Understanding the Proper Use of Homeowners Association Reserve Funds
The use of homeowners association reserve funds is a topic of much confusion and controversy within homeowners associations. Because of the importance of maintaining proper levels of reserve funds, they are afforded protections by state laws and/or an association’s governing documents and HOA board members and management personnel should be familiar with all requirements that are imposed on the use of reserve funds before making decisions relative to their use.
What are reserve funds?
It is critical to understand that an association’s reserve funds are not to be used for the payment of normal recurring operating expenses of the association. Reserve funds are funds that are set aside in a separate account (reserve account) that is established as a source of funds that are available for specific purposes of repair, restoration, replacement, or maintenance of major components that are part of the common areas that the association is responsible for. Examples of the proper purposes for the use of reserve funds include: (i) the replacement of common area roofs; (ii) the replacement of wood siding on common area building exteriors; (iii) repaving of community roads; (iv) painting or remodeling community facilities such as a clubhouse. The restrictions imposed by state laws and/or governing documents may also permit the use of an association’s reserve funds for funding litigation that involves the repair, restoration, replacement or maintenance of such components (i.e. construction defect litigation).
To maintain the separate identity of the reserve funds, an association needs to maintain one or more separate bank accounts for the holding of reserve funds and the reserve funds should never be commingled with an association’s operating funds. Furthermore, it is common for state laws and/or governing documents to limit those who are authorized to withdraw reserve funds from the accounts to board members and/or officers of the association. Thus, retained management personnel should never be authorized to withdraw funds from an association’s reserve bank account.
Where do the reserve funds come from?
The source of the funds that go into an association’s reserve account is the dues and assessments that are periodically (usually monthly or quarterly) paid by the association’s members. Associations that are relatively new, and under the control of a developer, may also require contributions to the reserve fund from the developer for lots, homes, or units that have not yet been sold. A specific portion of each payment made for dues and assessments is allocated for contribution to the association’s reserve account. The remaining portion is for payment of ongoing operating expenses.
Determining how much to set aside for reserve funds
A determination of how much money should be allocated to an association’s reserve fund requires the creation and periodic updating of a reserve study. Because the preparation of a reserve study requires knowledge and expertise that is beyond the capacity of the typical board member or management person, associations should retain outside third-party vendors who are in the business of preparing association reserve studies. The preparation of the reserve study necessitates the identification of virtually all components that exist within the physical properties of the association’s common areas and an assessment of the useful life of each such component and the cost of maintaining and replacing it. A properly prepared reserve study will enable an association’s board of directors to know exactly what components have to be properly maintained and periodically repaired and/or replaced. The reserve study will also specify the amount of funds that should be allocated to each such component for maintenance, repairs, and replacements. With this information, the association’s board of directors can determine the amount that should be on hand in the reserve account and how much additional funds should be contributed on a regular basis out of the dues and assessments paid by the members.
Because the preparation of a reserve study is based in large part on estimates made by the preparer of the study, it is not an exact science. The association’s physical components can fail sooner, or last longer, than anticipated and maintenance, repair, and/or replacement costs can be more or less than had been estimated. To accommodate for such variations, it is common for association boards to make periodic adjustments to the various line items contained within their reserve study.
With a properly prepared reserve study, an association can create a meaningful and accurate annual budget for circulation to the association members that should provide for payment of the normal operating funds of the association and the additional funds that will periodically be required to repair, restore, replace, or maintain common area components.
What if we don’t have the reserve funds that are required by a reserve study?
It is common for homeowners associations to be underfunded in their reserves. This typically occurs because accurate reserve studies were never prepared and/or the required regular contributions were not made to maintain the appropriate level of available funds in the reserve account. The reasons insufficient amounts are collected vary but frequent underfunding results from shortsighted thinking on the part of the association directors who, in an effort to avoid an increase in dues or assessments, decide to cut costs and forego required maintenance, repairs or replacements.
Association boards should have a realistic plan for the funding of the association’s reserves. Decisions to avoid necessary maintenance, repairs and/or replacements should not be a consideration. Instead, HOA boards should take immediate action to increase dues and/or levy special assessments in amounts that are sufficient to build the level of reserves to appropriate levels that will provide for funds that are needed for proper maintenance of the association’s common areas.
Use of reserve funds for unauthorized purposes
In the real world there are unexpected occurrences that result in expenses that were not anticipated and, as a result, associations can experience cash flow shortages. As a result, they may lack sufficient funds on hand in their operating accounts that are required for the payment of operating expenses. When confronted with such shortages, state laws and/or governing documents typically allow for the temporary borrowing of funds from the association’s reserve account. If it becomes necessary to borrow reserve funds, the board members who make the decision to borrow the reserve funds must be aware of the borrowing restrictions and requirements that must be complied with before the funds may be utilized. For example, in California, before boards can borrow reserve funds they must provide notice to the association members of their intent to borrow as an agenda item for a board meeting. The notice of the meeting must include a statement of the reason that the desired transfer of funds from the reserve account is needed along with a stated method of repayment and an indication of whether or not a special assessment will be considered to generate the funds required to pay back the reserve account. If, when acting on the agenda item at the board meeting, the board of directors authorizes the borrowing from the reserve fund, it must then make a written finding that is documented in the minutes of the meeting which includes the reasons for the borrowing / transfer from the reserve account and a description of when and how the borrowed funds will be repaid to the reserve account. A sample form resolution that may be adopted by an association’s board of directors to document a decision to borrow funds from the association’s reserve account may be obtained through the below link.
Conclusion
Homeowners association directors have legal, contractual, and fiduciary responsibilities that require the proper handling of association funds. The importance of being aware of all state laws and requirements imposed by an association’s governing documents relative to the maintenance and use of reserve funds cannot be overstated. The proper allocation and use of reserve funds will insure that the homeowners association has necessary funds available when needed and will facilitate the association’s operations while at the same time minimizing conflicts within the association that frequently result from the improper conduct relative to the collection and use of reserve funds.
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