Any financially healthy HOA in California has an operating fund as well as a reserve fund. How do these pools of money differ, and why is it important to have a strong reserve?
Your HOA reserve funds should be used to pay for specific types of expenses over the long term. When you have enough in the reserve to cover those expenses, you don’t have to go into debt or increase the fees that your homeowners pay.
The reserve fund has an impact on the financial stability of your community. You need to protect it and you also need to continue contributing to that fund so the security and lifespan of your HOA is never in danger.
We’re talking in this blog about some of the strategies your association can use to maximize your HOA reserve funds and ensure they’re only being used when it’s absolutely necessary and justified.
When to Use HOA Reserve Funds
Your operating funds are set up to pay for those recurring expenses that should be in your HOA budget. The operating fund is responsible for landscaping, for example, and pest control. If your association has a pool, the pool cleaners will be paid with operating funds.
Reserve funds are different because they pay for non-recurring expenses that occasionally pop up. You might use reserve funds to pay for a community improvement. Perhaps the clubhouse roof needs to be fixed or you’re repairing some broken equipment at a playground. Those are larger projects that aren’t necessarily planned in advance. The reserve funds are used because they’re available and the project needs immediate attention.
Capital improvements, however, are not meant to be paid for out of the reserve fund. HOA reserve funds only cover repairs, replacements, and unforeseen expenses. Something like a new building or feature within the community requires planning. Therefore, it requires a different fund to cover the cost.
All reserve fund spending must also stick to community bylaws and regulations.
Reserve Studies to Maximize Funds
One way to maximize what you have and what you save in your reserve fund is to conduct a reserve study. This is more than a best practice – it’s a legal requirement. According to California Civil Code §5550, an HOA is required to maintain reserve fund balances. The balance amount must be based on a reserve study done a minimum of once every three years.
The reserve study must:
- Identify the assets and maintenance concerns the community must address
- Identify the annual contribution amount to the reserve fund
- Estimate the lifespan of all systems and components within the community
Your HOA board needs to have an idea of how much money is in the reserve. They also need to budget for those unknown expenses that might have to be paid for out of the reserve. It’s not always easy to budget, and that’s why reserve studies are so essential.
Your reserve study is meant to analyze the HOA’s budget against the needs of the community, based on its condition. The result is an estimate of what will need to be renovated, repaired, and replaced over the next few years.
If your reserve study does not already include amenities, make sure you’re reviewing those on an annual basis. Knowing what kind of condition those amenities are in will help create a more accurate estimate for your board.
Funding Sources to Maximize Reserves
Where will the money come from? For a lot of HOA boards, contributing to the reserves is not easy.
Ideally, you’ll increase your funding every year. Raising assessments is often not the first nor the best option. Homeowners are likely to push back, and board members don’t want the reputation of trying to pull more money from residents into the reserve budget.
This could backfire, however. If your reserve is underfunded, you’ll need to levy a special assessment to pay for those last minute projects that should have been covered by the reserve.
Consider incremental and annual increases in assessments. A monthly increase of $10 every year isn’t as painful as a larger one-time special assessment when the board finds itself in a bind because they don’t have enough money to pay for a necessary project. This regular and soft increase will increase what you hold in your reserves and deliver more peace of mind and financial stability.
Investing Your HOA Reserve Funds
Experts tend to agree that investing some of your reserve funds is a good idea, especially when you’re looking for ways to maximize what you have. By investing a portion of your reserve, you can let the money grow over time.
When your reserve study shows you that the community is relatively well-maintained and nothing should need to be repaired or replaced in the next year or two, why not make some investments to keep those funds increasing?
If you’re thinking about taxes, remember that the IRS does not consider reserve funds as income that’s taxable – provided that those funds are in a separate account from your operating funds. California, however, may tax any interest that is earned on your investment. Talk with your HOA association management company or a CPA so you know exactly what kind of tax exposure you’re taking on when you invest part of your reserve funds.
A savvy board of directors will leverage strong partnerships with property managers, accounting professionals, and legal experts when it comes to how to use reserve funds. You want to maximize every dollar because you’re going to need the money eventually, and it’s a challenge never knowing exactly how much you’ll need and when.
Lean on your HOA property management partner. We can make some recommendations based on the unique needs of your community and we can help you get an accurate and proactive reserve study completed to show you where you are.
Contact us at Hill & Co. so we can tell you more about the HOA services we provide in California for HOA boards and community associations just like yours. We can deliver full-service management or virtual management if you’re looking for something more flexible and cost-effective.