Must Replacement Reserve Funds Be Held in a Separate Account?

Is there a legal or IRS requirement that replacement reserve funds be held in an account that is separate from the operating account? Or am I thinking of a CAI "best practice"? I mean a separate account with the financial institution. They are accounted for separately on the association's books.

Our HOA has approx. $850,000 in its replacement reserves. These funds are invested in CD's of various maturities. Recently the operating fund had a balance over $300,000 in a single bank account. When I pointed out that this exceeded the FDIC insurance limit, the management agent placed the excess funds into CD's under the CDARS program. When I inquired whether those CD's were registered differently from the reserve CD's, the head of the Finance Committee stated that they were not, and there was no requirement to do so.

I am concerned that if the funds are not registered separately, they could be co-mingled. This also means that the signature authority on the reserve funds is the same as on the operating account (which the MA and developer controlled board have access to). This does not strike me as a prudent financial control arrangement.

How do other HOA's handle this? It is my belief that the reserve CD's should be registered as something like: "XXXX Association Replacement Reserve Account", not simply in the name of the association, as the operating funds are. Am I being overly cautious?

Dave

Our reseveres are held in a seperate Money Market account.

Even if not legally required, so much easier to deal with.

Pat

David,

I feel quite certain in saying Bruce is correct in saying it is an IRS requirement. I know I read about this not too long ago but I can't put my finger on the document right now. BTW, the IRS refers to a reserve account as a "sinking fund".

Referring, first of all to the original post by DavidW5 — it seems to me that the answer to his main question is moot. My own conclusion is, regardless of the legal take on this question, it would certainly by very sensible to keep reserves as separate as possible from operating balances. There’s no question that one’s financial institution could ensure that the reserves-related funds are well-identified as such.

On the topic of earnings from invested monies, an article we recently wrote, says … About a third of all properties obtained between 17% and 24% of their Money In from interest, and 13½% obtained between 24.1% and 31% of their Money In from interest. (Money In is the total of reserve fund inputs from owners’ contributions and interest). It can be significant, and therefore it’s worth making sure it’s well-segregated from operating money.

IMHO - there should be 3 - 6 month's of regular budgeted operating funds as a cushion in the annual budget.

Your bylaws are vague for a reason. They should be the "bones" of your governing procedures. The current Board's rules and regulations and decisions should "flesh out" the reasons. What is happening today, may not be relevant or needed in 5 years. The bylaws give the Board the right to make decisions, based on many factors.

Jon - there are "reserves" in most funds - and then there is the Reserve Fund, talked about in Glen's post.

Your HOA needs a Reserve Fund study done (or do it yourself) to determine how to set up a plan for replacement/repairs of those assets which have a life of 20 - 25 years.

For example, we neede a roof on the community center. We put one on 4 years ago for $10,000. We expect to have to do that again in 20 years - 16 years from now. So we have been putting away a sum of money in the Reserve Fund every year, so when the 20 years date comes, the money is there (allowing for inflations, etc.)
That way we don't have to work it into our Annual Budget.

Thanks as always for your thoughtful and informative comments, which I'll share with our Board soon.

Dee said "Any surplus operating funds are subject to taxes."

Well, yeah . . .but that does not fit the definition of the not-for-profit: Revenues = expenditures; with no "profit" left over.

However, as I have stated in other threads, if the bylaws establish an Emergency Fund of 3 - 6 months operation/administrative and insurance deductible AND that any other excess funds be automatically deposited into the Reserve Fund, then the HOA is covered. All monies must be "designated" - that's what the IRS would be looking for - "loose" undesignated money.

We will have to have over a million dollars in our Reserve Fund some day. It is stated in the bylaws that we have this fund. We have designated those funds for that purpose.

I read somewhere that a strong reserve would be the equivalent of one year's dues per unit but 70% of that number would be considered a fairly healthy reserve. As our monthly dues are $325/month that would mean $3900/per unit in the reserve would be optimal. Therefore our 26-unit association would be considered to have a strong reserve if we had just over $100,000 ($101,400 to be exact). We only have about 40% of that currently but we've recently replaced a lot of high-ticket items (roof, balcony railings, etc.) so really we're not too bad off. Although, the elevator is going to need replacing within the next couple of years so we are charging a supplemental assessment twice a year for the next couple of years in anticipation of this cost. This brings up my question: what have other associations spent (ballpark) on the replacement of an elevator. Ours is a small cab (cab would not be replaced, just refurbished) 5-stop elevator. I've heard numbers ranging between $30,000 and $60,000. Anyone go through it recently? Thanks!

A number of things:

1) HOAs are "non-profit" in the eyes of state and local governments. The IRS does not recognize non-profits per se. They recognize charities and don't HOAs don't qualify.

2) My HOA's governing documents require that reserves be kept in a separate account (not just accounted for differently). Check your HOAs documents.

3) Based on our audit from last year, I suspect that to conform to "Generally Accepted Accounting Practices" (GAAP) such funds should be in a different account.

4) There may not be a legal requirement to maintain funds below the FDIC insured limit. But failure to do so may at some point be considered a breach of fiduciary responsibilities. If the association loses several thousand dollars there will be a clamoring about why this wasn't prevented.

5) There is good reason for leaving "contingencies" undefined. Failing to do so could leave the board having to make a huge assessment should a problem that was not foreseen come about.

6) Reserve funds should have a reserve study to accompany them. This will help you know what contingencies are likely to come about. It should also tell you if your $850,000 is enough, or over-kill. (And again, this is considered best practice by CAI.

Kirk,

You said: "There may not be a legal requirement to maintain funds below the FDIC insured limit. But failure to do so may at some point be considered a breach of fiduciary responsibilities. If the association loses several thousand dollars there will be a clamoring about why this wasn't prevented."

I would suggest checking with your bank if you have a reserve fund in excess of the FDIC insured limit. There are ways to deposit those funds in the same bank but still have the FDIC protection. I believe if the money is deposited in an account with more than one name on it, each name has the $100,000 protection. Also, you can have separate accounts with each account having the $100,000 protection. There are many ways to get around this and your bank mgr can advise you accordingly. I agree, it certainly would be a breach of fiduciary resp. if the assn lost $$$ because it wasn't covered by the FDIC protection.

501(c)(3) charitable non-profits get their "revenue" from donations and grants that are tax deductible for the donor. (as the IRS allows) Personal property taxes on the contents and buildings are waived, just like a church. Charities should spend ALL their donations on their mission i.e. programs, and are allowed a small emergency fund at the end of their fiscal year. They must submit a Form 990 to the IRS if their renveues are over $25,000 showing how they spend the donations. Payroll taxes and sales taxes also must be collected and paid by charities.

Homeowner's Associations that desire an IRS not-for-profit designation state their "revenue" as coming from dues and/or memberships.

There are over 18 different IRS designations for non-profits, and only the 501 (c)(3) is a charity (but cemetaries and fraternal organizatrions can accept donations) Some others are day care centers, frat and sororities, animal rights groups, churches, Black Lung Trusts, cemetaries, credit unions, veteran's organizations, social and welfare groups - and many more!

The Corporation Papers are filed with the State; then the IRS gives the designation of the non for profit status after the applicant fills out the paperwork.

My HOA uses a concept of physical vs. logical. Our physical allocation of funds is based on cash flow needs and maximizing investment interest income. Our logical allocation of funds includes both a restricted (to water & sewer replacement) and an unrestricted reserve fund as well as the operating fund that carries a large security deposit liability. We don't expect to expend the security deposit quickly as such deposits are only returned upon sale. We have more money in a CD than is the total of the two replacement/reserve funds. Using QuickBooks (class feature) we find that we can clearly show (separate) the reserve activity from the operating activity while handling our bank accounts in a straightforward with no thought to aligning the bank accounts with the logical QB accounts. Our auditor has a problem with this (sites IRS concerns) but our CPA thinks it makes sense. We see no problem with co-mingling as the QB accounting keeps things clearly separate. What do you think?

David,
In looking at your original post I realized you and I were dealing with the same issue. I was a little irritated that the ensuing posts wandered off into "how much reserve is proper" but I that happens often in forums so I decided to try to get it back on track. I personally have no problem responding to your homeowner's question by saying we post a balance sheet on the HOA's website monthly showing the allocation of the total funds to the various accounts (operating, reserve 1, reserve 2) and that it is "old school" to think the functional/logical accounts need to have their own bank accounts as the accounting software handles it just fine and it is totally traceable. I point out the advantages to not matching the accounts in maximizing the interest earnings and managing cash flow with the minimum of financial management time. So I think your answer to the homeowner satisfactory. I am only bothered by the auditor thinking the IRS wants the bank & the functional accounts to match.

You bring up the point about where the interest should reside, perhaps implying that it should go with the funding, but my response to that is it should be where the HOA policy documents say it should go.

So you and I differ on the 1st sentence in your last paragraph but we agree on your very last statement.