HOA Reserve Funds: The Pros and Cons of Underfunding Reserves
"I have a board member right now who wants to get his board to roll back assessments by 50 percent and not fund reserves," says David C. Swedelson, principal at Swedelson & Gottlieb, a law firm that represents associations in the Los Angeles area. "He's in [financial] trouble. So he's getting a petition of homeowners to compel the board to vote to reduce assessments."
In this ever-scary economy, Swedelson is surely not the only attorney to field questions from boards about whether they can stop or reduce their funding for reserves as a way to ease the burden on homeowners. Some, but not all states, have laws governing associations' reserve practices, so investigate your state law before your board takes any action.
Here, attorneys offer a taste of how state laws work from their perspective at each end of the country—California and Florida.
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Funding HOA Reserves in California
California law doesn't specifically require associations to fund reserves, but Swedelson says board members' fiduciary duties come into play. "In California, associations are required only to disclose annually the categories of major common area components they're reserving for, how many years of useful life each component has left, and how much money they've set aside for reserves for each. Associations could put zero," he explains. "But most people take the position that it would be a breach of the board's fiduciary duty not to have reserves. I think it's the board's fiduciary obligation to do what's in the best interest of the association, which is to have money set aside for improvements."
In fact, Swedelson says a lack of reserves can lead to bad decision-making. "I was at a meeting at which a board voted to put on a lesser roof because it didn't have the money for the more expensive option," he explains. "The contractor said the association could put on a flat roof that would last 10 years for $80,000 or one that would last 20 years for $100,000. The association could have spent $20,000 and doubled the life of the roof, but it didn't have the money."
Relying on special assessments to fund major repairs can also lead to a failure to maintain property and a loss in value for all units. "The pro of underfunding reserves is that boards can levy special assessments if they need to," says Swedelson. "But what happens if homeowners don't fund the special assessment? Other than helping out homeowners who are having financial difficulties, I don't think there are any pros to it.
"The con of underfunding reserves is that it devalues the association," Swedelson adds. "If I were going to buy and saw that one association had somewhat healthy reserves and the other didn't have much in reserves, I'd know the second association was likely to special assess as it went along."
What did Swedelson advise the association in which the board member is politicking for lower assessments? "My argument is that homeowners don't get to vote on that issue. That's a board function," he says. "In addition, not everybody's having hard times. Fortunately, this board's not going to lower its assessments and not fund reserves."
Another Perspective from Florida
In Florida, condo associations must follow specific rules governing reserves—unless they decide not to. "Florida condo associations are required by law to promulgate full reserves in all proposed budgets," says Robert L. Tankel, principal at Robert L. Tankel P.A. in Dunedin, Fla., a law firm that advises associations. "Those reserves have to be kept from day one, dollar one and funded in full unless the members vote to waive or reduce them."
Tankel says the process for voting on waiving or reducing funding for reserves isn't crystal clear under Florida law. "The legislature may have meant that it requires a majority of all voting interests or a majority of the voting interest at a duly called meeting at which a quorum is present," he explains. "Either way, the vote must take place before the beginning of the fiscal year to waive or reduce reserves before they become due."
Florida homeowners associations have the option of following the law that governs condo associations. "In 2008, the legislature allowed homeowners associations to implement the keeping of statutory reserves similar to the condo act," says Tankel. "This is either implemented by a vote of the membership or by the developer in developer-controlled associations. That decision isn't a legal issue but a business judgment. But I think it unnecessarily complicates life for boards."
Funding Association Reserves in Florida
If a Florida association doesn't waive the reserve funding requirements, it must collect for reserves, and the law even specifies the amount associations must collect. "Reserves are mandated for any item that costs more than $10,000 to repair or replace, but the reserve amount isn't mandated, nor is the method of calculation," says Tankel. "However, the law contemplates that the reserve item will be fully funded at the end of its useful life. So associations need to take the estimated replacement cost, divide it by the estimated useful life, and that's the reserve amount for a particular year."
Here's how that would work for elevators. Assume an elevator's estimated useful life is 40 years, and it would cost $400,000 to replace it. "Divide 40 into $400,000 and you get $10,000 a year that the association should be reserving for the elevator," explains Tankel. "However, the law allows expenditure of reserve funds for repairs if the life of the asset will be extended by more than a year, so members almost universally vote to waive the reserve funding requirement because it's likely they'll have a major repair that will extend the elevator's useful life for 10 years."
In other words, few associations would religiously reserve for the $400,000 expense since each time they did a major repair, they could use reserve funds to pay for the repair because it would extend the useful life of the elevator. That process can go on longer than most owners will live in the property.
As for whether associations should stop funding reserves to benefit community members during the recession, Tankel defers to his clients' judgment. "My advice to clients is to make sure they follow the rules because it's a pocketbook decision, not a legal decision, on whether to fund or not fund reserves," he says.
But he stresses that they must follow the law regardless of the path they take. "Communities frequently adopt budgets after the beginning of their fiscal year. If they don't vote to waive reserves or keep full reserves as required by law, they face a technical violation of the law for not properly funding. If they forget to waive the requirement, some member's going to come after them."