What Are HOA Reserve Funds For?

HOA reserve funds are integral to any homeowners association. Without them, your HOA may be forced to make unpopular financial decisions or delay crucial repairs.

What Are HOA Reserve Funds?

What does reserve funds mean? A reserve fund functions as the association’s savings account. It consists of money the association regularly sets aside so that major expenditures that come up in the future can be covered.

What can HOA reserve funds be used for? The HOA reserves are used to fund future projects, large-scale repairs, and unexpected expenses. Construction of a new swimming pool, a major roof repair, and hurricane damage are all projects that will be covered by the HOA’s reserve fund.

Since these are quite expensive projects, it would be difficult for an association to pay them off in a lump sum. So, instead, the HOA will allocate money in their reserve account for a period of time — or until the project needs to be paid off.

How Do Reserve Funds Differ from Operating Funds?

Before discussing ways to protect your association’s finances, it’s important to know the difference between operating funds vs reserve funds. You should also know why these accounts are important to your association.

Most associations have two accounts: reserve funds and operating funds.

As previously defined, homeowners association reserve funds are designated for major replacements, repairs, and maintenance. Meanwhile, an operating fund is used to pay for the day-to-day expenses of the community. This would include maintenance services, security, landscaping, utilities, management fees, taxes, and insurance.

Reserve funds and operating funds are usually respectively kept in a savings account and a checking account. Ideally, HOAs should have about 1 to 3 months’ worth of operating funds in their account.

Both reserve funds and operating funds are important to an association. Without the latter, the community would not be able to operate properly on a daily basis. And without a sufficient reserve fund, the community won’t be able to pursue projects that lead to scalability and growth.

How Much Should HOA Have in Reserve?

There is no ideal dollar amount that applies to all homeowners associations. Every HOA is different — they have different needs, sizes, and common elements. Though, an association’s reserves are considered fully funded if it can cover the cost of all the HOA’s major expenditures for the next 20 to 30 years.

Some states have specific HOA reserve fund laws that dictate an association’s reserve requirements. For instance, Ohio law mandates that reserve contributions should make up at least 10 percent of the annual budget.

More often than not, your governing documents will contain language dictating how much to keep in your reserves. Some documents set the HOA reserve funding percent requirement at 85 or 90 percent.

Though, a general HOA reserve rule of thumb is to maintain a funding level of 70 percent, at the least, at any time. For example, if the reserve study concluded that you should have $50,000 in reserves this year, then you should have at least $35,000.

The ultimate decision, though, rests upon the shoulders of the HOA board. Board members have a fiduciary duty to the association. This means board members must always act in good faith, with care, and with loyalty. As a board member, you must prioritize the needs of the community.

How Do You Account for Reserve Funds?

Much like the operating fund, homeowners association reserves are funded by the homeowners. Every year, the HOA board will come up with a proposed budget and allocate a line item for reserve fund contributions.

Optimal reserve funding is achieved through careful analysis of the association’s assets and finances. This is known as a reserve study. With the help of a reserve study, board members can somewhat accurately estimate how much the HOA will need to pay for future expenses.

HOA Reserves Calculation Example

For instance, if an association expects to pay $20,000 in 10 years for the repaving of all community roads, then the board should collect $2,000 in reserve fund contributions every year. That way, when the time comes to repave the roads, your HOA will have enough money to pay for it without charging homeowners a lump sum of $20,000.

Of course, your association will probably have more than one project to fund than just a simple repaving. Therefore, you will likely need to set more money aside than just $2,000.

Reserve Study Requirements by State

How often should an HOA do a reserve study? A handful of states statutorily require homeowners associations to conduct reserve studies every so often. California HOAs, for instance, must do one every 3 years. Other states that mandate reserve studies in one form or another are Delaware, Oregon, Nevada, Virginia, Hawaii, Washington, and Utah.

Other associations are required to do so by their governing documents. Even if state laws or your governing documents don’t mandate it, though, it is still a good idea to have a professional perform a reserve study every few years.

Are HOA Reserve Funds Taxable?

The IRS generally does not consider reserve funds to be taxable income. But, if you don’t keep your reserves in a separate bank account from your operating fund, then it may be subject to taxation. Bank interest, though, is considered interest income, which is taxable.

Can You Invest HOA Reserve Funds?

Because reserve funds usually sit in the HOA’s savings account for a long time, many boards naturally wonder whether it is smarter to invest these funds. Investing the reserve funds is a real option, but you have to consider three things: Safety, Liquidity, and Yield.

Safety is a priority when it comes to reserve fund investments. You should make sure your investment wholly protects your capital. In other words, go with an investment that offers low risk.

Liquidity refers to how easily you can convert your investment into cash. Since emergency expenses can happen at any time, your investment must offer flexibility when it comes to making withdrawals.

Finally, yield refers to the rate of return on your investment. Ideally, you would invest in something that offers low risk with moderate to high returns.

No Reserves? Here Are the Alternatives

When you lack money in your HOA reserves, there are three possible alternatives — none of which are particularly agreeable to homeowners.

• Special Assessments. A shortage of reserve funds will force you to impose special assessments on all homeowners. Due to the nature of the expenses that reserves cover, this usually means charging expensive assessments.
• Loans. If you have a steady source of revenue and little-to-no debt, you will find it easy to apply for a loan. Though, loans typically require you to pay interest and offer up collateral.
• Delay of Expenditures. If you don’t have the money for it, you might consider postponing major repairs or replacements. This, of course, will inevitably affect curb appeal, property values, and homeowner satisfaction.

How to Manage the Reserve Funds of the HOA

Theft, fraud, or embezzlement can create major damage to your association’s finances. Even if the HOA has adequate insurance coverage, there is no guarantee that you will be able to recover the money completely. In some cases, it may even take years to recover stolen HOA funds.

Nevertheless, the community needs to keep running. It will be up to the board to find ways to replenish reserves. This can be a major headache. As a precaution, it’s important to establish safeguards that will deter or eliminate fraudulent activity in your community.

Here are ways to manage HOA reserve funds and deter fraud:

1. Monitor HOA Accounts Regularly

Just because you have an HOA management company doesn’t mean that the board doesn’t have to monitor finances anymore. In fact, it is part of a board member’s fiduciary duty to oversee HOA finances regularly. With any kind of financial task, it’s better to have at least two separate parties as a check and balance. This means that one individual will never have complete responsibility for a financial task.

Board members should check bank statements, bank reconciliations, operating cash levels, HOA assessments, vendor payments, etc. Even without a financial background, it is easy to monitor the money coming in and out of your accounts and make sure your bank statements accurately reflect them.

2. Establish a Lockbox System

If you do not have an online portal for HOA fees, you are likely dealing with a large amount of cash and numerous checks each month. Leaving cash and checks lying unattended in your office — until you deposit them in the bank — creates unnecessary risk for your HOA.

To safeguard the HOA’s money, you can set up a lockbox system with your bank. Homeowners can directly mail their checks to the bank. The bank will then deposit the checks into the HOA’s account. Since there are fewer people handling these checks, there’s also a lower chance of fraudulent activity.

3. Restrict Access to Bank Accounts

HOA boards authorize management or employees to conduct financial tasks, such as withdrawing money from the bank, for more seamless operations.

However, the board may want to put restrictions when it comes to making major purchases, withdrawing large amounts, or transferring money to other accounts.

Anyone accessing the bank accounts should first receive authorization from the board.

You should also make sure that your reserve funds cannot be easily withdrawn or transferred. Talk to the institution holding your funds and ask them how to set up internal controls to prevent fraudulent activity.

4. Have Adequate Insurance Coverage

Make sure that your association’s insurance covers any money that you may lose to theft. Too often, HOAs think that their management’s fidelity insurance protects them — it doesn’t. It only protects the management company if an employee steals from them. So, whether it’s fidelity and crime insurance or directors & officers insurance, make sure you are covered for any loss — no matter who is lining their pockets.

5. Perform an Annual Audit

Get an audit — not an opinion, not a compilation, but a real, comprehensive audit. An audit from a third-party CPA is one of the best ways to ensure that your finances are all legitimate. The CPA can easily unearth evidence of fraud and embezzlement.

Yes, an audit is more expensive, but considering the huge increase in financial crimes in HOAS, this is not the time to be stingy. Remember, every person trusted the people who were scamming the association’s funds. The fact that a treasurer is a good person does not mean that they are not having personal financial problems.

Reserve Funds Are Essential

HOA reserve fund accounting is nary an easy thing to do, but it is an important part of managing a community. Your reserves act as protection for future or unforeseen expenditures. Without sufficient HOA reserve funds, you run the risk of falling into financial ruin. It is akin to a knight going into war without armor.

Many HOA management companies offer reserve planning as part of their services. Hire the best one in your area today by using our online directory for your search process.

RELATED ARTICLES:

• HOA Reserve Study 101: Does Your Community Need It?
• How To Plan For Your HOA Budget
• An HOA Accounting Guide For HOA Board Members