Can Reserve Monies be used for Capital Improvements and Other Items not included in Reserve Study?

Q - Can an Association use reserve monies for capital improvements or for any reserve component not previously included in the reserve study? Does it matter if the Association is fully funded?

A – As with most aspects of Association accounting, there is no absolute answer. In fact, the definition of “capital improvement” is under discussion by reserve study professionals. Is something that is of new material for the same component an “improvement”? Maybe. Does it matter what the amount of the additional cost is? Maybe. We will leave that discussion to engineers, attorneys and those who are better trained to define certain components. But, for the sake of this answer, let’s assume that we agree that this is a “capital improvement” or a component that, for whatever reason, has been left out of previously reserve studies. Then, let us break it down into the following categories, as related to accounting, auditing and preparation of financial statements:

• Governing documents
• State law
• IRS tax law
• GAAP
• Best operating practices

Governing Documents
As auditors, we will review whether the Association’s governing documents limits capital improvement expenditures. Absent any direct, concise wording in the Bylaws or Declaration limiting capital improvement expenditures, we assume that the Board has legal authority to use Association monies in the manner they deem appropriate. If there is any doubt in the matter, an attorney should be consulted.

State Law
Some states have specific requirements regarding use of reserve monies. In Washington, it appears that there is justification for use of reserve monies for capital improvements and other components that would otherwise meet the definition of a reserve component. Any dispute should be discussed with an attorney. The law states:

RCW 64.34.384 (Condominiums – New Act) and RCW 64.38.080 (Homeowner Associations) Payment for major maintenance, repair, or replacement of the reserve components out of cycle with the reserve study projections or not included in the reserve study may be made from the reserve account without meeting the notification or repayment requirements under this section.

IRS Tax Law
If the Association files form 1120-H, the reserve monies, for tax purposes, can be spent however the Board chooses.

If the Association files form 1120, then there are specific requirements for monies to be considered as capital contributions and, thus, excluded from taxation. For something not included in the reserve study the Association may have an issue meeting a couple of the requirements:

• Advance notification to the membership
• Justification

These two issues should be able to be mitigated by some thought-out actions on the part of the Association. There is no clear definition of how much in “advance” the notification needs to be. And, there is no specific requirement that “justification” can only come from a reserve study. Thus, Board should consider alternative ways to meet these conditions. The Board should check with their tax preparer to determine how best to proceed from a tax standpoint.

GAAP (Generally Accepted Accounting Principles)
GAAP is fairly silent about this matter. From an accounting standpoint, it appears that anything related to “long-term major repair and replacement activities” can be paid from reserves cash. As part of our audit process, we look to whether the Board made a documented decision to use reserve monies, especially if the item is not a component in the reserve study.

Here are the GAAP references – from Financial Accounting Standards Board (FASB) 972 – Real Estate – Common Interest Realty Associations:

972-205-45-8
The presentation of information about the fund for major repairs and replacements (the replacement fund) shall include information about assets, liabilities, and the fund balance specifically associated with the common interest realty association's long-term major repair and replacement activities.

972-205-45-9
All common interest realty association activities, except for replacement fund activities, shall be presented in the operating fund in the statement of revenues and expenses…

972-720-25
Common interest realty associations that use fund accounting shall charge expenditures for major repairs or replacements to the fund or funds established for major repairs or replacements.

Best Operating Practices
Based on our professional experience in this industry over the past 30 years and seeing the impact of decisions such as these on current and future homeowners, we have a few guidelines to suggest to the Board and management as “best operating practices” to consider after all legal, tax and accounting aspects have been measured:

• Are there excess monies in the Operating Fund? We generally recommend 1-3 months of operating expenses as a balance for contingencies and potential cash flow shortfalls. If the Association has adequate monies set aside for these items and there is still an excess in the Operating Fund, consider whether operating monies should be used before using reserve monies.
• Is the Replacement Fund fully funded or at a comfortable percent funded level? If the Association is well funded and the reserve monies are not needed immediately, there may be little chance of an unexpected special assessment. Thus, the Association may be able to use reserve monies for the unplanned project. Ask the reserve preparer to project out the impact on future reserve funding after this unexpected expenditure. If the impact is acceptable, then this increases the chance that the Board would be making a good business decision to proceed with the plan to use reserve monies.
• If the Replacement Fund is in a precarious position currently and/or special assessments are already recommended for current projects, then it probably does not seem reasonable to invade the Replacement Fund for an unbudgeted item. This will cause additional duress to the Association’s fiscal health and increase the potential for an unplanned and/or increased special assessment.
• Is this a matter of health, safety or involves water intrusion? In those cases, the Board may need to make the decision based on the priority of the project. This should be clearly and concisely recorded in the Board meeting minutes.
• Is there some dispute among the unit owners about the necessity of this additional project? Is it seen as superfluous or unnecessary? Does it only affect a small group of unit owners? If so, consider letting the membership vote on whether the project is wanted by either approving a special assessment to fund the project or approving use of reserve monies not previously designated for that specific purpose.

All the above are considerations that the Board, along with their manager (if any) and reserve professional should discuss and consider prior to making the decision. The process and the ultimate decision should be well documented so that the auditor, current and future members, management, and the reserve professional can properly address the situation in each of their areas of focus or concern.