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CAPITAL IMPROVEMENTS

QUESTION: We need to replace the roof of our common area clubhouse. We already have enough money in the reserve account for the new roof, but one of our owners (a CPA) insists that replacing the roof is a "capital improvement" and therefore the board has to get membership approval before it can replace the roof. That can't be right. Do we really need membership approval to use the money in the reserve account to replace our old, worn-out roof? Is a new roof (to replace the old, worn-out roof) really a "capital improvement"?

ANSWER: No, the board does not need membership approval to use reserve funds to replace the clubhouse roof. That falls within the duty and authority of the board.

While a new roof (to replace the old, worn-out roof) might be a "capital improvement" in an accountant's eyes, it is generally NOT considered to be a capital improvement in common interest developments (CIDs). This is true even if the association's bylaws require membership approval before the board can spend money on certain capital improvements. (Note: Not all bylaws have that requirement. As discussed in more detail below, the Davis-Stirling Act does not require membership approval for capital improvements. Boards should first check their association's bylaws in this regard.)

Your CPA-homeowner is using an accounting definition for capital improvement. Unfortunately, experience has shown that this definition does not work well in the context of a community association spending reserve funds to repair, restore, replace or maintain existing major components that the association is obligated (by law and/or the governing documents) to repair, restore, replace or maintain. Generally, to accountants, a capital improvement is a major expenditure to a fixed asset that is expected to last for at least one year and that (i) enhances the value of the asset, or (ii) extends the useful life of the asset, or (iii) adapts the asset so that it can be used in a new way. If you were to use this definition, virtually every reserve expenditure would be a capital improvement.

CID Definition. For CIDs where the association's bylaws require membership approval before the board can spend money on certain capital improvements, a different, more practical definition of "capital improvement" is needed, one that recognizes the difference between (1) an association's obligation to replace existing buildings, components, equipment, etc., once they reach the end of their useful life, and (2) an association's desire to add new buildings/amenities, or substantially alter existing buildings/amenities, to address the changing needs of the community as it grows and matures, and/or to address changing technologies, construction materials, etc. For those CIDs, a capital improvement is probably better defined as (i) any new common area amenity or (ii) any substantial discretionary expansion of an existing common area amenity.

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QUESTION: Why does it matter whether something is classified as a capital improvement?

ANSWER: In many associations, it doesn't really matter, at least not when discussing whether or not membership approval is required for capital improvements. As mentioned above, no California law (including the Davis-Stirling Act) requires membership approval of capital improvements. In fact, the Davis-Stirling Act does not define or even use the term capital improvement.

Many associations' bylaws do not require membership approval before the board can spend association funds on capital improvements. In those associations, it does not matter whether something is labeled as a capital improvement or not, when determining the board's authority to (1) replace an existing building, component, piece of equipment, etc., once it reaches the end of its useful life, (2) add a new buildings or amenity, or (3) substantially alter an existing building or amenity. This is because no membership approval is required for any of those board actions.

However, membership approval might separately be needed, if the association doesn't have enough money on hand to pay for the work and needs to impose a special assessment that exceeds 5% of the budgeted gross expenses. If the association does have enough money on hand (e.g., in the reserve fund and/or in some other "new/expanded facilities" fund), no membership approval will be required for the work.

However, some associations' bylaws do require membership approval before the board can spend money on capital improvements that exceed either a specified percentage of the budgeted gross expenses (usually 5%), or a flat dollar amount. In those associations, it is important to know whether a contemplated change to the common area is or isn't a capital improvement (as that term is used, but hardly ever defined, in those associations' bylaws), because that will determine whether or not membership approval is required under those bylaws, for that particular expenditure. Although there are numerous variations in the bylaws we have seen over the years, the most common language is something like:

Unless it first obtains the approval of a majority of a quorum of the members, the Board shall not incur aggregate expenditures for capital improvements to the Common Area in any fiscal year in excess of 5% of the budgeted gross expenses of the Association for that fiscal year.

It is important to recognize that the genesis of that language is not the Davis-Stirling Act, but rather the California Department of Real Estate's Regulations (§2792.21(b)(2)). The DRE requires some form of that language to be in the initial bylaws that are prepared by the developer. However, because there is no requirement for a "post-developer" association to retain language sourced solely from DRE Regulations in its governing documents, many associations choose to eliminate (or change) the capital improvement language (and other DRE-sourced provisions) when they amend/restate their governing documents. The DRE has never formally defined capital improvements for the purpose of Regulation 2792.21(b)(2) or otherwise. Therefore, it has been left to associations and their respective counsel to develop their own definition that works in the context of their particular association.

Using reserve funds to repair, restore, replace or maintain existing major components that the association is obligated by law and/or their governing documents to repair, restore, replace or maintain, and for which the funds were accumulated (such as a roof), does not require membership approval, even if the expenditure exceeds 5% of the budgeted gross expenses. Because Regulation 2792.21(b)(2) does not define capital improvement, many associations, when they amend their bylaws, add some form of the following sentence, to make it clear that membership approval is not required before the board can spend association funds to (1) repair, restore, replace or maintain existing major components that the association is obligated (by law and/or the governing documents) to repair, restore, replace or maintain or (2) construct new amenities, and for which the funds were accumulated:  "This limitation does not apply to the expenditure of funds accumulated by the Association if the expenditure is for the purpose for which the funds were accumulated."

If an association's bylaws do not contain some version of the Regulation 2792.21(b)(2) language, then membership approval of capital improvements is not required in that association because, as noted above, membership approval is not required by the Davis-Stirling Act or any other law. On the other hand, if an association's bylaws do contain some version of the Regulation 2792.21(b)(2) language, then that association's board will have to get approval for capital improvements that in any fiscal year are estimated to exceed 5% of the association's budgeted gross expenses for that fiscal year, unless (1) the expenditure is for the purpose for which the money was accumulated or (2) that association's version of the language contains other exceptions.

Boards are urged to review their own association's bylaws very carefully with respect to this important issue and consult with the association's legal counsel since the actual language of their bylaws (if any) determines whether or not membership approval is required for a particular proposed change to the common area. (Caution: some bylaws use the terms "capital improvement" and "new capital improvement" in the same paragraph, without explaining or defining the difference, which really confuses the issue.)

Going back to the roof question at the beginning of this page, and even assuming the bylaws contain the sample language above, membership approval would not be required because the reserve money is being used to pay for a roof, which is one of the purposes for which the reserve funds were collected.

NOTE:  All of the discussions regarding membership approval, on the rest of this page, apply only where an association's bylaws require membership approval before the board can spend money on certain capital improvements. Keep in mind that not all associations' bylaws have such a requirement, and the law does not have such a requirement.

Mandatory Changes. Some alterations or expansions of existing common area amenities are required for safety purposes. Others are required by federal, state and/or local law. For example, a board might choose to construct a retaining wall in the common area, in order to stabilize a slope for safety purposes. Or the local fire authority might require the installation of a fire control system. Or a swimming pool might have to be upgraded to incorporate ADA accessibility requirements. In associations where the bylaws have a member-approval requirement for capital improvement expenditures exceeding 5% of the budgeted gross expenses, it is generally agreed that such mandatory alterations/expansions do not require membership approval, even if they would cost more than 5% of the budgeted gross expenses. (If the association does not have enough money on hand to pay for the work, the board could, among other things, impose a special assessment and, depending on the circumstances, even an emergency situation assessment.

Upgrades of Materials and Technologies. Boards are encouraged to take advantage of improved building materials and designs, and improved technologies, whenever possible. There seems to be general agreement amongst CID attorneys that the installation or incorporation of upgraded materials and technologies does not require membership approval (even in associations where the bylaws have a member-approval requirement for capital improvement expenditures exceeding 5% of the budgeted gross expenses), especially when those upgrades result in components that have a longer useful life and/or provide more benefit/cost savings than what they are replacing (e.g., replacing incandescent and fluorescent bulbs with LED bulbs). However, most attorneys also generally caution restraint, because an upgrade that is significantly more expensive than what is being replaced, or that radically changes the look of the amenity, might raise some political and other issues, even if it has a longer useful life or provides more benefit/cost savings.

As noted above, some upgrades are mandated by the federal, state or local governmental entity. For example, if, as part of a major repair to an association's 30-year old elevators, the city orders a substantial upgrade to integrate the elevators with the building's fire alarm system, it is generally agreed that this "capital improvement" would not require membership approval, even if it would cost more than 5% of the budgeted gross expenses, because it is not voluntary. (If the association does not have enough money on hand to pay for the work, the board could, among other things, impose a special assessment and, depending on the circumstances, even an emergency situation assessment.)

Boards are urged to consult with the association's attorney when a major construction or renovation project includes significant materials or technologies upgrades.

Significant Alteration in Appearance. There seems to be general agreement amongst CID attorneys that any repair or replacement that constitutes a significant alteration in the appearance of the development or of a major amenity should involve the membership's input in some way or another, even if the estimated cost does not exceed the 5% threshold. Where the attorneys disagree, is on what is "significant". Some attorneys feel that boards need not seek membership input to change the material, as long as the color and look end up the same or very similar (e.g., grey-painted wood siding changed to grey-colored concrete siding). Other attorneys feel that boards need not seek membership input to change the color without membership input, as long as the material is the same or very similar (grey-painted wood siding changed to brown-painted wood siding). And a few (very cautious) attorneys feel that boards should not change either the material or the color without membership input.

If a board chooses to seek membership input on a significant discretionary change in appearance, there are many ways to do so. Townhall meetings have proven to be a very effective way for the board to provide valuable information to the members and for the members to provide valuable and meaningful input to the board, and have generally been very productive to the overall process. For very extensive proposed projects and/or in very large CIDs, more than one townhall meeting might be necessary to give members an opportunity to participate in the process. Surveys or non-binding advisory votes are occasionally used too, but boards should be very careful in interpreting the data because of the limitations and ambiguities inherent in such techniques, especially because response rates in associations are traditionally very low and responses are often artificially skewed toward a particular position or viewpoint whose supporters disproportionately promote participation in the survey. Submitting formal votes to the members on items that are within the board's statutory corporate authority is generally discouraged.

Privately Funded. Private funding of capital improvements is generally allowable.

Recommendation: When associations amend or restate their governing documents, they should strongly consider either eliminating the membership approval requirement for capital improvements, or using (and defining) some term other than capital improvement, to avoid the confusion with the accounting definition. If an association chooses to retain the term, we recommend defining it in a manner that clearly differentiates between (1) the association's obligation to replace existing buildings, components, equipment, etc., once they reach the end of their useful life and (2) the association's need to add new buildings/amenities, or substantially alter existing buildings/amenities, to address the changing needs of the community as it grows and matures, as well as to address changing technologies, construction materials, etc.


Cases that address capital improvements:
Behm v. Victory Lane Unit Owners' Association (1999) 133 Ohio App.3d 484.
George v. Beach Club Villas Condominium (2002) 833 So.2d 86.
Litvak v. 155 Harbor Drive Condominium Association (1993) 244 Ill.App.3d 220.
Ocean Club Condominium Association v. Gardner (1998) 318 N.J. Super. 237.
Ralph v. Envoy Point Condominium Association (1984) 455 So.2d 454.
Tiffany Place Condominium Association v. Spencer (1982) 416 So.2d 823.


ASSISTANCE: Associations needing legal assistance can contact us. To stay current with issues affecting community associations, subscribe to the Davis-Stirling Newsletter.

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