Contingencies in the Reserve Study

We are right in the middle of the reserve study busy season and are again being asked by a number of our clients whether or not it is permissible for them to have contingencies within their reserve study.

In some Associations, this is just a given. In other Associations, there are member factions that will react quite strongly against the inclusion of contingency in the reserve study.

There are a number of issues to consider when addressing the issue of adding a contingency factor into a reserve study.

    1. Is a contingency reserve permissible under state statute?
    2. Is a contingency reserve permissible under the Association’s governing documents?
    3. Is a contingency line item permissible under tax law?

If you're determined to have a contingency factor within your reserve study, once you get past the above issues, you then have a decision to make as to HOW contingencies will be included within the reserve study.

a)  Will contingency be a separate line item expense within the study? If so:

  • will it be a flat dollar amount?
  • will it be a percent of current year expenditures projected in future years?
  • will it be a percent of reserve fund assessments?
  • will it be the excess operating income that is transferred annually from the operating budget?

b)  If contingency is not treated as a line item within the report, can it then be factored into the study as a percentage of future expenditures?

And the last question, will your reserve software support the reserve calculation method you prefer?

As you can see, there a number of factors to consider in response to the simple question we are often asked of “Can we add a contingency factor to our reserve study?”

Some reserve preparers are adamantly opposed to ever including contingencies within the reserve study, perhaps because of the multiple unknowns identified above. Other reserve preparers don't seem to have a particular problem with contingencies, but generally have a specific manner in which they prefer to present the contingencies.

Let's take a look at each of these issues identified above:

  1. State statutes - The answer to this is not as transparent as we may wish, simply because most state statutes are silent on the issue of contingencies. Statutes primarily address the physical common area components for which the Association has maintenance responsibility, if they address content of the reserve study at all. I have not seen contingency specifically listed within state statutes. That doesn't mean it doesn't exist; it just means that I haven't seen it. Many interpret state statutes as being specific about reserves not being able to be included in the reserve study by the absence of a discussion on the matter. Others state that you are not necessarily prohibited from having a contingency reserve simply because it is not enumerated in statutes; many other things are also not specifically listed in statutes. However, depending upon how a contingency factor is added to the reserve study, it may not be an issue. (See item “b” above.)
  2. Governing documents - The position here is very similar to that of state statutes. Most governing documents do not have any language at all that addresses the issue of contingency within the reserve study. Therefore you are left with the same question of whether or not it is permissible to include contingencies in the reserve study simply because of the absence of any language addressing the issue.
  3. Tax law - For what may be the only time we can ever say this, the fact is that tax law is quite specific on the issue of contingencies within a reserve study. Many people may disagree with the following statement simply because it is exactly the opposite of what they have been told numerous times, but the fact is the IRS takes NO position with respect to contingencies in the reserve study.

The IRS cannot force any taxpayer (Association) to include or exclude ANY item from the reserve study. The only thing that the IRS can do is to react to what has been included in the reserve study by telling you the appropriate tax treatment of that item. While the HOA industry thinks in terms of operating versus reserve, the IRS thinks in terms of capital versus non-capital. They are not the same thing.

The IRS has issued three specific Revenue Rulings, 74-563, 75-370, and 75-371, all of which address the issue of reserves. All three rulings take the same position that for reserves to be excludable from taxable income under Internal Revenue Code Section 118 (contributions to the capital of a corporation), the reserve assessments must be for “specific capital purposes.” For that reason, IRS takes the position that contingency reserves, because they are not for a specific capital purpose, cannot qualify for the exclusion from taxable income under code section 118.

That is definitely not the same as saying that contingencies cannot be included in reserves, but it does reach a similar result. Why is this a critical distinction? Because many Associations are regularly including contingencies within their reserve study. How can they do that without incurring the wrath of the IRS? Simple! File Form 1120-H. On Form 1120-H, the IRS does not care if you included contingencies in your reserve study because the contingency reserve additions for any given year are considered to be exempt function income which is not taxable on Form 1120- H. That is the exact opposite of the tax treatment on Form 1120. On Form 1120, the contingency reserve addition for the current year is considered to be “member” income, which means it gets added back to your operating income. If net member income is a positive amount in a given tax year, it will be considered taxable income unless the Association makes an election under Revenue Ruling 70-604.

Next, let's look at the calculation methods identified above as items “a” and “b.” These calculation methods can also have a very significant impact upon how the contingency factor is included within the reserve study, how it is perceived by readers of the report, and how it is treated for tax purposes.

In all variations of item “a” above, the contingency factor is effectively presented as a line item within the reserve study, even though the methods of calculation may be different.

However, in item “b” above, the contingency factor is spread out amongst all of the components of the reserve study and loses its identity as a separate contingency line item. In fact, it cannot even be seen within the reserve study, but it still exists. Probably the easiest way to understand this is to conceptually treat the contingency the same as you would treat the inflation factor that is part of the reserve study. Let's look at an actual example. If a component has a current replacement cost of $100,000, and you are using a 3% inflation factor, and a 1% contingency factor, then the replacement cost calculated in the reserve study one year from now will be $100,000 (currently placement cost) plus $3,000 (inflation for one year) plus $1,000 (contingency for one year) for a total estimated future replacement cost, including contingency, of $104,000. Imagine that same calculation being repeated for dozens of items within a reserve study, and you'll see how the contingency factor can certainly exist but not be separately identifiable as a contingency line item.

Is this defensible from a tax standpoint? The answer is yes, because it is no different than an estimate for future inflation. That means it is part of an overall calculation that determines each year’s funding within the reserve study, although no part of it is separately identifiable as a contingency reserve.

The larger question is, “Should an Association have a contingency reserve?” Since all future costs, as well as future inflation and future interest earnings, are nothing more than estimates - no matter how sophisticated the calculations determining those estimates - there is little likelihood (a virtual impossibility) that future costs will occur exactly as planned. Therefore, many may consider a contingency factor to be a prudent judgment.

What if your Association is extremely underfunded and your current assessment structure makes it virtually impossible to raise reserve assessments to a level needed to bring the Association to a stable funding platform? Adding in an additional contingency factor that increases assessment requirements makes no sense in that scenario.

What if the Association is either very highly funded or even overfunded? Does it make sense to have the contingency factor then? It makes more sense then, but it still does not make it a necessity. It may be considered more prudent to recognize early on the highly funded or overfunded situation that exists, and reduce reserve assessments so that any overfunded situation works itself out.

Bottom line, there is no right or wrong answer to the issue of including a contingency factor in the reserve study. The reserve study belongs to the Association and it should reflect their best estimate of future major maintenance and replacement costs, and the funding plan that is appropriate for the Association.


This article was originally published at HOA Pulse in September 2013