Reserve Funds for Community Associations: Understanding the Why, How and When of Reserves
WHY
Community Associations maintain reserve accounts as a means of funding their long term needs for repair and replacement of major capital items. These Association assets typically include all common property under Association control such as roads, roofs, swimming pools and pool decks, sidewalks and clubhouses. Reserves are not intended to fund the Association's everyday operating expenses, which are set forth in its annual budget.
Properly funded reserves are a critical component of a board's fiduciary duty. Without necessary reserve funding, an Association can face painful financial realities that will almost certainly pinch the pockets of current homeowners and negatively affect the value of all the properties in the community.
For example, if an Association must replace its clubhouse roof and it has insufficient reserve funds to do that, it faces several unpleasant choices. It may have to enact a substantial assessment increase for the year in which the roof must be replaced, it may be compelled to levy a costly special assessment to fund the replacement, or, even worse, the Board may elect to defer necessary repair/replacement to the future, making the repair/replacement even more costly when the painful decision is finally confronted.
HOW
How does the board know how much to put in its reserves?
The most important tool in answering that question is a reserve study prepared by an engineer familiar with community association property. The reserve study assesses the condition of all common property, determines the useful life of those components, and determines the amount of money that will be needed to repair and replace these components when the time comes.
Based on this analysis, the board can see how much needs to be put in the reserve annually, and that payment is included in the annual budgets going forward.
The Association may also include an operating reserve in its budget. An operating reserve is used to cover expenses that could not have been reasonably anticipated, and is generally based on a percentage of the Association's total budget rather than on anticipated long term expenses.
WHEN
In general, your governing documents will define the items that the Association is responsible for and therefore should be reserving for, and a reserve study will help decide how much to reserve.
Interestingly, in Maryland and the District of Columbia there is no statutory duty to create a reserve account or fund it in a particular amount. The Virginia Property Owners Association Act, on the other hand, requires that a reserve study be performed at least once every five years and that reserves be budgeted in accordance with the findings of the reserve study.
Regardless of the existence of statutory requirements, failure to adequately fund reserves or using reserve funds for the wrong kinds of expenses may subject the board to liability for breach of fiduciary duty. Appellate courts in several jurisdictions have imposed liability on boards for failing to establish or adequately fund a reserve account.
Further, it is a critical error for Associations to borrow funds from reserve accounts to fund deficits in an annual operating budget. In addition to breaching the provisions of the Association's governing documents, borrowing funds in this manner can have negative tax consequences and can obviously lead the Association down a ruinous financial path.
In summary, one of the most critical aspects of the board's proper exercise of its fiduciary duty is the proper allocation and use of the Association funds, including reserves. Simply stated, the Association's operating fund is used for regularly occurring everyday expenses such as landscaping, property management, utilities expenses, insurance and taxes.
The use of Association reserve funds is generally strictly limited by the governing documents of the Association to expenditures for major capital expenses of a non-recurring nature.
If your board has any questions about the proper use and potential consequences of the use of reserve funds for a particular purpose, consult with your legal and tax advisors before authorizing such an expenditure.