Question
The repairs to the construction defects are finally completed and there is still money left. What should our Association do with this unexpected windfall? Should it be refunded to the owners, be deposited into reserves, be used to pay operating expenses or treated in some other fashion?

Answer
In a Private Letter Ruling a few years ago, the IRS determined that excess litigation/construction funds could be returned to the homeowners without adverse tax consequences to the Association. Such a refund, however, would reduce the owner’s basis in his or her home, which might have a tax impact upon the sale of the home. It should be noted however, that a Private Letter Ruling is not a legally binding precedent, but is often used as guidance for how the IRS will interpret similar issues in the future.

Refunds to homeowners can also present the problem of who should receive the refund – the unit owner during the litigation or reconstruction, or the owner at the time the refund is made. It is not uncommon for previous owners to claim a right to a refund made after the sale is completed, and the Association must consider this issue before the refunds are made.

The IRS has stated that a transfer into the Association’s long-term capital reserve, such as Roofing, is an appropriate use of excess funds. Conversely, the IRS has determined that it is not appropriate to use excess litigation/construction funds for operating expenses or for reserves that are not long-term reserves. Examples of these types of short-term reserves are Painting and Contingency. Using excess money for operating expenses or transferring the money into one or more short term or contingency reserves could result in the excess money becoming fully taxable.

An Association may prudently and safely decide to maintain the excess funds to be used for construction defect repairs not completed during the initial repair program. The possibility of future problems developing is common and creating a “latent defect fund” to handle these situations helps the Association stay financially strong.

There is no one correct treatment of excess litigation construction funds. However, there are consequences for selecting the wrong treatment, and all Boards of Directors should consult with their attorney and accountant before finalizing its decision.