Learn Everything about Reserve Funds For Homeowners Associations

Although reserve funds are often not mandatory, an ample reserve can play a big role in protecting a community’s long-term financial health.

To function as intended, a homeowners’ association (HOA) must rely on assessment revenue from its members.  Most communities calculate assessments, at least in part, based on an annual budget of anticipated expenses.  These typically include the costs involved in performing all of the HOA’s maintenance duties, procuring necessary insurance, and covering overhead, along with any other fixed or reasonably foreseeable outlays.  The resulting gross budget is then divided among the members of the association, and homeowners are assessed accordingly.

When creating an annual budget in this manner, it’s generally a good idea to be as precise, analytical, and transparent as practically possible.  However, a budgeting approach that relies exclusively on predetermined, repeating, line-item expenses doesn’t leave much room for error.  After all, what if an essential common element is unforeseeably damaged—resulting in significant repair or replacement costs—and there’s no money in the budget or insurance to cover the loss?  Or it may be that the association has some legal issues arise and incurs attorney’s fees much higher than could have been reasonably anticipated.  And, of course, some common elements don’t need maintenance every year, but, when maintenance time comes, it’s costly.

Rather than get caught scrambling for cash when an unexpected contingency or major maintenance need arises, many communities maintain “reserve accounts” or “reserve funds,” as a sort of back-up savings slated for emergencies, long-term upkeep costs, and irregular expenditures. Although reserve funds are often not mandatory, an ample reserve can play a big role in protecting a community’s long-term financial health.

What are Reserve Funds?

We’re all familiar with the differences between checking and savings accounts.  Aside from cash itself, a checking account is as liquid as assets get.  You use it to pay bills, buy groceries—the sort of everyday expenditures it takes to run a household.  A savings account, on the other hand, serves as a rainy-day fund you can tap when something unexpected arises—like, say, your vehicle needs a new catalytic converter.

Most homeowners’ associations have an operating account or similarly designated checking account to cover the routine expenses.  Office supplies and regular maintenance of common elements, for instance, are typically paid from the operating fund.

An HOA’s reserve fund, in contrast, is an account dedicated to unanticipated and deferred expenditures, particularly large ones.  The association allocates money toward its reserve account over time so that, when a costly repair or comparable outlay becomes necessary, cash reserves are available to handle the expense without sacrificing day-to-day functions.

By way of example, an HOA might pay out the costs of routine snow removal from its operating account.  If the community expects to need plowing a few times each winter, the board will build the costs into the annual budget.  But when all the plowing over the years leaves a significant portion of the development’s roads in need of repaving, the money is more likely to come from a reserve fund.

Reserve requirements are not addressed under every state’s HOA laws.  And some states that do address them, leave a lot to the board’s discretion.  More commonly, reserve account standards are found in a community’s declaration or bylaws.  Statutes governing condominiums are usually more explicit in setting forth precisely what is required of an association with regard to reserves.

The Purpose of Reserve Funds

An association’s annual budget takes into account reasonably foreseeable expenses like landscaping, equipment upkeep, and payroll if the HOA has employees.  But when an association-owned building needs a new roof, the community pool requires a major repair, or all the equipment in the fitness center starts breaking down, the unbudgeted costs will need to be paid from reserves.

A reserve fund can also be used to cover expenses that are not necessarily unforeseen, but arise infrequently enough that it wouldn’t make sense to include them within annual budgets.  If the community’s tennis courts need to be resurfaced every ten years, the board might hold back in reserve around ten percent of the cost each year so that, when the time comes, the resurfacing costs can be paid outright.  Of course, it’s not always so easy to predict precisely how much money will be needed.

Reserve Studies for Homeowners’ Associations

Reserve funds present something of a conundrum for HOA boards.  If you maintain reserves for the express purpose of paying expenses that are unanticipated and infrequent, then how does the board decide how much it needs to hold in reserve?  If the association holds back too much, it is essentially over-taxing its members.  But if reserves are inadequate, then the HOA might find itself insufficiently liquid to meet its obligations without imposing a costly special assessment or taking out a loan—neither of which is likely to be popular with homeowners.

Reserve studies are intended to help Goldilocks (i.e., the HOA board) find the porridge (i.e., the reserve amount) that’s just right.  A reserve study is an examination conducted by a consultant or accounting firm for the purpose of analyzing probable long-term expenses.  The idea is to use the analysis to estimate the community’s reserve needs as scientifically as possible.

Along with reviewing the association’s assets (including current reserves), budget, and anticipated revenue, the auditor will survey community equipment, buildings, and other common elements.  Based on all available information, the auditor comes up with a long-term schedule of expected repairs, replacements, major maintenance, and any other relevant liabilities likely to affect the HOA’s bottom line.

Once the study is concluded, the board uses the estimates to calculate the level of regular homeowner assessments needed to maintain the optimal reserve account balance.  For instance, if the study estimates that a parking lot within the community will need new asphalt in ten years, and that the cost will be around $20,000, the board might adjust the budget and assessments to hold back $2,000 in additional reserves each year.  That additional $2,000 is divided among all members’ annual dues so that, when the time comes for new asphalt, the funds are already available in the reserve account.

Of course, a study will in all likelihood identify numerous potential expenditures over the relevant period, and the reserve recommendation will be based on the aggregate anticipated long-term cash needs—not just any single item.  But the principle is still the same.

Reserve studies cost money, so they don’t make sense in every situation.  In a small association with only minimal commons and simple maintenance duties, a reserve study would probably cost more than the value it could reasonably be expected to provide.  At the same time, a large association with elaborate commons and extensive duties would be imprudent not to use a reserve study or other means of scientifically calculating reserve needs.

Reserve Funding Requirements

The appropriate dollar balance for any given community’s reserve fund depends in large part on the size of the association, the nature of the common elements, and the extent of the HOA’s obligations.  Some state HOA and condo laws establish specific reserve requirements, but funding needs are more commonly set by the board in accordance with standards detailed in the association’s governing documents.  A reserve account is “fully funded” if it covers 100% of the community’s reasonably foreseeable expenses.  Many communities choose to set reserve requirements at a percentage of anticipated expenses, as estimated by the board or identified in a reserve study.  So, for example, an association might require the board to hold in reserve at least 75% of anticipated expenses at any given time, adjusted based on the schedule for deferred maintenance.

A few states establish specific funding requirements for reserves stated as a percentage of the association’s overall budget.  See, e.g., Ohio Rev. Code §5311.081(A)(1) (requiring annual reserve contributions of at least 10% of budget, but allowing waiver by majority vote).  More commonly, states adopt statutory principles for reserves but leave the specifics to the discretion of the board or community as a whole.  Generally, condo laws go into much more detail when it comes to reserve requirements.

Florida’s condo statute requires an association’s annual budget to include reserves for “capital expenditures and deferred maintenance … [including but not limited to] roof replacement, building painting, and pavement resurfacing,” and any other deferred maintenance or replacement cost exceeding $10,000.  Fla. Stat. §718.112(f)2a.  For each included item, the calculation must be based on the “estimated remaining useful life and estimated replacement cost or deferred maintenance expense.”  Id.

Though Florida’s condo statute requires reserves by default, it also allows a condo association to waive reserve requirements, or require a lesser amount, by majority vote.  Id.  Florida’s HOA statute likewise makes reserves optional.  If a community opts for reserves, the reserve account funding must be calculated based on each asset’s estimated deferred maintenance or replacement cost divided by its predicted useful life remaining.  Fla. Stat. §720.303(6)(g).

California requires associations to maintain reserve balances based on reserve studies conducted at least once every three years and including diligent, on-site inspections.  Civil Code §5550.   The study must, at a minimum, identify all major components the HOA is obligated to maintain, the estimated costs and useful life associated with each, and the annual reserve contribution necessary to defray the costs.  Id.

Similarly, Washington requires calculation of reserve contributions in communities with “significant assets” (defined as assets valued at 50% or more of the association’s gross budget) based on regular reserve studies.  Wash. Code §64.34.020.  At least every three years, the study must be conducted by an independent professional who visually inspects the relevant assets.  Notably, though, the Washington statute merely “encourage[s]” HOAs “to establish a reserve account… to fund major maintenance, repair, and replacement of common elements.”  Wash. Code §64.34.380.

State legislation routinely recognizes the importance of reserve funds to homeowners’ associations but doesn’t make them mandatory. However, deferred maintenance, repair and replacement of major elements, and surprise expenses will inevitably come up.  When adequate reserves aren’t available, a community will need to employ alternate means of paying for these significant costs.

Homeowner Recourse

A homeowner who believes an association’s board is mishandling or underfunding reserves has a few options.  First, the homeowner can bring up reserve issues at the next homeowners’ or open board meeting, or informally discuss concerns with a board member.  A formal records request can also help provide detailed information about how reserves are being maintained and used and whether there is in fact a problem.

Because of the democratic character of community associations, there’s also the option of running for the board in the next election or organizing a campaign to amend the association’s declaration to include more stringent or specific reserve requirements. If misconduct or fiduciary lapses are involved, an individual homeowner or group of homeowners usually have standing to pursue legal claims against the board or its members, depending upon the specifics of the situation and whether actual damages have been incurred.  It’s almost always a good idea to consult with an experienced attorney before asserting or pursuing legal claims.

In situations involving outright fraud or embezzlement, homeowners should bring the matter to the attention of local law enforcement agencies.  Misappropriation of funds entrusted to an individual is criminal conduct in every state, though, of course, the precise standards vary by jurisdiction.