What is an HOA Reserve Fund?
A Homeowners Association (HOA) reserve fund is a reserve account maintained by the HOA to cover costs associated with maintaining, repairing, or replacing communal amenities and infrastructure within a neighborhood. Examples of infrastructure include roofs and siding on townhouses and row houses, piping and power infrastructure, and amenities including playgrounds, parks, clubhouses and pools. Reserve accounts are governed by state laws and are intended to be accurately funded to ensure that a consistent level of maintenance , repairs and replacement costs are covered.
The HOA reserve audit and study is prepared by a qualified professional or committee to identify various common area assets throughout the neighborhood, estimate the remaining useful life of each asset, and project the cost to repair or replace the same as of the date of the reserve study. The projected cost estimates are then allocated to multiple future fiscal years assuming a reasonable and appropriate annual contribution of reserve account funds to ensure, to the extent possible, that there are reserve funds available for each asset needed.
Legal Requirements for HOA Reserve Funds
HOA reserves are impacted by federal, state and local laws, as well as individual association governing documents. First, let’s set our floor. We will take a more national look at laws and legal issues relating to reserve funds nationwide, so no local municipal ordinances will be reviewed here. The floor for reserves (and even the ceiling) is typically found within the association’s governing documents.
Federal law concerning HOA reserves is very limited. Fannie Mae, which is a government sponsored enterprise (GSE) that offers mortgage-backed securities to investors (i.e. shares in mortgage loans), and Freddie Mac, which is a similar GSE, have each set specific requirements for HOAs and projects that have a sufficient number of units financed by loans from Fannie or Freddie. There is more detailed information on these requirements in Tier 1 and Tier 2 sections of this guide, but it comes down to Fannie and Freddie determining that if an association does not meet certain reserve levels it will not insure a loan to the buyer of a unit. Pretty simple, right? Not likely, as it requires an association to closely monitor its reserves and frequently, usually at a cost to its unit owners, hire an accountant to help those numbers come into line.
Most states have laws that require associations to maintain reserves. Arizona, Colorado, California, Connecticut, Florida, Illinois, Massachusetts, Nevada, New Jersey, New Mexico, New York, Texas and Washington all have mandatory reserve laws. Some other states like Kentucky and North Carolina have laws that allow owners to opt out of the reserve fund requirements. Many states have laws that require associations that are governed by Bylaws and CCIOA (Colorado Common Interest Ownership Act) to create and maintain a reserve fund, and to undertake a reserve study every 5 years to determine the adequacy of the reserve fund plan. Some go beyond this and also require reserve studies every 3 years (Nevada). Other programs require a reserve plan but do not mandate reserve study reports. Some states, like California, require reserves when the HOA has debt. And yet others like Alaska, South Carolina and Utah have varying levels of reserve fund requirements and requirements for when a reserve study must be performed.
It is important to consult the laws of the state in which an association is located to determine whether a stated reserve fund level is achievable and how often a reserve study is required. And, it is best for the HOA to consult with a qualified CPA to determine whether its reserves are sufficient to cover repairs, replacements, and other items that must be provided by the association for the benefit of the owners.
Variations in HOA Reserve Fund Laws by State
State-specific HOA reserve fund laws can vary dramatically across the United States. For instance, California law in section 5550 of the Civil Code is the most highly detailed and specific law regarding reserves for HOAs. In contrast, Colorado law in section 38-33.3-209.5 of the Colorado Common Interest Ownership Act is one of the shortest state laws that addresses reserves. We discuss each of these statutes below.
California law in section 5550 requires an association that collects more than $100,000 in annual assessments to prepare a reserve study to ensure that the correct amount is being assessed for future capital repair needs. California law in section 5500 requires the board to review the reserve analysis at least annually.
Colorado law in section 38-33.3-209.5 only requires that the board "consider" the creation of reserves. Unfortunately, many associations fail to do anything related to reserve studies or analyzing reserves, which can result in the "Taxable Portion of Homeowners Associational Reserves" issue for many associations in Colorado.
Florida law in section 719.108 requires each association with a budget that includes $100,000 or more for member assessments to prepare reserve studies.
Nevada law in section 116.31152(1) and (2) requires an association to obtain written reserve study every five years. Nevada reserves laws are some of the strictest in the country.
This blog post doesn’t include a list of reserve fund laws for every state. There are many other blogs that have provided this information. We mention these state-by-state statutes as examples of how varied HOA reserve fund laws can be. We are currently working with an association that has properties in three states, and are having to track these laws for each state. Each service requirement for reserves is starting to intersect with corporate governance issues and COVID-19, which makes the work even more challenging and the need for a reserve study even more apparent.
We have also seen a variety of state laws that are not solely related to reserve studies for HOAs. These laws can include, for example: commercial and residential associations (including mixed-use); "residential-type" regulations on mobile home parks; and environmental efficacy (e.g., green construction). On top of these state laws, there are different local building codes that may apply to associations. In addition, certain counties, cities, and towns may be more or less strict than the local building code.
In addition, federal law may apply in certain circumstances. For example, the Americans with Disabilities Act (ADA) may apply to many common areas of HOAs. Related to the ADA is the Fair Housing Act (FHA), which also may apply to HOAs. The Fair Housing Act regulation applies when an association employs a "housing provider" to perform services for its residents. If an HOA has 4+ units (with one unit being owner-occupied), Section 8 of the FHA may apply to the service provider. This is one example of how federal law can apply to HOAs.
As can be seen from our small sampling of state laws and federal law, performing even routine maintenance for HOAs can be a daunting task. At James LeDeput Law Firm, P.A., we are currently researching reserve fund laws in all fifty states to ensure that our clients’ rules, regulations, and policies are state compliant.
Essential Elements of a Reserve Study
A reserve study is a contract between the HOA and a consultant outlining what will be prepared to meet the requirements of the Washington statute. The consultant may be an engineer, a professional reserve study company, an architect or a qualified management company. In effect, the reserve study company will be doing an inspection of the common elements, often with an engineer accompanying them. There are interactive reserve studies done online that provide rudimentary results, but not a professional report that meets the statutory requirements.
There are three primary components of a reserve study: (1) Inventory of Common Elements; (2) Useful Life Estimate; and (3) Estimated Current Cost of Repair/Replacement.
1. Inventory of Common Elements
The first step in a reserve study is to conduct a thorough inventory of the common elements of the HOA. Each common element should be exclusive of the other common elements.
2. Useful life or remaining useful life of the component/element
The reserve study consultant will assign an estimate of the remaining useful life of the component/elements listed in the inventory of common elements. For example, if an item has a remaining life of five years and a typical life cycle of ten to fifteen years they will then determine if it will need to be repaired or replaced at the year five mark. If not, the useful life for that component could be extended by several years.
3. Estimated current cost to repair or replace each component
The third step in a reserve study is to estimate the current cost to repair or replace the common elements in the inventory. In doing so the consultant will look at component specifications (i.e., size, scope and quantity). The consultant may conduct a walk through the property and its facilities. They will generally consult various trade reference material or even conduct phone interviews with contractors or vendors to confirm costs.
Together, these three components of a reserve study can be used to calculate the 3rd component of the statute: Whether it is necessary to require the HOA to maintain reserves.
Enforcement and Compliance Concerns
When an HOA fails to comply with the requirements of the reserve funds laws it can expose the association to legal repercussions. For example, if the directors of an association fail to comply with the statutory reserve fund law, they may be found personally liable for all damages resulting from that failure. Further , a court may order the directors to comply with the law and to pay any damages resulting from their failure to act.
An HOA may also seek an order from a court within 60 days of the end of its fiscal year requiring the directors to perform the reserve study required by law and ordering them to levy a special assessment to establish a reserve fund. If the court finds that the directors have willfully failed to perform those duties, it may hold the directors personally liable for any other damages resulting from that failure, as well as the costs and expenses incurred by the HOA in enforcing its rights and obtaining that order.
Best Practices for HOA Reserve Funds
Since the reserve fund and components of which make up the fund are essential to the financial security of every association (and ultimately every association member), we recommend that the board keeps the following in mind when managing its reserve fund:
- Keep the reserve fund in a separate account from other association funds. Since reserve funds, by definition, are funds the association has already set aside for future repairs and replacements on the property and should not be used for day-to-day operations, it is critical that the reserve fund be kept separate from other operating funds. Not only does this avoid co-mingling of funds which generally runs against IRS regulations regarding association funds and accounts, and may result in negative tax implications for the association, but also will avoid any temptation to dip into the fund for operating needs during cash flow emergencies.
- Use investments that are FDIC insured or NCUSIF insured, as applicable. Investment of reserve funds, like with all association funds, should warrant a high degree of care given the fiduciary responsibility of the board. To that end, the board should invest its reserve in instruments that are as risk-free as possible. Government backed Certificates of Deposit or savings accounts that are individually FDIC insured or otherwise insured by the NCUSIF are a preferred money management tool for insurance security, liquidity, and marketability. These types of accounts are also more convenient for handling day-to-day transactions. Higher returns may be realized through longer-term, higher risk investments, however these types of investments are not recommended for reserve funds and should be left to investment specialists whose advice is sought for the best return on investment. Alternative investments should be reviewed by legal counsel and only undertaken with a realization that the risks involved in those investments may not be insurable.
- Where possible do not borrow from the operating fund for repair and replacement of HOA common areas. Again, reserve funds are intended to be used for capital expenditure repairs and replacement of association property. Where borrowing from the operating funds is necessary, prompt reimbursement from the reserve fund should be factored into cash flow and reserve fund usage and routine reporting to members on the use of the reserve fund should be communicated to avoid any potential for mixed messages. Reimbursement for operating fund borrowing over time should be accomplished using reserve funds to ensure that the reserve fund is not always being used and the fund is always replenished.
- Ensure slideshows, PowerPoint presentations and reports for the annual budget meeting and board meetings clearly convey the importance of the reserve fund and why reserve assessments should be maintained. When a reserve fund is established, regular reassessment of that fund is necessary to ensure the fund is adequately maintained based on the association’s long-term capital maintenance plan. This requires regular reporting to the board and members on the status of the reserve fund as compared to projected expenses, along with notice of recommendations to strengthen the fund and replenish the fund that has been used. Keep in mind that regular reassessment will trigger regular reporting to the members, and constant clear communication is essential to successful maintenance of the reserve fund. Meetings and presentations at which the reserve fund is discussed should be made interesting and informative to ensure that members understand the importance of reserve funds recently and historically, and why sufficient funding is so important to the financial security and protection of their property values.
- Consistently put adequate reserve assessments in place to maintain and grow the reserve fund. When a reserve fund is created, assessment levels for that fund must be maintained. Failure to do so will result in inadequate funding of the fund and require that special assessments be put in place to replenish the fund and maintain it in the future. Many factors can drive members’ desire to not raise assessments, including hardship for some owners based on fixed income, an inability to sell their home if assessments increase, and others. Unfortunately, such factors drive the desire to maintain low assessments, but also result in an unwillingness to pay special assessments when adequate reserve assessments have not been put in place. The only way to ensure that the association is able to maintain the property and fund its future repair and replacement is to establish adequate assessments over the long term. These assessments, when instituted properly in conjunction with a well-maintained reserve study, will surpass what special assessments would need to be when the funds become necessary. Importantly, such assessments may be instituted only to the extent the property will actually be improved or repaired, and so, just like with everyday operating assessments, a portion of association members will benefit from the work to the detriment of others. However, the value the work done provides to the property, as a whole, will outweigh the cost to the minority of the membership who do not benefit directly.
Future Trends in HOA Reserve Fund Law
As the financial implications of inadequate reserves become better understood from both sides of the table, it is likely that states will see a push toward stricter reserve requirements. Owners and prospective owners will begin to demand sound planning on the part of associations in order to secure their future investment. While courts will continue to rely on precepts of financial responsibility and the enforceability of governing documents to resolve issues of inadequate reserves, it is likely that owners, managers, and board members will simply do a better job of planning for future capital expenditures.
HOA reserve fund requirements are likely to continue to shift toward one of two trends. On one hand, a "pay as you go" trend has begun to emerge by legislatures , which allows associations to budget for projects in the fiscal year in which they are expected to be completed. Under a "pay as you go" model, an association would only be mandated to reserve for the next fiscal year, and not future years in which a given project would be completed. While this approach limits the burden imposed on owners, it fails to account for long-term expenditures and may result in serious assessments for projects that require substantial funding. On the other hand, some legislatures may look to strengthen the current HOA reserve fund legal framework by requiring greater notice to homeowners and establishing plans for remedy when an association has insufficient reserves. Among the areas that have begun to receive attention in past few years are: