ESTABLISHING RESERVE POLICIES

by Gary Porter

After all, what is a reserve study? And why do we need any policies to manage reserves?

First, the reserve study is a rather limited scope evaluation of the association’s physical common area components for the sole purpose of establishing a financial plan for the orderly accumulation of funds to be available when necessary.

Second, if you don’t plan (with policies), how can you make it occur? What should be included in reserves? Your answer may not agree with your neighbor’s answer.

It became apparent from a recent inquiry form one of our clients that there is still much confusion over the issue of what should be included in a reserve study, and what should be excluded. That confusion is understandable because there are no hard and fast rules about what should or should not be included in the reserve study. The reason is that the determination of what should be included in reserve study is left in the hands of the Board of Directors of the association. That’s exactly how it should be, because the board has the responsibility for defining what is included in the reserve study. Unfortunately, too few associations have made the effort to establish any formal guidelines in this regard.

The purpose of this article is to help the association Board Member identify and consider the items that should be in a reserve study but only to do it in the broad context of the overall physical maintenance plan for and financial plan of the association. My recommendation is that every association should establish a formal policy to provide guidance in this area.

Like any board policy, it may be overturned by a future board. However, the primary goal of this is what I call the establishment of an “institutional memory” for the association. The board members may change every few years and the management company or management and staff may change every few years. Unfortunately, when that occurs the institutional memory walks out with those people. Replacement board members or staff are left only to wonder why certain actions were taken and why events occurred as they did.

The establishment of policies and plans, particularly when they are well supported and well thought out, generally provide a structure and framework that future boards can and will use because it makes it obvious that it is not necessary to reinvent the wheel with every new board. Further, a policy like this provides a year-to-year consistency that will outlive each board and management company or manager and staff, although they may contribute to changes in such policies.

Many associations use outside reserve consultants to prepare their reserve studies on an annual or every-few-years basis. Too often, that outside reserve preparer is the one who determines what goes into the reserve study. The result is that, as the association changes reserve preparers, it also changes the consistency of the association’s policies and reserve study itself. It should never be left solely up to the outside reserve preparer to make this determination. Rather, the reserve preparer should be brought in as a consultant in the formation and creation of the policies of establishing reserves. Another very significant factor to consider here is the qualifications of the reserve preparer. Some have extensive construction knowledge or engineering experience directly related to construction issues, others do not. The entire quality of the reserve study rests upon the qualifications of the individual performing the work.

So let’s get down to it. What should be included in a reserve study? The first question is do you have to have a reserve study? Generally, the answer is yes. If you are maintaining common area components, you should have a reserve study.

The next question, how often should you prepare a reserve study or how often should it be updated? The answer to these questions can vary. In some cases, State Civil Statutes may dictate maximum time periods between reserve studies, however, it is generally a good idea for the association to update the reserve study annually. After all, when you look at the budget for the association you will generally find that the majority of money is spent on the maintenance of the physical property components of the association. This includes funds expended from the operating budget, as a large portion of the operating budget is generally directed towards the ongoing maintenance association physical property components. If this ongoing operational maintenance program is not conducted properly, it has a direct and significant impact upon the reserves of the association.

No association can have an effective reserve study unless it has an effective maintenance program. The maintenance plan should not be determined by the vendor who is maintaining the pool or landscaping or elevators. The maintenance plan should be established by the Board of Directors in consultation with those, or other, experts. Perhaps an independent consultant should be retained to determine the proper method of maintaining the common area components. Why do I say this is necessary? Too often Boards establish maintenance expectations by their award of contracts to various providers. What I mean by this is that rather than drawing up the specifications for painting the condominium buildings, the Board of Directors awards the contract to the low bidder without determining that the low bidder is not providing the same level of service as the high bidder. Maintenance standards should be determined in advance of any contracts being awarded, and contracts should only be awarded to vendors bidding in accordance with specified maintenance standards.

An effective maintenance program should also make sure that you are performing your maintenance functions in the right order. We recently had to advise an association that they had wasted approximately $50,000 on roof repairs because they performed maintenance steps in the wrong order. They had no sooner completed installation of new tile roofs than they started a pest control program that included tenting of the buildings. Guess who’s walking all over those new tile roofs as they tent the buildings? Guess how much damage there was to the tile roofs? Had the association instead established a maintenance plan in advance and entered into an integrated pest management program (as many of our associations have now done) they would have tented the buildings before the new roofs were installed and kept people off the roofs by later performing spot pest eradication on an as-needed basis.

Another thing to consider in a reserve study is the materiality of each reserve component. For instance, do you reserve for items that only cost $100, $300, $500 or $1,000? Somewhere, the association needs to establish a relative dollar limit as to what will be included in the study, and every association is different. A small association (with a $200,000 annual budget) may establish a limit of $500 as being the minimum item that would be included in a reserve study. Any item under $500 can be paid for out of the annual operating budget. A large association (with a $10,000,000 annual budget) may establish a $10,000 reserve limitation and items under that amount would be included in the annual operating budget. Again, each association should make it’s own determination. Often this will mirror the association’s capitalization policy.

The next item to consider is the useful life of each item. If an item is expected to be replaced every year, it is a very good candidate of the operating budget, not the reserve budget. If it is only to be replaced every five years, then it becomes a candidate for the reserve budget.

There is also the continuing disagreement over painting, which never ceases to amaze me.

There are many that argue painting should not be included in the reserve study because the IRS does not allow it as a capital contribution. While that is true, be aware of two things you should consider. One, file Form 1120-H and painting becomes a non-issue. Two, you should never let the tax tale wag the economic dog of the association.

The IRS deems painting to be a non-annual maintenance expense. For many condominium associations it is one of the largest expenditures. Should it be excluded from reserves? Generally not.

But let’s look at an example where you may purposely exclude painting from your reserve study. One association we deal with was built in phases over a ten year period, and is approximately 30 years old. Their maintenance program eventually evolved into a situation where approximately 1/7th of the condominium complex, consisting of more than 100 buildings, was painted every year. Therefore, in the course of seven years they repaint the entire complex. For various reasons, their scheduled painting cycle is seven years. Therefore, in year eight they simply start over again with their painting program. That is perfect example of an item that would be included in the operating budget.

But, an interesting thing happened to this association in 1994. They are located in Southern California, relatively close to Northridge. In 1994 we had a minor seismic event known as the Northridge Earthquake, which caused significant damage to a number of the association’s buildings. As the association rebuilt from this event it became obvious that the clock had been reset to zero for many of the association’s common area components. This caused a change in the maintenance schedule, which caused a change in the association’s reserve policies. Painting is now included in reserves because now the entire complex is painted every seven years, rather than 1/7th being painted every year. This is a textbook example of how the maintenance program drives the reserve study.

Next the association should carefully consider all of the common areas for which it is responsible for maintaining. Many associations, upon reaching the 30-40 year age level, are surprised to discover that they own the utilities from the meter into the association and that after 30-40 years they have to replace underground utilities that were never included in the reserve study. The same is true of interior plumbing. Thirty-forty years ago much of the interior plumbing was galvanized pipe or PVC piping, which has not withstood the test of time. Many of my association clients are now replacing interior plumbing with copper pipe. Again, a very significant cost that was never included in reserve studies in the past.

Many individuals maintain that since the normal projection period for the reserve study is 30 years that you are not required to include any assets with a remaining life in excess of 30 years. Is that true or not true? Again, this depends on the association. The board has total control over establishing this policy. For instance if you have a tile roof that had a 35 year life, would you not fund for it for the first five years and then in the sixth year begin funding for it because it now had a remaining life of less than 30 years? I don’t think so; it seems more prudent to include all the common area components that you are responsible for maintaining, if they have a limited life and an estimable replacement time and cost.

Does this mean that you must include the structural components of the buildings themselves? Generally not. They are usually expected to have such a long term-life they would never require replacement, assuming adequate maintenance during their lifetime. That doesn’t mean that they have an unlimited life, but it may be discovered that at the end of a 100 or 150-year life that there is a higher and better use for the property than it’s present use. I generally do not recommend including structural components of buildings within the study unless it is known that they have a shorter than anticipated lifespan. This can only be determined a thorough inspection by an individual qualified to make that evaluation.

Next, something that many fail to consider as part of their reserve policies is the financial consideration. I recommend that the reserve policies should address the nature of the funding plan, cash handling procedures, investment of reserve funds, and delineation of capital improvements.

The funding plan is the method of projecting how to accumulate funds to meet the anticipated expenditures. Will it be on a pooled cash flow method or on a segregated line item basis? (I recommend the pooled cash flow method.)

Cash handling procedures of reserve funds should be directly addressed. In California, the Civil Code mandates that only two directors or a director and an officer who is not a director may authorize the expenditure of reserve funds. While most other states do not have this requirement, it is simply a good business practice. Make sure you have at least two people that agree that you’re going to spend this kind of money because most reserve expenditures will tend to be large in amount.

Clearly establish in your reserve policies the difference between major repair and replacement of association common areas from capital improvements which can be defined as new facilities or equipment that do not represent replacement of existing items. New items obviously will require reserves to be accumulated once they are put into place but the accumulation of new items do not appropriately fit into the reserve methods. They should be in a separate capital improvements budget.

The association accounting records, including the general ledger and financial statements, should also clearly reflect the segregation of operating activities from reserve activities and the segregation of operating cash from reserve cash. For those who are very concerned with items such painting and contingency and the IRS rulings related to these issues, you may wish to establish two sets of reserve cash accounts. One to accumulate capital items such as roof, street and fence replacement and another one to accumulate painting contingency funds which are deemed to be non capital in nature by the Internal Revenue Service.

The key issue here is that we in the industry tend to view items as being either reserve or operating, whereas the IRS views items as either capital or non capital. In the issue of painting and contingency funds inside of reserves, there is a definite cross-over in definition between the IRS and the industry. It is this cross-over that creates the significant issues with respect to filing of tax returns on Form 1120.

The last major issue that should be part of any policy of reserves is the maintenance of administrative and financial records to support the past activity of the association. I refer to this as “institutional memory.” Most associations do not keep any formal historical record of their reserve activities. Too many times as I have tried to find out from association management staff or board members when a specific item was last replaced, and nobody has any record of it other than somebody’s fuzzy memory. For this reason we strongly recommend that the association establish a system for accumulating and maintaining information regarding the history of their reserves. As we assist associations in this area, we find out many times that significant funds have be expended from reserves for which no reserve categories were ever established. When establishing new categories to accommodate these components, the association often discovers that while they thought they may have been accumulating adequate reserve funds, those funds are inadequate when they do a complete inventory of the common area components and include the missing components in the study.

For many years in assisting my association clients I have repeated the mantra that they must maintain detailed records to be able to provide adequate information to properly maintain their common area components and prepare the reserve study. Two little attention has been paid to the area that requires the largest expenditure of funds for most associations.

The first step is to establish reserve policies and get started in the right direction. Attached to this article is a sample reserve policy, which the association may use as a guideline to begin crafting their own reserve policies. This example is what I would call a “bare bones” example and should be fleshed out considerably with the level of detail that is appropriate to your association.

RESOLUTION

ADOPTION OF 2003 RESERVE STUDY

WHEREAS, Article of the Declaration of Conditions, Covenants, and Restrictions charges the Association with certain community service responsibilities; and

WHEREAS, there is a need to provide a sound financial plan for the delivery of such services; and

WHEREAS, it is the intent of the board of directors to adopt an annual budget as its financial plan for the fiscal year ending ;

WHEREAS, the Association has caused to be prepared a reserve study or update thereof which indicates an annual assessment for reserves that is incorporated into the Associations annual budget, it is

RESOLVED THAT:

1. The treasurer of the Association shall transfer all monies and property presently held in reserve to a savings account[s] to be held, invested, and expended by the Board of Directors for the repair and replacement of the common areas.

2. The board may authorize expenditures which result in an increase in the amount budgeted, provided such increase is not greater than five (5) percent of the original budget.

3. Proposed increases in expenditures from the amount budgeted for a category greater than five (5) percent but less than one thousand dollars ($ 1,000) shall require board approval.

4. Proposed increases in expenditures from the amount budgeted for a category greater than one thousand dollars ($1,000) shall require amendment of this Budget Resolution.

This resolution is adopted and made a part of the minutes of the meeting of .

BY:
President

ATTESTED:
Secretary

Note that the allocation for reserves within the annual budget must agree to the required annual contribution per the reserve study. Failure to have these amount agree seriously weakens the association's evidence when trying to document its intent on tax matters, as the documents contradict each other.

PERMANENT RESOLUTION
EXAMPLE REPLACEMENT FUND (RESERVES) POLICIES

WHEREAS, Article of the Declaration of Conditions, Covenants, and Restrictions charges the Association with certain community service responsibilities; states that the assessments shall be sufficient to, among other things, establish and maintain adequate repair and replacement reserves; and

WHEREAS, there is a need to provide a sound financial plan for the delivery of such services; and

WHEREAS, among the expenses of the Association, are all expenses for the administration, maintenance, repair and replacement of the common areas and facilities, which are to be set aside and held in "reserve" to be subsequently expended for the replacement of the common facilities and improvements due to their damage, exhaustion, or obsolescence; and

WHEREAS, the members of the Association wish to avoid any adverse federal income tax consequences upon the contribution of their annual assessments to the capital of the association, particularly the portion to be set aside and held in reserve for repair and replacement of improvements to the common areas; and

WHEREAS, in Internal Revenue Code (IRC) Section 118, the Internal Revenue Service indicated that amounts paid to a corporation as a conduit, agent, or trustee and with the prior understanding that such amounts are to be expended and applied for a specific capital purpose; and

WHEREAS, the Board, in order to satisfy the criteria of IRC Code Section 118 and Revenue Ruling 74-563, 75-370 and 75-371, wishes to formally segregate all portions of the annual assessments thus set aside and held in reserve, as well as such portion of any future annual assessments, and to hold and expend such sums solely and specifically in pursuance of the objects and purposes set forth in the Declarations, Articles, and By-laws of the Association.

WHEREAS, the Board wishes to formally segregate each year a portion of the assessments, to be set aside in a separate interest-bearing account and held in reserve, to hold and expend such funds solely and specifically as set forth herein;

RESOLVED THAT:

1. A reserve fund for major repair and capital replacements shall be established.

2. The Association shall cause a reserve study to be prepared at least every three years, in accordance with the provisions of California Civil Code Section 1365.5

3. The Association shall cause an annual update to the reserve study to be prepared for all years in which a full reserve study is not prepared, in accordance with the provisions of California Civil Code Section 1365.5

4. The Association shall annually make all reserve disclosures necessary to its members in accordance with California Civil Code Section 1365. The owners shall be advised that henceforth the portion of the annual assessment to be held in reserve will be transferred, held, and expended pursuant to the terms of this resolution, a copy of which shall be on file at the offices of the association for inspection by any owner.

5. The treasurer of the Association shall transfer all monies and property presently held in reserve to account[s] to be held, invested, and expended by the Board of Directors for the repair and replacement of improvements to the common areas. These accounts shall be maintained separately from the operating accounts of the Association.

6. Bank accounts for those reserve components designated as "non capital" in nature shall be maintained separately from those reserve components designated as "capital" in nature.

7. The authorized signatories for the reserve account shall be the any two directors, or one director and an officer who is not a director, in accordance with the provisions of California Civil Code Section 1365.5. The signatures of two persons are required to make withdrawals from this account.

8. Reserve amounts shall be maintained in accordance with the Association's reserve study, which shall cover all real property, furniture, fixtures and equipment owned or maintained by the Association.

9. Withdrawals from the Repair and Replacement Reserve may only be used for restoration, repair and replacement of existing capital improvements, not for new facilities or additions or improvements to existing facilities or property.

10. The Association's financial records (general ledger and financial statements) shall reflect the segregation of cash account referred to in item 4 above. The financial records shall also separately account for members equity from operating activity and members equity from replacement (reserve) activity in accordance with California Civil Statutes and the recommendations of the American Institute of CPA's Audit and Accounting Guide for Common Interest Realty Associations.

This resolution is adopted and made a part of the minutes of the meeting of .

11. The Association’s reserve study, in order to be prepared on a consistent basis, shall be based upon the following parameters:

a) The study shall include all components with a replacement cycle of two or more years.
b) The study shall exclude all components:
1) with a replacement cycle of less than two years
2) with a replacement cost of less than $1,000
3) with a replacement cycle of more than 30 years (remaining life), otherwise known as lifetime components.

12. Association common area components shall be maintained in accordance with the association’s maintenance plan.

13. The reserve study financial projection shall be based upon a pooled funding method and shall include provisions for:

a) investment earnings
b) inflation
c) income taxes

BY:
President

ATTESTED:
Secretary

PERMANENT RESOLUTION
CASH MANAGEMENT POLICIES

RESOLVED THAT:

1) The association will establish one or more operating Bank Accounts - Generally consisting of a checking account, and one or more savings accounts.

2) The association will establish one or more Non-Capital Reserve Accounts - Generally consisting of one or more bank accounts for non-capital reserve items such as painting, contingency, termite, tree trimming, and any other items that are non-capital in nature.

3) The association will establish one or more Capital Replacement Fund (Reserve) Accounts - Generally consisting of a series of bank or investment accounts. These accounts should only contain funds for items that are capital in nature as defined by the IRS.

4) Member assessments received will be deposited into the association's operating account[s], then the reserves portion of the dues income will be immediately (within 1-2 weeks) transferred by two separate checks to:

a) the capital replacement fund account[s]
b) the non-capital replacement fund account[s]

5) Replacement fund expenditures will be paid directly from the replacement fund bank accounts. If for any reason replacement fund type expenditures are instead paid from the operating account, they should immediately be reimbursed for the exact amount from the replacement fund account[s].

6) Regardless of provisions in the California Civil Code allowing inter-fund loans and transfers, the association will refrain from making inter-fund (replacement fund to operating) loans or transfers. If inter-fund transactions occur, they will be fully documented in the minutes and by note documents with specific repayment terms.

This resolution is adopted and made a part of the minutes of the meeting of
.

BY:
President

ATTESTED:
Secretary

Gary Porter, CPA began his accounting career with the national CPA firm Touche Ross in 1971. He is licensed by the California Board of Accountancy and the Nevada Board of Accountancy. Mr. Porter has restricted his practice to work only with Common Interest Realty Associations (CIRAs), including homeowners associations, condominium associations, property owners associations, timeshare associations, fractional associations, condo-hotels, commercial associations, and other associations.

Gary Porter is the creator and coauthor of Practitioners Publishing Company (PPC) Guide to Homeowners Associations and other Common Interest Realty Associations, and Homeowners Association Tax Library. Mr. Porter served as Editor of CAI’s Ledger Quarterly from 1989 through 2004 and is the author of more than 200 articles. In addition, he has had articles published in The Practical Accountant, Common Ground and numerous CAI Chapter newsletters. He has been quoted or published in The Wall Street Journal, Money Magazine, Kiplinger’s Personal Finance, and many major newspapers.

Mr. Porter is a member of Community Associations Institute (CAI), American Resort Development Associations (ARDA), and California Association of Community Managers (CACM). Mr. Porter served as national president of CAI in 1998 – 1999.