2-Minute video
Restrictions on Fund Transfers
Reserve accounts are given significant protections by the Davis-Stirling Act. Associations must set up bank accounts that are separate and distinct from their managing agent's funds and separated into operating and reserve accounts. Boards may not spend reserve funds for any purpose other than the repair, restoration, replacement, or maintenance of, or litigation involving the repair, restoration, replacement, or maintenance of, major components the association is obligated to repair, restore, replace, or maintain. (Civ. Code § 5510(b).)
Two Signatures. Finally, the signatures of at least two board members or one officer who is not a member of the board plus a board member are required to withdraw money from the reserve account. (Civ. Code § 5510(a).)
Reallocate for Unexpected Expenses
The reserve fund is a pool of money that can shift between line items in a reserve account to meet reserve funding needs. It is expected to adjust from year to year to reallocate funds to cover items that fail prematurely or cost less than anticipated. For example, if a boiler fails in year eight instead of year ten, as projected by the reserve study, funds can be shifted from other line items to cover the unexpected early expense. Or, if a pool heater replacement costs half the projected cost, the leftover funds can be assigned to other reserve line items. Such reallocations are not unusual.
There are three primary reasons why an association may be in a situation to overspend from reserves:
- the repair/replacement expense is higher than expected,
- the expense is earlier than expected, or
- the expense was not anticipated, and no reserve funds were set aside.
When that occurs, the reserve study is updated, and if necessary, allocations to reserves are increased to cover the shortfall. The board may need to impose emergency special assessments if the unexpected expense is significant. For example, The plumbing system is expected to last 50 years, and no funds are set aside because the development is only 15 years old. The system begins to fail in year fifteen due to latent construction defects and requires repairs that will cost $1 million--the entire amount currently in the reserve account.
Borrowing From Reserves
Without a membership vote, boards can borrow from reserves to meet short-term cash flow problems or other expenses. (Civ. Code § 5515(a).) (Some CPAs refer to reserve borrowing as designated investments, accrued obligations, internal asset designation, or asset allocation.) Examples of short-term cash flow problems include:
- Delinquencies. To cover shortfalls created by delinquencies.
- Insurance. To pay for unexpected increases in insurance premiums.
- Termites. To pay for unplanned termite treatment.
- Common Area Damage. To pay for unexpected damage to the common areas.
- Litigation. To pay litigation legal fees.
- Settlements. To settle claims.
- Amendments & Restatements. To pay to amend or restate CC&Rs and bylaws.
Borrowing for Litigation. Associations can borrow from reserves to pay for litigation, including construction defect litigation. Using reserve funds for litigation is deemed a "temporary transfer." (Civ. Code § 5520.) When temporary transfers are made, boards must explain to the membership the reasons for the transfer and when and how the money will be repaid to the reserve fund. In addition, the funds must be restored within one year of the initial transfer date. (Civ. Code § 5515.) Even though you anticipate litigation expenses next year, they do not qualify as a reserve item. Reserve accounts are for monies "identified for use to defray the future repair or replacement of, or additions to, those major components the association is obligated to maintain." (Civ. Code § 5550.) Legal expenses do not meet the definition of a "component," nor do they meet National Reserve Study Standards. The appropriate place for anticipated legal expenses is the association's operating budget. This will likely increase your budget, which may require a dues increase or a special assessment for the next fiscal year. In addition, even though a temporary delay in restoring borrowed reserve funds is allowed, boards must exercise prudent fiscal management in maintaining the integrity of the reserve account "and shall, if necessary, levy a special assessment" to repay the funds within one year. (Civ. Code § 5515.)
Other Expenses. The term “other expenses” referenced in section § 5515(a) is sufficiently broad to permit a temporary transfer of reserve funds to the general operating account to fund expenses such as those related to a restatement of an association's governing documents. However, the statute contemplates temporary transfers intended to be repaid promptly. Although not expressly limited to emergency or extraordinary expenses, transfers from reserves should not be for routine and anticipated operating expenses since they are supposed to be funded by regular or special assessments sufficient to perform the association’s obligation under the governing documents and the Davis-Stirling Act. (Civ. Code § 5600(a).)
Suspending Reserve Deposits. Although no statute or case law exists on this issue, some believe suspending reserve deposits qualifies as borrowing from reserves. The argument is that monies allocated to the reserve account are pledged in the reserve funding plan and published annually to the membership, and the operating budget is mailed to all members before the start of the fiscal year. Those funds are then collected from the membership for that purpose. Intercepting reserve monies before they are deposited into the reserve account or waiting until after they are deposited produces the same result--reserve monies are used for non-reserve expenses.
The counterargument that suspending reserve contributions does not qualify as borrowing is found in Civil Code § 5515. It states that the statute applies only to the “temporary transfer of money from a reserve fund to the association’s general operating fund,” which does not occur. There is no transfer from the reserve fund. The fact that money is budgeted for a specific purpose is not binding and does not mean it cannot be redirected elsewhere if the need arises. Budgets are projections, and sometimes unexpected expenses that must be met, such as a sudden significant increase in insurance premiums or utility costs, occur. Reserve transfers can be temporarily reduced or suspended to meet those unexpected expenses.
Notice of Intent to Borrow & Repayment
Board Meeting Agenda. Boards must give notice of their intent to borrow reserve funds by listing it as an agenda item in its notice of board meeting. The notice must include the reasons the reserve transfer is needed, some of the options for repayment, and whether a special assessment may be considered. If the board authorizes the transfer, it must issue a written finding, recorded in the minutes, explaining the reasons for the transfer and describing when and how the money will be repaid to the reserve fund. (Civ. Code § 5515(c).)
Repay Reserves Within One Year. Monies borrowed from the reserves must be repaid to the reserve fund within one year of the date of the initial transfer, except that the board may, after giving the same notice required for considering a transfer and, upon making a finding supported by documentation that a temporary delay would be in the best interests of the association, temporarily delay the repayment. (Civ. Code § 5515(d).) Associations are allowed to levy special assessments to replenish reserve funds.
Transfers Between Reserve Line Items
Sometimes associations need to repair/replace a reserve component that failed earlier than had been scheduled in the reserve study. A good example is the replacement of roofs. An early failure means insufficient funds are available for roof replacements. When that happens, the board can reallocate funds from other components into the roof line item to ensure sufficient funds are available to replace the roofs. This is not considered borrowing from the reserves. Borrowing is defined by Civil Code § 5515(a) as the "temporary transfer of money from a reserve fund to the association’s general operating fund to meet short-term cash flow requirements or other expenses..." Using available reserve funds to handle the early failure of a component does not meet the definition of borrowing. There is no requirement in the Davis-Stirling Act that associations lock in reserve funds on a component-by-component basis. In other words, the association is not required to have a "roof fund" or a "street maintenance fund." The statute, instead, requires a "reserve fund." Accordingly, the reserve fund is more accurately a pool of money available for significant repairs and/or replacement of the association's major common area components. Even with the component allocation method, the Davis-Stirling Act allows for the imprecise nature of reserve studies by authorizing adjustments to the study in annual updates in the years between visual inspections on the third year. Not only can components last longer or fail sooner than expected, but they can also cost less or more to repair than initially projected. As a result, adjustments to line items can be made without the need for constant "borrowing" resolutions in the minutes and notices to the membership.
Investing Reserve Funds
See "Investing Reserve Funds."
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