Using Reserve Account Funds Appropriately
Q: I’m a new board member on my community association’s board of directors, and I’m getting up to speed on association issues. There has been some discussion about whether it’s appropriate to borrow from our reserve account. What is a reserve account, and what are some guidelines for using its funds?
A: A reserve account is an account specifically designed to pay for common elements for which a useful life can be estimated—for example, the replacement of an existing swimming pool, tennis court, or clubhouse roof. It’s not intended to fund everyday needs that are covered by the community’s general operating account. Reserve account funds are part of any association’s long-term financial plan, which helps to strengthen the community’s fiscal health and increase the homes’ market values, and allows boards to fulfill their fiduciary responsibilities.
A well-funded reserve account clearly signifies that a community association is equipped to deal with its long-range needs. Without a well-funded reserve account, an association’s only option to pay for repair needs that arise may be to impose a special assessment, which some members may feel is unfair because it penalizes those members who happen to live in the community when these predictable expenses become due.
There are several proper uses of reserve account funds. For example, with the proper establishment of a reserve account, income taxes can be reduced and an association can assure that every present and future member pays a fair share of required future capital expenditures. To determine how much to fund a reserve account, the board should hire an engineer to prepare a replacement study that will project the repair and replacement needs and costs of the association’s common elements.
Once funded, the reserve account should generally be tapped only to pay for items listed in the replacement study—with certain exceptions. To use the reserve account appropriately, follow these guidelines:
Guideline #1: Charge capital items from most recent replacement study to reserve account. If an item’s actual cost is significantly greater, or the useful life is shorter, than estimated, then the engineer should be consulted to update the replacement study as quickly as possible to reflect this transaction’s impact. The updated study should be integrated into the coming year’s budget.
Guideline #2: Charge capital items excluded from replacement study to reserve account. Since engineering studies only estimate the common elements’ replacement costs, certain items may have been missed during the preparation of the engineer’s report, or the costs and conditions of an item’s replacement may have changed over time. An association should recoup both the element’s replacement cost and the deficit created by the unexpected expenditure through an increased replacement contribution level.
Guideline #3: Don’t charge minor repairs to reserve account. These should be funded through the operating budget. Associations should define thresholds for “minor” and “major” repairs with their managing agent and accountant.
Guideline #4: Don’t charge maintenance costs to reserve account; establish separate fund. A deferred maintenance fund should provide for the periodic maintenance of items, such as painting, caulking, and power washing. It would be inappropriate to use the reserve account for these types of maintenance expenditures. Boards should establish a deferred maintenance fund for the maintenance of items that don’t recur annually.
Guideline #5: Charge developer transition-related items to reserve account. During the initial years of an association’s existence there may be situations in which a developer is responsible for various replacements to the common elements. However, due to transition litigation, the developer may refuse to perform the necessary repairs or replacements. These types of expenditures can be charged to the reserve account, and any money subsequently received should reimburse the account. If there is no settlement, the engineer should be consulted to determine the impact on the association’s reserve account, and the association’s future funding policy.
Guideline #6: Charge income taxes to reserve account. Many associations choose to allocate any interest or investment income earned by the reserve account back to the fund. Such income may be contributed net of the federal income taxes, because associations must pay tax on such income.
Guideline #7: Charge interest expense to reserve account. If applicable, interest expense may be charged to the fund. Many associations have authorized major capital replacement projects only to discover that they are unable to fund all of the planned replacements. Absent a special assessment, many associations seek assistance from lending institutions to close these funding gaps. Proper practice is to include the expenditure, debt service, and the future assessments required for debt repayment in the reserve account budget.
Guideline #8: Don’t borrow from reserve account. Borrowing could create negative tax implications and may ultimately lead the association down the road to financial ruin. To avoid this, an association should regularly monitor its operating budget to ensure that each year’s deficit, if any, is addressed in the subsequent year.