Should income taxes on interest earned be paid from the reserve fund?
The majority of reserve study funding plans do include the calculation of income tax liability based upon the amount of investment earnings that are estimated in the plan. This is a reasonable position to take considering that the majority of most association’s interest earnings are generated by the reserve fund.
However we do caution you to both consult with your legal counsel and Association accountant to determine if this is appropriate. While this may seem like overkill, there is a reason for this. Some Association lawyers have interpreted governing documents and or state law as prohibiting the expenditure of reserve funds for any purpose other than the major repair or replacement of common area components. Payment of income taxes clearly does not meet this requirement therefore we urge caution on the part of the Association.
Assuming that Association legal counsel indicates that taxes may be paid on the reserve fund and then it becomes strictly a matter of Association policy as to whether or not income taxes are paid out of the reserve fund or the operating fund. Our recommendation generally is that it is simpler to pay for income taxes out of the operating fund.