchase 201,250 shares of common stock at $2.00 per share. These options expired in 2004. During fiscal year 2000 the Company granted options to
purchase 50,000 shares of common stock at $2.00 per share in connection with the issuance of a note payable. The options expire in five years, in 2005. During fiscal year 2002 the Company granted options to purchase 100,000 shares of common stock at
$2.00 a share. During 2004 the Company granted options to purchase 161,250 shares of common stock at $2.00 per share.



The following depicts option activity for the years ended December 31, 2004 and 2003:



|                                        |  |                 |   |  |                                |      |       |   |          
|--------------------------------------- |  | --------------- | - |  | ------------------------------ | ---- | ----- | - | ---------
|                                        |  | Number ofShares |   |  | Weighted-AverageExercise Price |      | Range
|Options outstanding at end of year2002 |  | 398,939         |   |  | $                              | 1.95 |       | $ | 1.002.00
|Options granted2003                    |  |                |   |  |                                |     |       |   |         
|Options expired2003                    |  | (27,689         | ) |  |                                | 2.00 |       |   | 2.00     
|                                        |  |                 |   |  |                                |      |       |   |          
|Options outstanding at end of year 2003 |  | 371,250         |   |  |                                | 1.96 |       |   | 1.002.00
|Options granted2004                    |  | 161,250         |   |  |                                | 2.00 |       |   | 2.00     
|Options expired2004                    |  | (201,250        | ) |  |                                | 2.00 |       |   | 2.00     
|Options exercised-2004                  |  | (20,000         | ) |  |                                | 1.00 |       |   | 1.00     
|                                        |  |                 |   |  |                                |      |       |   |          
|Options outstanding at end of year2004 |  | 311,250         |   |  | $                              | 2.00 |       | $ | 2.00     
|                                        |  |                 |   |  |                                |      |       |   |          



At December 31, 2003 all of the
Companys outstanding options were exercisable. The weighted average exercise price of these options is $2.00 and the weighted average remaining contractual life in years is 3.5.



NOTE GPROPERTY AND EQUIPMENT



Property and equipment consists of the following as of December 31:



|                               |  |      |         |      |   |        
|------------------------------ |  | ---- | ------- | ---- | - | -------
|                               |  | 2004 |         | 2003
|Furniture and equipment        |  | $    | 53,025  |      | $ | 53,025 
|Automobiles                    |  |      | 27,074  |      |   | 27,074 
|Computer software              |  |      | 73,266  |      |   | 57,583 
|                               |  |      |         |      |   |        
|                               |  |      | 153,365 |      |   | 137,682
|Less: Accumulated depreciation |  |      | 119,610 |      |   | 98,560 
|                               |  |      |         |      |   |        
|                               |  | $    | 33,755  |      | $ | 39,122 
|                               |  |      |         |      |   |        



32



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KH Funding Company



Notes to Financial Statements



For the Years Ended December 31, 2004 and 2003



Depreciation expense related to property and equipment for the years ended December 31, 2004 and 2003, totaled $21,050 and $21,008, respectively.



NOTE HREAL ESTATE OWNED



Real estate owned currently consists of rental and held for sale real estate.



|                               |  |      |         |      |   |        
|------------------------------ |  | ---- | ------- | ---- | - | -------
|                               |  | 2004 |         | 2003
|Rental property:               |  |      |         |      |   |        
|Buildings                      |  | $    | 668,087 |      | $ | 775,974
|Less: Accumulated depreciation |  |      | 61,864  |      |   | 66,952 
|                               |  |      |         |      |   |        
|                               |  |      | 606,223 |      |   | 709,022
|Landrental property           |  |      | 103,750 |      |   | 154,750
|                               |  |      |         |      |   |        
|Total Rental                   |  | $    | 709,973 |      | $ | 863,772
|                               |  |      |         |      |   |        
|Held for resale:               |  |      |         |      |   |        
|Buildings                      |  | $    | -0-     |      | $ | 136,482
|Landheld for resale           |  |      | -0-     |      |   | 14,000 
|                               |  |      |         |      |   |        
|Total held for Resale          |  | $    | -0-     |      | $ | 150,482
|                               |  |      |         |      |   |        



Depreciation expense
related to rental property for the years ended December 31, 2004 and 2003, totaled $25,201 and $28,314, respectively.



NOTE IRELATED PARTY TRANSACTIONS



The following related party transactions exist as of the dates shown below:



| |  |  | Included in loans receivable at December 31, 2004 and 2003, are eight notes and six notes totaling $1,833,611 and $856,798, respectively, from officers, stockholders and a company
controlled by an officer.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Included in the notes payable balance at December 31, 2004 and 2003, are 52 and 49 notes totaling $5,389,637 and $5,508,831, respectively, which are held by shareholders.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | A director of our company is a broker at the firm through which we purchase our marketable securities (bonds). He earns one sixteenth of one percent per purchase for providing this
service. In 2004, he earned approximately $400 on our trades and in 2003 approximately $2,500.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | There is a loan of $185,450, shown on the Balance Sheet as a contra-equity, made to the Companys CEO for the purchase of 100,000 shares of stock in the Company. The interest
rate on this loan is seven percent. The stock has a book value of about $47,900 as of December 31, 2004. Accrued interest receivable on this loan totals $69,800 at December 31, 2004.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



33



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KH Funding Company



Notes to Financial Statements



For the Years Ended December 31, 2004 and 2003



All of the above transactions were consummated on substantially the same terms, including interest rates and collateral, as those prevailing for comparable transactions with other customers.



34



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KH Funding Company



Notes to Financial Statements



For the Years Ended December 31, 2004 and 2003



NOTE JCOMMITMENTS AND CONTINGENCIES



Lease Commitment



The Company leases
office space under a non-cancelable-operating lease expiring October 31, 2008. The following is a schedule by years of approximate future minimum payments under the lease as of December 31, 2004:



|                         |  |   |        
|------------------------ |  | - | -------
|Year ending December 31, |  |  
|2005                     |  | $ | 43,450 
|2006                     |  |   | 45,622 
|2007                     |  |   | 47,903 
|2008                     |  |   | 41,569 
|Thereafter               |  |   |       
|                         |  |   |        
|Total                    |  | $ | 178,544



Rent expense under
operating leases totaled $43,001 and $40,967 for the years ended December 31, 2004 and 2003, respectively.



NOTE KOTHER LOANS PAYABLE



As of December 31, 2003 the Company had borrowed $1,300,000 on its margin account which is collaterized by its marketable securities. The interest rate on this account is variable and as of December 31, 2003 was 3.25%. As of December 31,
2004 the Company had no outstanding balance in its brokerage margin account.



NOTE LLOAN PARTICIPATION



There was one
loan as of December 31, 2004 of $207,009, and as of December 31, 2003 of $211,272, one-half owned by a participant in the loan. The Company services the loan for no charge and both the Company and the participant have equal parity in the ownership
of the loan.



35



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KH Funding Company



Notes to Financial Statements



For the Years Ended December 31, 2004 and 2003



NOTE MTRUST ACTIVITIES



The Company
became a trustee of IRA accounts in February 2003. The IRA accounts are self-directed. A portion of the assets under the trust have been invested in notes payable of the Company. As a trustee, the Company is subject to Section 1.408-2(e) of the
Internal Revenue Code and is subject to reviews by IRS examiners. No such reviews have occurred in 2004 or 2003.



|                                                       |  |      |           |      |   |          
|------------------------------------------------------ |  | ---- | --------- | ---- | - | ---------
|                                                       |  | 2004 |           | 2003
|Total Assets Under Trust                               |  | $    | 2,167,256 |      | $ | 1,299,208
|Portion of Assets Invested in KH Funding Notes Payable |  |      | 2,024,117 |      |   | 1,156,069
|Portion of Assets Invested in Outside Investments      |  |      | 218,139   |      |   | 143,139  



NOTE N  RECENT ACCOUNTING
PRONOUNCEMENTS



In December 2004, the Financial Accounting Standards Board
(FASB) issued SFAS No. 153, Exchanges of Nonmonetary Assets, an amendment of APB Opinion No.29, Accounting for Nonmonetary Transactions. This statement amends the principle that exchanges of nonmonetary assets should be
measured based on the fair value of the assets exchanged and more broadly provides for exceptions regarding exchanges of nonmonetary assets that do not have commercial substance. This Statement is effective for nonmonetary asset changes occurring in
fiscal periods beginning after June 15, 2005. The adoption of this standard is not expected to have a material impact on financial condition, results of operations, or liquidity.



In December 2004, FASB issued SFAS No. 123R, Share-Based Payment, which is a revision of SFAS No. 123, Accounting for
Stock Issued for Employees. SFAS No. 123R requires that all share-based payments to employees, including grants of employee stock options, be valued at fair value on the grant date and be expensed over the applicable vesting period. SFAS No.
123R is effective for the Company on July 1, 2005. The Company will transition to SFAS No. 123R using the modified prospective application. Under the modified prospective application, compensation costs will be recognized in
the financial statements for all new share-based payments granted after January 1, 2005. Additionally, the Company will recognize compensation costs for the portion of previously granted awards for which the requisite service has not been rendered
(nonvested awards) that are outstanding as of January 1, 2005 over the remaining requisite service period of the awards. The compensation expense to be recognized for the nonvested awards will be based on the fair value of the awards.
The Company is in the process of analyzing the effects of the impact of this standard on its operations.



In November 2003 the Emerging Issues Task Force (EITF) of the Financial Accounting Standards Board (FASB) issued EITF Abstract 03-1, The Meaning of Other-Than-Temporary Impairment and its
Application to Certain Investments (EITF 03-1) effective for fiscal year ending after December 15, 2003. The abstract provides guidelines on the meaning of other than-temporary impairment and its application to investments in
addition to requiring quantitative and qualitative disclosures in the financial statements. The Company has implemented the guidelines of this Consensus. The adoption of this Consensus did not have any impact on the Companys financial
condition, results of operations, or liquidity.



36



---

ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.



None.



ITEM 8A. CONTROLS AND PROCEDURES



Evaluation of Disclosure Controls and Procedures.Our Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness of the
design and operation of our disclosure controls and procedures in accordance with Rule 13a-14 of the Securities Exchange Act of 1934 (the Exchange Act). Based on their evaluation, the Chief Executive Officer and Chief Financial Officer
concluded that, as of the end of the period covered by this report, our disclosure controls and procedures were effective in enabling us to record, process, summarize and report in a timely manner the information required to be disclosed in reports
we file under the Exchange Act.



Changes in Internal
Controls. No change in our internal control over financial reporting occurred during our fourth quarter of 2004 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.



Limitations on the Effectiveness of Controls. KH
Fundings management, including the Chief Executive Officer and Chief Financial Officer, does not expect that its disclosure or internal controls will prevent all errors or fraud. A control system, no matter how well conceived and operated, can
provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered
relative to their costs. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.



ITEM 8B. OTHER INFORMATION.



None.



37



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PART III



ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE WITH SECTION 16(A) OF THE EXCHANGE ACT



Directors and Executive Officers. Information regarding our directors
and executive officers is incorporated by reference from certain pages of our definitive Proxy Statement filed with the Securities and Exchange Commission in connection with our 2005 Annual Meeting.



Audit Committee. Information regarding our Audit Committee is
incorporated by reference from certain pages of our definitive Proxy Statement filed with the Securities and Exchange Commission in connection with our 2005 Annual Meeting.



Audit Committee Financial Expert. Rules recently adopted by the Securities and Exchange Commission (the
SEC) require that we disclose whether our Board of Directors has determined that our Audit Committee includes a member who qualifies as an audit committee financial expert as that term is defined in the SECs rules. To
qualify as an audit committee financial expert under the SECs rules, a person must have a relatively high level of accounting and financial knowledge or expertise which he or she has acquired through specialized education or training or
through experience in certain types of positions. Messers. Connor and Shapiro are each an audit committee financial expert as that term is defined in Item 401 of Regulation S-B and by the listing standards of the American Stock Exchange.



Compliance with Section 16(a) of the Securities Exchange
Act of 1934. Information regarding compliance by our directors, executive officers and principal shareholders with the reporting requirements of Section 16(a) of the Securities Exchange Act of 1934 is incorporated by reference from certain pages
of our definitive Proxy Statement filed with the Securities and Exchange Commission in connection with our 2005 Annual Meeting.



Code of Ethics. Our Board of Directors has adopted a Code of Ethics that applies to our directors and to all our executive officers, including
without limitation our principal executive officer and principal financial officer. A copy of our Code of Ethics will soon be posted on our website, www.khfunding.com. In addition, a copy will be provided without charge to any person upon request.
Requests for copies of our Code of Ethics should be sent by mail to Corporate Secretary at KH Funding, 10801 Lockwood Drive, Suite 370, Silver Spring, Maryland 20901, or by telephone to (301) 592-8100.



ITEM 10. EXECUTIVE COMPENSATION



Information regarding compensation paid to our executive officers and
directors is incorporated by reference from certain pages of our definitive Proxy Statement filed with the Securities and Exchange Commission in connection with our 2005 Annual Meeting.



ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS



Beneficial Ownership of Securities. Information regarding the
beneficial ownership of our common stock by our directors, executive officers and principal shareholders is incorporated by reference from certain pages of our definitive Proxy Statement filed with the Securities and Exchange Commission in
connection with our 2005 Annual Meeting.



ITEM 12. CERTAIN RELATIONSHIPS AND
RELATED TRANSACTIONS



Information regarding transactions
between us and our directors and executive officers is incorporated by reference from certain pages of our definitive Proxy Statement filed with the Securities and Exchange Commission in connection with our 2005 Annual Meeting.



38



---

ITEM 13. EXHIBITS



|(a) | Exhibits. The following exhibits are filed with or incorporated by reference into this report.
|--- | ----------------------------------------------------------------------------------------------



|     |  |                                                                                                                                                                                                               
|---- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|3.1  |  | Articles of Incorporation of KH Funding Company (Incorporated by reference from Exhibits to our Registration Statement on Form SB-2, Registration File No. 333-106501)                                        
|     | 
|3.2  |  | Articles of Amendment of KH Funding Company (Incorporated by reference from Exhibits to our Registration Statement on Form SB-2, Registration File No. 333-106501)                                            
|     | 
|3.3  |  | Bylaws of KH Funding Company (Incorporated by reference from Exhibits to our Registration Statement on Form SB-2, Registration File No. 333-106501)                                                           
|     | 
|10.1 |  | 1998 Stock Incentive Plan (Incorporated by reference from Exhibits to our Registration Statement on Form SB-2, Registration File No. 333-106501)                                                              
|     | 
|10.2 |  | Selling Agreement by and between KH Funding Company and Capital Financial Services Inc. (Incorporated by reference from Exhibits to our Registration Statement on Form SB-2, Registration File
No. 333-117038)
|     | 
|10.3 |  | Selling Agreement by and between KH Funding Company and Spencer Edwards, Inc.                                                                                                                                 
|     | 
|21   |  | List of Subsidiaries                                                                                                                                                                                          
|     | 
|23   |  | Consent of Stegman & Co.                                                                                                                                                                                      
|     | 
|31.1 |  | Certification by the Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                                                                        
|     | 
|31.2 |  | Certification by the Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                                                                        
|     | 
|32.1 |  | Certification by the Chief Executive Officer Pursuant to 18 U.S.C. Section 1350 Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                                                             
|     | 
|32.2 |  | Certification by the Chief Financial Officer Pursuant to 18 U.S.C. Section 1350 Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                                                             
|     | 
|99*  |  | Or definitive Proxy Statement filed with the Securities and Exchange Commission in connection with our 2005 Annual Meeting                                                                                    

---

|* | Being filed separately.
|- | -----------------------



Item 14. Principal Accountant Fees and Services



Information regarding services provided to us by our independent accountants is incorporated by reference from certain pages of our definitive Proxy Statement filed with the Securities and Exchange Commission in
connection with our 2005 Annual Meeting.



39



---

SIGNATURES



In accordance with Section 13 or 15(d) of the Securities Exchange Act of 1934, we have caused this Report to be signed on our behalf by the
undersigned, thereunto duly authorized.



|                      |  |                    |  |                                      
|--------------------- |  | ------------------ |  | -------------------------------------
|Dated: April 15, 2004 |  | KH FUNDING COMPANY
|                      |  |                   
|                      |  | By:                |  | /s/ Robert L. Harris                 
|                      |  |                    |  | Robert L. Harris,                    
|                      |  |                    |  | President and Chief Executive Officer



In accordance with
Section 13 or 15(d) of the Securities Exchange Act of 1934, this Report has been signed by the following persons on our and in the capacities as of April 15, 2004.



|                       |  |                                                 
|---------------------- |  | ------------------------------------------------
|Name                   |  | Title                                           
|/s/ Robert L. Harris   |  | President, Chief Executive Officer and Director 
|Robert L. Harris       |  |                                                 
|                       | 
|/s/ Louise B. Sehman   |  | Chief Financial Officer, Secretary and Treasurer
|Louise B. Sehman       |  |                                                 
|                       | 
|/s/ Jack Breskow       |  | Director                                        
|Jack Breskow           |  |                                                 
|                       | 
|/s/ Jeremiah A. Connor |  | Director                                        
|Jeremiah A. Connor     |  |                                                 
|                       | 
|/s/ Dr. Mervyn Feldman |  | Director                                        
|Dr. Mervyn Feldman     |  |                                                 
|                       | 
|/s/ Solomon Kaspi      |  | Director                                        
|Solomon Kaspi          |  |                                                 
|                       | 
|/s/ Jin S. Kim         |  | Director                                        
|Jin S. Kim             |  |                                                 
|                       | 
|/s/ Alvin Shapiro      |  | Director                                        
|Alvin Shapiro          |  |                                                 



---

EXHIBIT INDEX



|     |  |                                                                                                                                                                                                               
|---- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|3.1  |  | Articles of Incorporation of KH Funding Company (Incorporated by reference from Exhibits to our Registration Statement on Form SB-2, Registration File No. 333-106501)                                        
|     | 
|3.2  |  | Articles of Amendment of KH Funding Company (Incorporated by reference from Exhibits to our Registration Statement on Form SB-2, Registration File No. 333-106501)                                            
|     | 
|3.3  |  | Bylaws of KH Funding Company (Incorporated by reference from Exhibits to our Registration Statement on Form SB-2, Registration File No. 333-106501)                                                           
|     | 
|10.1 |  | 1998 Stock Incentive Plan (Incorporated by reference from Exhibits to our Registration Statement on Form SB-2, Registration File No. 333-106501)                                                              
|     | 
|10.2 |  | Selling Agreement by and between KH Funding Company and Capital Financial Services Inc. (Incorporated by reference from Exhibits to our Registration Statement on Form SB-2, Registration File
No. 333-117038)
|     | 
|10.3 |  | Selling Agreement by and between KH Funding Company and Spencer Edwards, Inc.                                                                                                                                 
|     | 
|21   |  | List of Subsidiaries                                                                                                                                                                                          
|     | 
|23   |  | Consent of Stegman & Co.                                                                                                                                                                                      
|     | 
|31.1 |  | Certification by the Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                                                                        
|     | 
|31.2 |  | Certification by the Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                                                                        
|     | 
|32.1 |  | Certification by the Chief Executive Officer Pursuant to 18 U.S.C. Section 1350 Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                                                             
|     | 
|32.2 |  | Certification by the Chief Financial Officer Pursuant to 18 U.S.C. Section 1350 Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                                                             
|     | 
|99*  |  | Or definitive Proxy Statement filed with the Securities and Exchange Commission in connection with our 2005 Annual Meeting                                                                                    

---

|* | Being filed separately.
|- | -----------------------