Capital Reserve Funds
Capital Improvement Reserves are funds set aside separately to fund future capital repairs or improvements of a homeowners association or condominium association’s common elements. Capital items can be roofs, streets, sidewalks, pools, tennis courts, elevators, and other common elements.
Some Membership FAQ:
Why does an HOA need Reserves? Why should I take money out of my personal bank account and put in the association’s bank account for future expenses that I might not even be here to benefit from? Why can’t we just do special assessments when we need the funds? Why should I have to put money aside for a swimming pool that I never use?
Why?
1. Reserve funds are generally required by an association’s governing documents.
2. Mortgage providers may require Reserve Funding to make loans in an association.
3. Capital Reserves help reduce the possibility of litigation from the membership.
4. Funded Reserves reduce the likelihood of special assessments.
5. Reserves generally increase the home resale value for everyone in the membership.
6. Maintaining Reserves makes fair and equal distribution of expenses between the former, current, and future membership.
1. Reserve funds are generally required by a homeowners association or condominium association’s governing documents.
Even though most governing documents do not specify an amount to be funded; language such as the following is common: “The Association shall establish and maintain an adequate reserve fund.”
2. Mortgage providers may require Reserve Funding to make loans in a homeowners association or condominium association. Most lenders require that financial data be provided by the association’s management company when originating a loan. Lenders are concerned with how their security will be maintained if there are no funds to replace common elements. Lenders are also apprehensive about how their borrower would be able to pay the loan back along with any special assessments that may arise.
3. To help reduce the possibility of litigation from the membership.
In California, insurance providers report between 14 and 20 percent of lawsuits against Boards of Directors are for the lack of reserve funds or for the misappropriation of reserve funds.
4. Funded Reserves reduce the likelihood of special assessments.
While special assessments are necessary at times, especially when unexpected expenses arise, funded reserves should curtail the necessity. When special assessments are used in place of funding reserves, membership delinquencies normally increase. Special assessments can play havoc on the morale of the membership.
5. Reserves generally increase the home resale value for everyone in the membership.
Poorly funded reserves and frequent special assessments, without a doubt, have a negative influence on property values.
6. Maintaining Reserves makes fair and equal distribution of expenses between the former, current, and future HOA or condominium membership.
Properly funded reserves prevent the current, possibly new, membership from paying for repair or replacement of a capital element that they may not have had full enjoyment of for the element’s useful life. For example, a brand new owner receives a $2,500 special assessment for a roof that they have not had the enjoyment of and this owner will be moving again before the useful life of the roof is over.
The Methods & The Process
Frequently Asked Questions: What are fully funded reserves? How much do we need in Reserves? Are our Reserves fully funded? If our association is not fully funded where are we? What are reserve studies?
There are generally three reserve funding classifications or funding goals: Baseline, Threshold & Full.
Baseline Funding is the riskiest form with the objective of just funding “some” dollar amount with the hope that the association does not run out of money and does not need to make up the difference with a special assessment or a bank loan.
Threshold Funding is the objective of funding to a specific amount and maintaining that amount. This chosen amount may or may not cover the future reserve needs. There can be less risk with Threshold than with Baseline.
Full Funding objectives are funding reserves to meet all known future capital expenditures. This type of funding is the least likely to result in special assessments or bank loans. William Douglas Management always recommends Full Funding of all Capital Reserves if feasible by the association’s governing documents.
Reserve Funding – The Process
The reserve process begins with the association’s annual budget. Your William Douglas Management Association Budget Worksheet, which is provided to our clients during budget preparation time, will provide assistance in this process. We encourage Boards of Directors to be pragmatic with regard to expenses and to raise dues accordingly. Moderately raising dues gradually to adequately fund operating expenses and reserves is generally more palatable to everyone than a large special assessment will be years down the road.
Reserve Studies
A Reserve Study generally allows an association to more accurately predict what future funds are needed and to budget accordingly today. A Reserve Study should analyze the present condition of your association’s common elements and provide an estimate on the remaining life of this common element. The Reserve Study should also estimate the cost of repair or replacement at the needed point in the future. Reserve studies can start around $1,500 and go up proportionally from there depending on depth and scope. If you are interested in receiving a proposal/estimate please contact your association manager.
Points Regarding Reserves
The IRS generally considers general maintenance items an inappropriate use of Reserve funds. For example, painting may not qualify as a Reserve item.
Reserves should be allocated for a specific purpose. Contingency Reserves, General Reserves, and Rainy Day Reserves may not be appropriate.
Why is the IRS concerned about how an association sets up reserves and spends reserves? An association is a nonprofit corporation and, like any other type of corporate entity, funds not spent in a fiscal year have to be accounted for properly. WDMC
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