Community associations rely on HOA reserve funds for major repairs and replacements. Yet, far too often, these reserves are nowhere near the right level of funding. Healthy reserves prepare the association for the future, and boards can gauge whether or not they have enough funding by following simple practices.
What are HOA Reserve Funds?
The homeowners association reserve fund consists of money used to pay for major repairs and replacements once capital components reach the end of their useful life. It essentially functions as a savings account, set aside for long-term expenses.
Reserves play a crucial role in preserving the association’s finances and assets. Without properly funded reserves, boards would need to defer maintenance, levy special assessments, significantly raise dues, or take out a loan to cover the shortfall.
What are the HOA Reserve Requirements?
State laws and the governing documents determine if an association is required to fund reserves.
Currently, only 12 states require condo associations to fund reserves. These are Connecticut, Delaware, Florida, Hawaii, Illinois, Maryland, Massachusetts, Michigan, Minnesota, Nevada, Ohio, and Oregon. Condominiums have broader maintenance responsibilities because they have more shared elements.
Apart from HOA reserve fund laws, board members must also review their CC&Rs and bylaws. Even if state laws are silent, the governing documents may mandate reserve funding.
What Can HOA Reserve Funds Be Used For?
Depending on the governing documents, an association can generally use HOA reserve funding to cover repairs and replacements of major components or infrastructure.
Examples include:
- Fixing or replacing roofs on shared buildings such as clubhouses or security gates
- Repaving community parking lots, private streets, and shared driveways
- Resurfacing community swimming pools
- Upgrading playground equipment
- Replacing shared HVAC systems, elevators, or fencing in common areas
That said, associations generally can’t use reserve funds to pay for operating expenses, such as routine maintenance and management fees. That’s what the operating fund is for.
What is the Right HOA Reserve Funding Percent?
Ideally, an association should aim to keep its reserves between 70% and 100% funded at all times.
There is no exact dollar amount that works for all associations. Every community has different needs, infrastructure, and risks. Even when two buildings are constructed exactly alike, they can differ in wear, damage, and long-term use.
To determine the right funding level, associations must conduct a reserve study. This study identifies the major capital components of the HOA, how much useful life they have remaining, and the cost to repair or replace them. That said, the HOA reserve rule of thumb is to have at least 70% of its funding needs covered at any time.
What are the HOA Reserve Funding Strategies?
There are three funding strategies for HOA reserves: full funding, threshold funding, and baseline funding. Let’s break these down below.
1. Full Funding Strategy
A full funding strategy aims to keep the reserve balance at or near 100% of the calculated amount in the reserve study.
This strategy offers maximum protection, as it ensures that the association can cover all of its reserve costs. Of course, it may require higher reserve contributions over a shorter period.
2. Threshold Funding Strategy
A threshold funding strategy establishes a minimum percentage that’s considered safe for a reserve balance. Typically, this is 70% of the fully funded amount as indicated in the reserve study.
Threshold funding balances risk mitigation and affordability for homeowners in terms of reserve contributions. For this reason, it is the most favored funding strategy.
3. Baseline Funding
A baseline funding strategy sets contributions just high enough to keep the reserve balance from reaching zero at any time. This strategy keeps HOA dues low, but it doesn’t leave much room for error or unexpected costs. There is also a higher risk of special assessments.
Drawbacks of Underfunded HOA Reserves
When an association lacks adequate reserves, it can face consequences.
The need for major repairs and replacements will eventually catch up. When that time comes, if the HOA doesn’t have sufficient reserves, it will have to levy large special assessments or significantly raise dues. Another option is to take out a loan from a bank, but that’s only a temporary fix. Owners must still be held responsible for repayment.
Apart from the financial impact, underfunded reserves can also have legal implications. Board members have a fiduciary duty to maintain the association. Poor reserve planning and the resulting inability to repair or replace components may constitute a breach of this duty. Owners may take legal action against the HOA and even the board members themselves.
Without money, boards will need to defer major repairs and replacements. This can cause irreversible damage and deterioration, thereby lowering curb appeal and property values. In the end, homeowners won’t get a satisfactory return on their investment.
How are HOA Reserves Funded?
Reserves are funded by the homeowners, with a portion of their regular dues allocated as the HOA reserve contribution.
Board members rely on an updated reserve study to determine how much each owner must contribute to the reserves. Gradual contributions through regular dues are the norm, but the board may turn to large special assessments if its reserves are underfunded and a major repair is scheduled soon.
Are HOA Reserve Funds Taxable?
In general, reserve contributions are not taxable income, but the interest or investment earnings on those funds are.
If an HOA wishes to prevent the IRS from classifying reserves as taxable income, it should follow specific accounting practices. These include keeping the reserves completely separate from the operating funds and only spending the reserves on major capital repairs or replacements.
Best Practices for HOA Reserve Fund Management
Managing the reserves requires discipline, compliance, and expertise. Professional HOA management can help with reserve planning and oversight, but self-managed boards must rely on the following tips.
1. Keep Accounts Separate
Associations must always keep the HOA reserve account and operating account separate. Commingling funds not only makes it harder to track money but can also render the reserves taxable. Remember that operating funds pay for day-to-day expenses, while reserve funds cover major capital repairs and replacements.
2. Conduct a Reserve Study
A reserve study can determine the condition of each major component, its remaining useful life, and the total repair or replacement cost. It also comes with a funding plan that ensures an HOA has sufficient reserves.
Several states require associations to perform a reserve study every few years. In Virginia, for instance, HOAs must conduct this study once every five years to account for economic changes and evolving market projections (Section 55.1-1826). Even without a statutory requirement, boards would be wise to hire a professional reserve specialist to conduct this study.
3. Invest Wisely
Since reserves tend to remain stagnant for several years, associations may wish to invest them to maximize returns. That said, when choosing investment plans, the board must always prioritize safety and liquidity while keeping FDIC insurance limits in mind.
The Best Way Forward
The HOA reserve funds play an essential role in long-term capital planning and financial stability. Board members must maintain a healthy funding level and employ the industry’s best practices. When in doubt, hiring an HOA management company can help.
Westward360 is a trusted partner for HOAs and condo associations across the United States. For expert association management, contact us today or request a proposal online!
