Get 6 months of free community web site hosting from Community123.com!
Monday, December 22, 2014
HOA Websites by Community123.com (National Community Website Provider)
We built HOATalk and we'll build your community website for free!  Click here for information on a free trial website.
Community Associations Network (National HOA Reference Library)
News, articles and blogs about condos/HOA's
Only members have access to all features.
Click here to join HOATalk for Free! Members click here to login and access all features.
Subject: Investment of Excess Operating Funds vs. Reserves
Prev Next
Please login to post a reply (click Member Login on the menu).
Author Messages
DavidW5
(Virginia)

Posts:523


08/25/2011 7:12 AM  
I'll try to keep this short:

I became chairman of the Finance Committee in February. Our HOA has run a surplus in the operating account for each of the last three years averaging $150,000 per year. Current year (thru July) we are $154,000 under budget. We just had a level II reserve study update done and the reserves are fully funded. The calculated reserve contribution from the assessments will go down by $85,000 for 2012.

All of our investments total $510,000 more than the balance sheet shows for the amount of replacement reserves. These investments consist of laddered CD's and bank Money Market accounts. None of the investment accounts are specifically identified or registered as either "reserves" or "operating funds". In all prior years all of the interest earned on all of the investments has been shown as income in the operating budget. Our monthly financial statements, prepared by the management company are not in "fund accounting" format and they say their system can't produce that format.

I believe that the interest on invested reserves should remain in reserves. Under the circumstances how do we determine how much of the interest earned is from invested reserves when it is not clear which investments are reserve funds and which are invested excess operating funds?

What are our options for applying the excess operating funds? My understanding is that we have three options:

1. The unspent funds can be returned to the association members.
2. The unspent funds can be applied to the following year's operating budget.
3. The excess funds can be allocated to reserves.

It seems to me that there are implications of #2 and #3 that have to be considered.

For #2 - If the following year the requirement for operating funds does not increase and we apply the excess from the previous year, then to have a balanced budget the assessment would have to be reduced.

For #3 - The funding of the reserves is based on the reserve study. If the study says that the reserve contribution for the year should be, for example, $400,000 and we apply $100,000 of prior year excess operating funds to the reserves, then the current year contribution to reserves from the operating account only needs to be $300,000. If we don't reduce the assessments, then the operating account will have a built in excess of $100,000.

It seems that if we continue to underspend the operating budget, eventually we will have to reduce assessments. Maybe there is another alternative I am not aware of.

We have only been under homeowner control of the association for 15 months and are still in the process of addressing maintenance and repairs that the declarant neglected. We are also in the process of renegotiating and/or awarding major contracts (such as landscaping for 91 acres of common grounds). Given those and other uncertainties, I am reluctant to recommend to the board that assessments be reduced and they are unlikely to go along, even if I do.

Given all of the above, in your collective wisdom and experience, what is the best course of action?

BruceF1
(Connecticut)

Posts:2486


08/25/2011 7:45 AM  
David,

There may be tax implications. HOAs are not supposed to make a profit. To avoid tax on the excess, you may have to return it to the homeowners. The IRS has rules regarding sources of income (certain percentages must be met) and expenses in order to qualify for the preferred tax status as an HOA. The following quote regarding the expenditure test is from the instructions from IRS Form 1120-H (the HOA tax form):

"Item C. 90% expenditure test. At least 90% of the association’s expenditures for the tax year must
consist of expenses to acquire, build, manage, maintain, and care for property, and in the case of a
timeshare association, for activities provided to, or on behalf of, members of the timeshare association. Include current and capital expenditures. Use the association’s accounting method to figure the total.

Include:
1. Salary for an association manager or secretary.
2. Expenses for gardening, paving, street signs, security guards, and property taxes assessed on association property.
3. Current operating and capital expenditures for tennis courts, swimming pools, recreation halls, etc.
4. Replacement costs for common buildings, heating, air conditioning, elevators, etc.

Do not include expenditures for property that is not association property. Also, do not include investments or transfers of funds held to meet future costs. An example would be transfers to a sinking fund to replace a roof, even if the roof is association property."

Your best bet would be to consult with a tax advisor or a tax attorney.
PetunkaM
(Florida)

Posts:958


08/25/2011 8:12 AM  
What are our options for applying the excess operating funds? My understanding is that we have three options:

1. The unspent funds can be returned to the association members.
2. The unspent funds can be applied to the following year's operating budget.
3. The excess funds can be allocated to reserves.

David,
To avoid tax implications: our accountant told us that we can move operating reserves to any of our reserve funds IF the membership votes on the issue and approves.
I do not know if the vote to move the money around would require a majority of the membership or a majority of those present at the meeting, in your community.
DavidW5
(Virginia)

Posts:523


08/25/2011 9:45 AM  
Posted By BruceF1 on 08/25/2011 7:45 AM
David,

There may be tax implications. HOAs are not supposed to make a profit. To avoid tax on the excess, you may have to return it to the homeowners. The IRS has rules regarding sources of income (certain percentages must be met) and expenses in order to qualify for the preferred tax status as an HOA. The following quote regarding the expenditure test is from the instructions from IRS Form 1120-H (the HOA tax form):

"Item C. 90% expenditure test. At least 90% of the association’s expenditures for the tax year must
consist of expenses to acquire, build, manage, maintain, and care for property, and in the case of a
timeshare association, for activities provided to, or on behalf of, members of the timeshare association. Include current and capital expenditures. Use the association’s accounting method to figure the total.

Include:
1. Salary for an association manager or secretary.
2. Expenses for gardening, paving, street signs, security guards, and property taxes assessed on association property.
3. Current operating and capital expenditures for tennis courts, swimming pools, recreation halls, etc.
4. Replacement costs for common buildings, heating, air conditioning, elevators, etc.

Do not include expenditures for property that is not association property. Also, do not include investments or transfers of funds held to meet future costs. An example would be transfers to a sinking fund to replace a roof, even if the roof is association property."

Your best bet would be to consult with a tax advisor or a tax attorney.




Bruce,

On advice of our auditor (CPA) we file a Form 1120 tax return rather than 1120-H, so I don't believe those rules apply.
DavidW5
(Virginia)

Posts:523


08/25/2011 9:48 AM  
Posted By PetunkaM on 08/25/2011 8:12 AM
What are our options for applying the excess operating funds? My understanding is that we have three options:

1. The unspent funds can be returned to the association members.
2. The unspent funds can be applied to the following year's operating budget.
3. The excess funds can be allocated to reserves.

David,
To avoid tax implications: our accountant told us that we can move operating reserves to any of our reserve funds IF the membership votes on the issue and approves.
I do not know if the vote to move the money around would require a majority of the membership or a majority of those present at the meeting, in your community.




In the past excess operating funds were applied to replacement reserves. This was done by vote of the board. Our governing docs do not require a membership vote on this or to approve the budget.
PetunkaM
(Florida)

Posts:958


08/25/2011 10:42 AM  
David,

Yes, usually the Board has all the powers to prepare and approve the budget. I also agree that surplus money is governed by the docs and some docs do not say how the surplus money must be handled. However, it is my understanding that if the association does not file 1120H, there will be tax consequences for rolling over the surplus without the owners’ vote. But I can be wrong. Disclaimer: I know nothing about taxes.

PS: Our docs tate that any funds in the reserve account or accounts shall be used only for that purpose unless use for other purposes is approved by a majority vote. So, we always vote at the annual meeting - if there is any money to worry about, that is.
BruceF1
(Connecticut)

Posts:2486


08/25/2011 11:27 AM  
David,

I'm surprised your association doesn't file an 1120H to claim the tax status of an HOA.

I've just signed up for a tax prep course to become a professional tax preparer. Just think, in a few months I'll be an "expert." (Ha!)
GlenL
(Ohio)

Posts:5244


08/25/2011 3:08 PM  
David, do your documents cover this at all? For instance our documents require all homeowners to be assessed equally for any budget shortfalls and for any excess funds to be returned equally to the homeowners in the form of reduced assessments until they are gone. Then Ohio changed the law in 2005 which allows excess funds to be placed in reserves. You should also check the VA HOA laws to see if they have anything relevant to your question.

French historian and author of Democracy in America Alexis de Tocqueville famously observed, "In a community association, members get the boards they deserve."
TimB4
(Virginia)

Posts:9726


08/25/2011 3:22 PM  
David,

I do not think you are allowed to return the funds to the membership except by way of a reduced assessment.

As you know the assessment is the sum of the operating budget + amount needed for reserves + amount needed for a contingency fund divided by the number of lots.

If there are excess funds perhaps you can look at projects you wanted to get done but weren't funded for. Perhaps extra street lighting. Major trimming of trees in the development, etc.

Tim
JohnM48
(Pennsylvania)

Posts:89


08/25/2011 3:26 PM  
Posted By TimB4 on 08/25/2011 3:22 PM
David,

I do not think you are allowed to return the funds to the membership except by way of a reduced assessment.
Tim




At least in PA, the method of returning funds is up to the HOA. We can credit the homeowner's account or cut lump-sum checks for everyone.

Association President
PetunkaM
(Florida)

Posts:958


08/25/2011 3:34 PM  
I do not think you are allowed to return the funds to the membership except by way of a reduced assessment. (Tim)

These are the owners money. Either way should allowed I think. This is why the vote by the members is so important when it comes to money management.
BruceF1
(Connecticut)

Posts:2486


08/26/2011 5:17 AM  
Posted By TimB4 on 08/25/2011 3:22 PM
I do not think you are allowed to return the funds to the membership except by way of a reduced assessment.


Our documents, and state law, allow excess funds to be returned to the membership, or carried over to the next year to reduce the next year's assessments. This is also allowed under IRS tax rules for HOAs (see instructions for IRS Form 1120-H).
SusanW1
(Michigan)

Posts:5202


08/26/2011 5:33 AM  
Only 15 months on your own? (HOA turnover) and still assessing the developer's screw-ups?

Too soon to be worrying about what to do with the "excesses"

You need to re-evaluate your Reserve Fund ASAP. Bet there would be some adjustments that could eat up any excesses.


DavidW5
(Virginia)

Posts:523


08/26/2011 6:10 AM  
Susan,

Sorry I didn't give a complete picture. Negotiation with the developer over a list of 65 deficiencies was completed several weeks ago and a financial settlement of just under $300,000 was made. Those funds have been placed in a separate bank account and will be used to correct the deficiencies. I did not include these funds in the discussion above.
EllieD
(Vermont)

Posts:378


08/26/2011 7:41 AM  
DavidW5,

You wrote:

We just had a level II reserve study update done and the reserves are fully funded. The calculated reserve contribution from the assessments will go down by $85,000 for 2012.

Would you explain what a “level II” reserve study update is? I am not familiar with that terminology.
DavidW5
(Virginia)

Posts:523


08/26/2011 8:13 AM  
Posted By EllieD on 08/26/2011 7:41 AM
DavidW5,

You wrote:

We just had a level II reserve study update done and the reserves are fully funded. The calculated reserve contribution from the assessments will go down by $85,000 for 2012.

Would you explain what a “level II” reserve study update is? I am not familiar with that terminology.




A level II reserve study is an update to the previous study which includes a site visit to inspect the common elements covered by reserves and to adjust their remaining economic life and estimated replacement costs, if necessary. This differs from a Level III update, which does not include a site visit.

In our case we brought back the same company who had done the Level I (original full)study in 2006 to do the Level II study.
EllieD
(Vermont)

Posts:378


08/26/2011 12:32 PM  
DavidW5,

Since you had the same company back to update the Reserve Study, have you independently verified, or gotten a second opinion on any of the larger reserve items, perhaps by checking with a local contractor, to ask what might it cost now, and what might it cost in say 20 years, or whenever?

My concern would be that the study might be on “the low side”.
DavidW5
(Virginia)

Posts:523


08/26/2011 1:48 PM  
Ellie,

No, we do not check prices with a local contractor. The firm that did the study specializes in doing them. A local contractor's "guesstimate" of what it might cost to replace the clubhouse roof 30 years from now is of dubious value.

The state of Virginia requires a reserve study to be updated at least every 5 years. The two methods generally used to calculate reserve requirements (cash flow method and component method) are both quite conservative and are more likely to overestimate the need for reserves rather than underestimate them.

In most cases where HOA's find themselves short on funds for a major replacement, this results from boards not funding reserves to the amounts calculated by the study, not because the study underestimated requirements.
KellyM3
(North Carolina)

Posts:1116


08/28/2011 11:59 AM  
David,

If you're still assessing deferred maintenance in your common property areas, you can't be 100% sure that your HOA is fully funded. You've not spent the cash to bring all your maintenance up to par. At that point, I think you can assess your savings situation, when you really have zero outstanding needs and a plan to schedule savings for future repairs.

But, a tax professional/accountant is your best source of advice.

I'd plow cash back into the getting my core amenities to their expected standard before refunding money or reducing assessments. Repair bills always come due sooner or later. If you're blessed with the cash flow now, exercise the "sooner" when making repairs.
DavidW5
(Virginia)

Posts:523


08/29/2011 5:59 AM  
OK, I finally decided to do the basic research and figured this out. I read the IRS regulations, read everything I could find on Revenue Ruling 70-604 and went through our HOA's tax returns for the past 3 years. Here is what I found out:

First of all, as I stated above the 2010 audit report recommended that we file using the corporate method (Form 1120). However, the association actually has filed 1120-H for 2008, 2009, and 2010 (this turns out to be a good thing).

Revenue ruling 70-604 is only applicable if you file 1120, not if you file 1120-H. So none of the provisions in that ruling apply to my HOA for the years in question. Therefore, although we had excess operating income in those years we were free to apply that excess to reserves or to carry it over as unappropriated members equity without paying income tax on it.

Using 1120-H we only paid tax on the interest income (and some other minor income items) but at a 30% tax rate. If you elect to file 1120, the tax rate is only 15% however, any excess income MUST be offset by an equally large deficit in the following year, else the excess is taxable. Also, the consensus among tax professionals seems to be that the vaguely worded 70-604 precludes an HOA from carrying forward excess income for multiple years OR from applying it to reserves without jumping through a number of other hoops.

My conclusion is that the 2010 audit recommendation was an error. I have emailed the auditor to ask about this but haven't yet received an answer.

As to the allocation of interest earned on investments, whether reserve funds or operating excess - it appears we can do whatever we think best with no tax consequences as long as we continue to file 1120-H.

If there are any CPA's out there, I would appreciate any feedback on these conclusions.
Please login to post a reply (click Member Login on the menu).
Forums > Homeowner Association > HOA Discussions > Investment of Excess Operating Funds vs. Reserves



General Legal Notice:  The content of forum messages are from the posting member and have not been reviewed nor endorsed by HOATalk.com.  Messages posted by HOATalk or other members are for informational purposes only, are not legal or professional advice and do not constitute an attorney-client relationship.  Readers should not act upon this information without seeking professional counsel.  HOATalk is not a licensed attorney, CPA, tax advisor, financial advisor or any other licensed professional.  HOATalk accepts ads from sponsors but does not verify sponsor qualifications nor endorse/guarantee any sponsor's product or service.
HindmanSanchez Legal Notice:  (For messages posted by HindmanSanchez) This message has been prepared by HindmanSanchez for informational purposes only and does not constitute legal advice. This information is not intended to create, and receipt of it does not constitute an attorney-client relationship. Members of HOATalk.com should not act on this information without seeking professional counsel. Please do not send us confidential information unless you speak with one of our attorneys and get authorization to send that information to us. If you wish to initiate possible representation, please contact an attorney in our firm. Our attorneys are licensed to practice law in the state of Colorado only.

Legal Notice For Messages Posted by Sponsoring Attorneys: This message has been prepared by the sponsoring attorney for informational purposes only and does not constitute legal advice. This information is not intended to create, and receipt of it does not constitute an attorney-client relationship. Readers of HOATalk.com should not act on this information without seeking professional counsel. Please do not send any sponsoring attorney confidential information unless you speak with the sponsoring attorney or an attorney from the sponsoring attorney’s firm and get authorization to send that information to them. If you wish to initiate possible representation, please contact an attorney in the firm of the sponsoring attorney. Sponsoring attorneys that post messages here are licensed to practice law in a specific state or states as indicated in their message signature or sponsor’s profile page. (NOTE: A ‘sponsoring attorney’ is an attorney that is a HOATalk.com official sponsor and is identified as such in the posted message or on our sponsor page.)

Only members have access to all features.
Click here to join HOATalk for Free! Members click here to login and access all features.
Copyright HOA Talk.com, A Service of Community123 LLC ( Homeowners Association Discussions )   Terms Of Use  Privacy Statement