Can HOA reserve funds be used for operating expenses? When faced with a budget shortfall, some boards’ first instinct is to borrow from reserves. Yet, this practice may not be permissible depending on the association’s governing documents. Understanding what is and isn’t allowed can help safeguard against both liability and financial problems.
What’s the Difference Between Reserve Expenses and Operating Expenses?
Reserve expenses refer to major capital repairs and replacements, whereas operating expenses refer to ongoing costs that an association incurs day-to-day.
Reserve Fund and Expenses
The reserve fund acts as a savings account. Its primary purpose is to cover major repairs or replacements of capital components once they reach the end of their useful life. Due to the nature of these costs, associations incur them infrequently.
Associations fund their reserves through contributions. These contributions are taken from regular dues and are generally mandatory.
Common examples of reserve expenses include road paving, roof replacements, and sidewalk repairs. Condominiums typically require more significant funding because they have more shared elements.
Operating Fund and Expenses
The operating fund is more of a checking account. Its primary purpose is to cover daily expenses, such as routine maintenance, insurance, utilities, landscaping, and management fees. These costs are predictable and occur regularly.
As with reserves, associations fund the operating budget through regular dues. The HOA or condo board prepares the annual budget by anticipating costs. From there, they calculate how much each owner must pay to meet those budgetary needs.
Money moves frequently in the operating fund, with payments to vendors and deposits from dues. It is highly liquid, which means associations usually can’t keep it in a time deposit.
Can HOA Reserve Funds be Used for Operating Expenses?
State laws and the association’s governing documents determine whether reserve funds may be used for operating expenses, but the general practice is no.
There are several reasons an HOA might dip into its reserves to cover operating costs. Inaccurate projections are a common example. This happens when estimates are far lower than the actual figures. A high delinquency rate can also lead to a budget shortfall, as there isn’t enough money to cover costs.
That said, it is generally not recommended to use reserve funds to pay for operating expenses. Doing so may violate the board’s fiduciary duties. Most governing documents also require that reserves be used only for their intended purpose.
Texas law explicitly prohibits condominiums in declarant control from using reserves to cover operating costs. This is in accordance with Section 82.112 of the Texas Uniform Condominium Act. No similar provision exists for associations under homeowner control.
In rare cases, the CC&Rs and bylaws may allow temporary use of the reserves to cover an operating deficit. This typically comes with certain conditions, such as formal board authorization and a scheduled repayment plan. In stricter communities, homeowner approval may even be mandatory.
Tax Implications of Borrowing HOA Reserves
Transferring money from the reserve fund to the operating fund comes with tax implications. If an association operates as a corporation under Section 277 of the Internal Revenue Code, the IRS may tag the reserves as taxable income.
On the other hand, if an association operates under Section 528 of the IRC, transferring the reserves to the operating account may not come with any tax ramifications. This is provided that both the governing documents and the HOA board authorize the move.
How to Approve the Use of Reserve Funds for Operating Expenses
In the rare event that an HOA must borrow from its reserves to cover operating costs, approval is generally necessary. While exact procedures vary, here are the general steps boards must follow.
1. Check Governing Documents
First, boards must confirm that state laws and the governing documents permit the transfer. The CC&Rs and bylaws also typically outline the requirements and procedures for the move.
2. Notify Homeowners
Homeowners have the right to know about the association’s financial activities. Boards must notify them of the proposed action, including details regarding the amount and the purpose.
3. Establish a Strict Repayment Plan
Borrowing from the reserves is a temporary situation. Just like a bank loan, associations must repay the sum according to a strict repayment plan.
Associations must put this plan in writing. The plan must outline the installment amount, the repayment period, and the funding source. Most communities raise regular dues or impose special assessments to meet obligations.
Failure to follow the repayment plan may constitute a breach of fiduciary duty.
4. Vote at an Open Meeting
Board members must vote on the proposal and repayment plan at a properly noticed meeting. This meeting must be open to all homeowners. If the vote passes, a board resolution follows.
5. Document Everything
Associations must document the move every step of the way, from its initial stages up to implementation. Keep records of notices, decisions, resolutions, and meeting minutes.
How to Avoid Using Reserve Funds for Operating Expenses
Associations typically decide to use reserves when operating funds fall short. To avoid borrowing from reserves altogether, it is important to address the root problem.
Here are the best ways to avoid borrowing from reserves:
- Make Accurate Cost Projections. It’s nearly impossible to anticipate costs down to the last decimal, but boards can get close by reviewing historical data, negotiating with vendors, and examining trends.
- Collect Unpaid Dues. Don’t let delinquent accounts accumulate. Boards should monitor unpaid dues and pursue them more aggressively while still complying with state laws, governing documents, and collection policies.
- Establish a Contingency Fund. Otherwise known as operating reserves, a contingency fund acts as a cushion for unexpected costs. This eliminates or greatly reduces the need to borrow from the reserve fund.
- Keep Funds in Separate Accounts. Commingling funds makes it infinitely easier to use reserves for operating expenses, even unintentionally. Associations must keep reserves in a separate bank account from the operating fund.
Can HOA Reserve Funds be Used For Operating Expenses? Answered!
An association’s reserve fund and operating fund serve two distinct purposes. On the rare occasion that an HOA must use its reserves to cover operating costs, following the approval requirements and procedures is integral. When in doubt, it is best to consult an HOA attorney or management company.
PAMco offers exceptional HOA management services to communities in Central Texas. Call us today at 512-918-8100 or contact us online to learn more!
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