Is It Time for a Reserve Analysis for Your Community Association?
- Kristine M. Caruso
When you buy a house, you know (or quickly learn) that you must factor maintenance expenses into your annual budget. Like individual homeowners, community associations also need to budget for yearly operating expenses. But in addition to regular maintenance expenses — for things like landscaping, pool maintenance, and trash pickup — communities must also budget for a portion of the big-ticket investments that must be made every few years, such as parking lot resurfacing, roof replacements, and pool repairs.
Community associations typically pay for regular maintenance out of annual operating funds. Even an unusual but relatively minor repair, like replacing a broken handrail on a set of outdoor stairs, would typically be paid out of the operating budget. However, when it comes time to replace all the handrails throughout a complex because of deterioration due to exposure to weather, that’s the kind of project more likely to be funded out of the association’s reserve.
Each homeowner’s annual community assessment should include a reserve contribution that goes toward funding these major improvements. This process presents a challenge for the community association board members, as they need to determine how much to charge each owner in order to adequately fund the upcoming renovations and replacements.
To come up with an accurate reserve contribution figure for the community, the board of directors should engage a specialist to perform a reserve analysis. This detailed review doesn’t need to be done annually, but it’s good to update it at least every two to three years, and anytime significant new assets are added to the property.
The reserve study should list all the significant replaceable assets and estimate their remaining useful lives. The report should estimate the future costs to replace those assets at the end of their projected lives, as well as any possible significant upgrades or scheduled major overhauls that may lie ahead. Lastly, the analysis should look at the cash in the reserve account and determine how much more will be needed to fund future replacements.
Once the leadership has a reserve analysis in hand, they begin the tricky process of determining how much of the reserve projection to fund. Some communities choose the conservative route of fully funding the reserve (i.e., setting aside 100% of the projected costs). Others elect partial funding on the expectation that they may find a more cost-effective alternative, such as a significant overhaul or a purchase of a refurbished asset instead of a new one.
The reserve funds should be maintained in a separate account and not commingled with funds used for day-to-day operations and maintenance expenses. Tax rules allow for more favorable treatment of the return on investment in reserve funds, as they are meant to be held long-term and used for major repairs and replacements.
When homeowners pay their fees, their checks are typically deposited into the operating funds. The reserve contribution should be transferred out of the operating funds and into the separate reserve account. Typically, when payment for a repair is authorized out of the replacement reserves, the money is transferred back to the operating fund, and the check is written from that account. It may seem like an odd series of extra steps, but it’s an accounting formality that keeps the funds separate and reduces the income tax bill for the community.
Determining the right level of replacement reserves is an important role for community association board members, who must balance the community’s needs for a healthy annual budget and sensible replacement reserve with homeowners’ needs for affordable community assessments.
If your association would like to learn more about calculating replacement reserves and their impact on the association’s balance sheet, reach out to CRI’s community association specialists.
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