Reserve Study Books and Articles

Reserve Study Vs. PCA or Insurance Appraisal

By Gary Porter, RS, PRA and David McDermott, AIA

Three relatively similar services are frequently provided to communities within the homeowners’ association industry. Because there is still some confusion over what each service represents, an Association can occasionally have expectations that far exceed the scope of a reserve study (the most superficial of the three services).

The three services are the reserve study, the insurance valuation (or appraisal), and the PCA( or property condition assessment, also known as the project condition assessment). In certain parts of the country, the reserve study is also typically referred to as an “engineering study,” which further adds to the confusion, as it implies a level of service not contemplated by a reserve study but more suggestive of a PCA.

What distinguishes these three separate services are their purpose, the methodology used in compiling the data, and the data presented in the final report.

The reserve study report is a budgetary tool based on a physical evaluation of the replaceable common area components of the Association. The purpose is to prepare a financial forecast( normally for a 30-year period) of future expenditures, and to understand the required reserve contributions to fund these future expenditures. In a condominium Association, replacement of the condominium structure itself is generally an excluded component, as it is considered to be a lifetime structure. However, painting of exterior walls, possible replacement of siding, ad roofing replacement would be included in the reserve study, as they represent the major replaceable components that are part of the condominium structure. The reserve study is based on future replacement costs.

The insurance appraisal report is a valuation service of all of the common area components of the Association. This list of common area components will necessarily include a number of items that are not considered in the reserve study. The purpose is to determine the overall insurable values of the property, to make sure that the Association is carrying adequate insurance. For purposes of the insurance valuation report for a condominium project, the condominium structure is the single highest cost item included within the study. Rather than evaluating each of the separate components of that building (ie, building envelope, roofing, mechanical equipment, etc.), the insurance valuation is generally based on a cost per square foot for replacement of the type of construction used in the project. The insurance valuation report looks at current replacement costs as the basis of the valuation.

The property condition assessment (PCA) report is an overall evaluation of the physical property that results in a report to help interested parties understand the condition of the property. The PCA report should generally include the following elements, presented in a clear and easily understood format:

  • Summary of the property’s visible components, including site development /landscaping, exterior envelope, structural elements, interior finishes, equipment and systems, and handicap accessibility compliance
  • Details of any physical defects or damage discovered during the property inspection
  • Identification of any maintenance deficiencies
  • Estimate of costs for correcting observed deficiencies
  • Quality of workmanship
  • Quality of construction materials used
  • Statement of the terms and conditions of the report

The PCA can be viewed as a blend of both the reserve study report and the insurance valuation report.

First, like the insurance appraisal report, it considers all components of the property, not just the replaceable components. But unlike the insurance appraisal report, it does not attempt to arrive at an overall valuation for replacement of the project. The PCA is based upon current costs.

Second, like the reserve study, it should identify physical defects or damages observed, and provide an estimate of the cost for correcting the deficiencies noted. The PCA does not use future costs. Contact names and numbers of vendors supplying systems maintenance and replacement are usually included in the PCA.

What are the benefits of a PCA? It provides an expert evaluation of the quality of construction and the integrity of the related building systems, and identifies necessary repair costs to bring the project to a normal condition. Readers of the PCA report are thus provided the information they need to make critical decisions. For commercial real estate transactions, the PCA is very important to lenders and investors related to the potential purchase of real estate. Insurance underwriters use the report for setting rates. Within the homeowners’ association industry, the PCA may often be a guide to determining the scope of future repairs and possible replacement with alternative products. In a more extreme example (and we've seen this happen more than once), it may help the Association board of directors determine whether a particular building is salvageable through repairs, or whether it should be torn down and replaced. We have seen 40-year-old clubhouses that were not adequately maintained razed and replaced with new, multi-million dollar clubhouses. In some associations, aesthetic values also weigh heavily on such decisions.

Providers of PCA services are generally architects, engineers, or contractors that have extensive construction knowledge. It is necessary for the provider of the service to have an understanding of the latest industry standards on structural components. Familiarity with construction products and materials and knowledge of mechanical equipment, fire protection (such as sprinkler / alarm systems), lighting, and other interior systems are also important.

While it is desirable for a reserve study provider to have that same level of knowledge, the reserve study is a budgetary tool and as such, is a more superficial analysis that does not require the same level of knowledge. The reserve study report should be a reflection of the Association’s maintenance plan. Therefore, far more reliance is placed upon the knowledge of the Association’s operating and reserve maintenance activities, as well as interaction with the vendors that supply those services.

Recognizing a Failed Reserve Funding Plan


By: Gary Porter, RS, PRA


We recently performed a reserve study for a 40-year old condominium association and discovered an all-too-familiar scenario we’ve seen in older projects.  The situation? Huge deferred maintenance obligations that should have been resolved long ago, and an assessment structure that is higher than comparable projects.


How did this association get to this place?  Forty years ago, reserve studies as we know them today were rare.  This association never prepared a complete reserve study.  Instead, they prepared an annual budget that included reserve calculations for the major reserve categories; roofing, painting, and paving.  The association then created a fixed amount reserve funding plan that fit the “political” assessment climate within the association.  This was done in the very early years of the association’s existence, but that was not based on any comprehensive analysis of the actual major repair and replacement needs of the association.  There was considerable reluctance to raise the assessment because this “senior” community consisted primarily of fixed income retirees.


Over time, the association was not able to afford all of the reserve maintenance projects that needed attention, because of their “fixed income” reserve funding policy. While they knew that special assessments or borrowing funds from a commercial lender were options, the board felt that these options were politically impractical based on their member demographics. What each board decided to do was to simply fund all of the maintenance projects that they could each year until they ran out of money.  This literally became the association’s policy.  This caused them to defer any uncompleted projects to the following year, thus passing the buck to the succeeding board.  Unfortunately, the uncompleted projects continued to accumulate, so that this “uncompleted projects” list grew to include a several year accumulation of maintenance projects.


When we came on the scene, this problem had reached critical mass and could not be ignored.  We were engaged to perform the first comprehensive reserve study for the association, and had a number of meetings with the board to help them understand how they had reached this position.  The association’s failure to perform timely maintenance caused further damage by the complete failure of certain components that would not have required replacement had the scheduled maintenance been performed.  An example of this was the failure to correct numerous water intrusion issues from poor roofing, poorly designed gutter and downspout systems, misdirected irrigation sprinklers, landscaping issues such as earth/wood contact on wood siding, etc.  These issues ultimately required the complete replacement of siding on many buildings; a cost that could have been avoided.  This is just one example of issues that caused future repair costs to escalate even further.


In the more recent years before we were engaged, the association had begun to recognize that it had a problem and had more aggressively raised reserve assessments to the point that they were higher than those of comparable projects.  But, it still was not enough to overcome decades of underfunding.  Further, our reserve study and analysis of the association’s reserve expenditures over the last few years resulted in almost doubling the reserve requirements.   This was because the association paid for numerous “small” repair projects from reserve that were clearly appropriate reserve expenditures, but for which the association had never established a reserve budget.  They were spending money on projects for which no assessments ever existed.


We have observed several associations over last 25 years attempting to fund their deferred maintenance projects in this manner. All suffered a very predictable ending. The fact is if you just spend the amount of money you’ve got available and not the amount of money it takes to actually complete a project, the projects never get completed as planned, and your deferred maintenance projects snowball into an insurmountable problem. This is not a plan, this is a reaction.


A responsible board must make tough decisions rather than passing the buck to the successor board. That often means that a current board has to resolve problems created by a prior board. The fact is that you don’t get to play the cards that you want, you get to play the cards that you’re dealt. When the board is faced with a situation of not enough money coming in and too much money going out, there are only two possible solutions. One, increase revenues, or two decrease expenses.


An association may attempt to decrease expenses by making temporary repairs that extend the life of a component or by substituting lower-cost products in making repairs or replacements. Since most associations have already done this analysis and still are coming up short, the only remaining answer is to increase revenues. This generally means that the association must make a special assessment or borrow funds, or a combination of both.


In this particular association, we also recommended that several substitute products that didn’t exist forty years ago be used in repair and replacement work.  While these resulted in higher immediate costs, it considerably reduced the long term maintenance costs to the association.


How expensive was this for the association?  They ended up borrowing $30,000,000 (about $10,000 per member) to fund major reserve repair and replacement projects. Unfortunately, they will still need more, as that does not address all the association’s needs.  Had that amount instead been assessed ratably over time to the members from inception, it would only have amounted to about $20 per month per member.  Effectively, given the age of the association and member demographics, this resulted in a shift of the entire cost from one generation to the next.


Gary Porter, RS, PRA


Facilities Advisors, Inc.

Should Painting Be Included In The Reserve Study?

 

The question of including painting in reserves continues to arise, even 15 years after the matter should have been settled.  To understand why, you need to know that this issue first arose from tax considerations, not because of any budget, maintenance, or economic factors.

Painting is one of the largest expenditures that most condominium associations will incur. The primary purpose for establishing reserves is to assure funding is available for major repairs and replacements that do not occur on an annual basis.  Consequently it is logical that it should be included in reserves because it is not an annual maintenance expense. For most associations painting will occur every 7 to 15 years.

The tax issues causing this perceived problem arose in 1993 when the IRS audited approximately 15 associations in San Diego, California.  IRS proposed to add back as taxable income all the painting reserve assessments that had been excluded from income in calculating taxable income on the Form 1120 tax returns.  This created a national furor within the HOA industry on the concept of the inclusion of painting in reserves, but only because of the misunderstanding that occurred related to this issue.  The difference lies in definitions and perceptions, not in any differences of facts.

HOA Industry Positions

These are general statements only, and like all general statements, there will always be exceptions.

1. The HOA industry has generally always considered reserves as “capital contributions” for tax purposes

2. The HOA industry has generally excluded reserve assessments from taxable income for tax purposes.  If the association is filing Form 1120, this is a major factor in eliminating taxable MEMBER income.

3. Many tax preparers recommend Form 1120 so that the association can take advantage of the lower 15% tax rates of Form 1120, versus the 30% tax rates of Form 1120-H

 

It is also necessary to state certain tax facts

1. Form 1120 carries a 15% tax rate for the first $50,000 of taxable income

2. Form 1120 requires the association to delineate between capital and noncapital transactions

3. Form 1120 requires noncapital transactions to be separated between member and nonmember activities

4. Form 1120 considers all nonmember activities to be taxable

5. Form 1120 considers member activities to be taxable only if there is a net member income

6. Form 1120-H does not tax ANY exempt function activities

7. Form 1120-H taxes all nonexempt function activities at a flat 30% tax rate

It is important to note that member activities on Form 1120 are generally similar to exempt function activities on Form 1120-H, but with critical differences that can affect certain tax returns.

IRS Positions

1. The IRS has its own rules

2. The IRS doesn't care what the HOA industry thinks

3. Internal Revenue Code (IRC) Section 277 requires separation of member and nonmember activities on Form 1120

4. IRC Section 263 defines capital activities – painting is not considered a capital activity (in most circumstances)

5. IRC Section 118 (with numerous interpretations in Rulings and Tax Court cases) defines contributions to the capital of a corporation

6. Revenue Ruling 75-370 specifically states that painting does not qualify as a capital activity that may be excluded from the income of a homeowners association as a contribution to capital.  Painting is considered to be a non annual maintenance expense.

The crux of the issue is that the HOA industry refers to expenditures as being either operating or reserve in nature, and considers all reserves to be “capital” expenditures. The IRS refers to expenditures as being either noncapital or capital in nature.  These two definitions are not the same, and the major area of difference is painting expense.

The simplest way to look at this is to realize that painting is simply a noncapital reserve component.  OK.  So now what?

Let me state for the record that I, as a reserve preparer, am of the opinion that the components to be included in any reserve study should be determined by the maintenance plan, budget policies, and economic considerations.  Tax considerations should NOT be a determining factor in what components are included in a reserve study.

Certain conclusions can be drawn from the above discussion of tax issues related to painting as a reserve component.

·           It’s acceptable to include painting in the reserve study

·           Painting reserve assessments cause potential tax issues on Form 1120

·           Careful tax planning can allow you to minimize tax risks of painting reserve assessments on Form 1120

·           Painting reserve assessments cause NO potential tax issues on Form 1120-H

 

 

 

Consideration of Interest and Inflation In The Reserve Study

 

Both interest and inflation considerations are important to the calculation of your future reserve requirements.  Unless the association has made a conscious decision to transfer all interest earnings to the operating fund (which is the subject of an entirely different article), it is generally assumed that interest earnings will be retained in the reserve fund.  Likewise, inflation is a factor that will cause the prices you pay for future repairs to be higher than the cost you’re paying presently for those same repairs and replacements.

The two questions that continually arise are “Should interest and inflation be included in the reserve study; don’t they cancel each other out?” and “How do you calculate what interest or inflation rate to use?”

I believe that both inflation and interest earnings should generally be considered in the funding plan of a reserve study.  To ignore these would be to ignore reality. While it is a policy matter of the board of directors whether or not to include these items, it is common practice to include both interest earnings and inflation in the funding plan of the reserve study.  Inflation should never be ignored.  Failure to consider inflation will generally lead to significant future underfunding, unless the association updates its reserve study and underlying cost assumptions annually.

The fact is that interest earnings do not offset inflation.  While interest and inflation rates may be similar, the inflation factor is applied to the total estimated future expenditures for all common area components included in the funding plan.  This is (virtually) always a higher number than the current funds set aside for reserves.  Conversely, the funds set aside for reserves are (virtually) always a smaller amount.  That means that the dollar amount of interest earnings will grow far slower than the dollar amount of inflated costs, even if the rates are the same. An example is that an association may anticipate spending $3,000,000 over the next 30 years, which includes inflation calculations.  The current reserve cash on hand may be as little as a few hundred thousand dollars, as that is all that is required to pay for planned expenditures arising in the next few years.  Inflation of 2% on $3,000,000 is $60,000 annually.  An interest rate of 2% on $500,000 of cash invested generates only $10,000 of interest earnings annually, creating an annual funding gap of $50,000.

The second question, how do you calculate these rates, has no correct answer.  Some people use a rule of thumb.  Others look at their current interest earnings rates as a guide.  Current interest earnings rates cannot be ignored, but if they unusually high or low, it is not practical to expect those rates to continue indefinitely. However, so long as you keep your assumed interest earnings rate relatively the same as your inflation assumption, you shouldn't get into too much trouble, as they do usually move in tandem.  California associations should be aware that California law limits the interest rate assumptions that may be used in a reserve study to 2% above the discount rate published by the San Francisco Federal Reserve Bank.

Since the funding “window” of a reserve study is normally a 30-year projection, many believe it is legitimate to consider average rates rather than current rates in establishing your funding plan.  The attached historical tables of interest and inflation rates allow you to put current rates into perspective.  Table 1 reflects solely at annual rates.  Table 2 reflects the 5-year average rate in any given year.   Table 3 reflects the 30-year average rate in any given year.  You will note that Table 3 does not contain the sharp peaks and valleys of the annual rates in Table 1.  However, general trends are still similar.

Note that regardless of sometimes significant annual variations in rates, the moving 5 and 30-year averages smooth out the rates considerably, eliminating the extreme spies and valleys that generally occur for only short periods of time.  Since the reserve funding plan typically projects for a 30-year period, it is usually safe to ignore current extreme changes in rates in favor of longer term moving averages.

I was forced to address this issue when I first started preparing reserve studies in 1982.  Look at the annual rates for that year and you can understand why.  If we had used the current interest and inflation rates of that year, NO reserve study could be developed that would provide adequate funding without “breaking the bank” by forcing reserve assessments so high that no one could pay them.  We opted then for using approximately 5% interest and inflation rates, because we knew the current situation was abnormal and could not be sustained.  Time proved us right on that assumption, but the fact is no one could reliably predict future rates.

 

Current interest rates are at an all time historical low.  Despite political pressure to keep rates low, they are beginning to trend back up.  Inflation rates reported by the government are also at all time lows, actually reflecting a deflationary rate in 2009.  However, because of changes made in recent years to the government data as to what is included in their calculations of the official inflation rate, current inflation rates are not comparable to prior data.

ARE RESERVE FUND ADDITIONS "CAPITAL CONTRIBUTIONS"  FOR TAX PURPOSES?

By: Gary Porter, RS, FMP, CPA

 

Most discussions about homeowner association income taxes begin and end with the single issue of filing Form 1120 or Form 1120-H.  This is usually discussed simply from the perspective as the difference in tax rates.  But, Form 1120 carries significantly higher tax risk.  The largest risk, and the focus of this article, is the issue of reserves being considered as capital contributions for tax purposes.  This an important issue because capital contributions are automatically excluded from income.  It has no significant impact if filing Form 1120-H, as Exempt Function Income (EFI) is not taxed on that Form.  It is a critical issue on Form 1120, as any amounts received from members that cannot be classified as capital contributions may create excess member income under IRC Section 277 that is subject to taxation.

The Internal Revenue Code (IRC) is law passed by Congress.  Regulations are the Internal Revenue Service (IRS) interpretation of that law.  Revenue Rulings are specific situations described by the IRS that clarify how certain tax rules are to be applied.  Judicial decisions by various courts provide the final say in how certain tax law is interpreted.  There are actually numerous other levels of authoritative rulings, but these are the primary guiding authorities.  It is important to understand this framework to see why something as simple as a reserve contribution can actually be very complex.

The basic structure of the Internal Revenue Code is that all receipts are considered income under IRC Section 61, unless exempted from income by another section of the Code.  IRC Section 118, “Contributions to the Capital of a Corporation,” exempts capital contributions from income.  IRC Section 118 has been interpreted by numerous subsequent rulings. The balance of this article examines each of the criteria raised by those various rulings.

While IRC Section 118 establishes the broad principle that capital contributions are not included in taxable income, the detailed parameters established by subsequent rulings are:

1)      The PURPOSE of the assessment must be capital in nature (IRC Section 263, Revenue Rulings 74-563, 75-370, and 75-375, Court cases Chicago Board of Trade and Maryland Country Club)

2)      ADVANCE NOTICE must be given to members as to the intent of the purpose of the capital contribution (Court cases Gibbons and Maryland Country Club, Revenue Rulings 75-370 and 75-371, GCM [General Counsel Memorandum] 35929)

3)      Money contributed must be ACCOUNTED FOR as a capital contribution (IRC Section 118, Court case Chicago Board of Trade, GCM 35929)

4)      Money must be HELD FOR THAT PURPOSE and no other purpose (Court cases Chicago Board of Trade and Maryland Country Club)

5)      Money must be HELD IN SEPARATE BANK ACCOUNTS from the operating (noncapital) bank accounts of the association (Revenue Rulings 75-370 and 75-371)

6)      Money must be actually EXPENDED FOR THE INTENDED PURPOSE (Court Case United Grocers)

7)      Money must INCREASE THE CAPITAL ACCOUNT OF THE MEMBER or unit owner-stockholder (Court case Chicago Board of Trade , GCM 35929)

My many years of experience as a tax preparer in the homeowner association industry have provided numerous examples to me that virtually no associations are aware of these critically important rules, and few tax preparers believe they are important.  I have been retained as a consultant on dozens of homeowner association IRS audits, probably more than any other tax practitioner in the country.  In all but one case, Form 1120 was involved.  I did not prepare ANY of the tax returns being audited by the IRS; I was retained at the recommendation of the CPA firm or tax attorney as their expert consultant.  The issue of capital contributions existed in 100% of these IRS audits.

Associations that do not adhere to each of the parameters set forth above MAY not lose their reserves as capital contributions in an IRS audit, but each instance where the association fails to adhere significantly increases the risk that your reserve additions will not qualify as capital contributions.

How associations can qualify under each of the parameters set forth above.

1)      The PURPOSE of the assessment is described in IRC Section 263 as “Any amount paid out for new buildings or for permanent improvements or benefits made to increase the value . . . “ and “Any amount expended in restoring property . . . “  That pretty much describes the majority of reserve funds expended by associations.  But, it also includes additions to or replacements of personal property.  It DOES NOT include monies expended or set aside for painting or contingencies.

The purpose for which funds are being accumulated in reserves is generally set forth in the reserve study  Is a reserve study absolutely required to establish the capital purpose?  No, it could be more informal, such as being described in the budget.  However, the reserve study is better, and this is an instance where it is better to comply than to have to fight this issue in an IRS audit.

Other critical mistakes associations make are (a) not formally adopting their reserve study, (b) having a reserve study that contains multiple proposed funding plans with no indication of which plan was adopted, (c) having a reserve study that does not agree with the amounts adopted in the association’s annual budget as reserve contributions.

2)      ADVANCE NOTICE is usually given to members as part of the annual budget, with accompanying information that discloses the reason for the “Capital” reserve assessments.  It is critical to note that if painting or contingency are part of the reserve budget and the amounts are not disclosed it jeopardizes the entire capital contribution, because painting and contingency are not capital in nature.

3)      Money contributed must be ACCOUNTED FOR as a capital contribution in the association’s financial statements.  While this is routinely done in professionally managed associations, too many small, self-managed associations fail to take this critical step.  As long as reserve monies are held in a separate bank account and there is a clear record of reserve contributions and expenditures, the association should be able to overcome this accounting deficiency in an IRS audit situation.

4)      Money must be HELD FOR THAT PURPOSE and no other purpose.  This means that once you set aside monies in reserve accounts, you should NEVER invade those reserve accounts for operating purposes.  California statutes permit associations to borrow from reserve under certain circumstances.  While permitted under California law, federal tax law does allow such use of funds.

5)      Money must be HELD IN SEPARATE BANK ACCOUNTS from the operating (noncapital) bank accounts of the association.  The IRS interpretation of this is that (as an example) roofing and paving funds, considered capital in nature, cannot be held in the same bank account as painting monies.  Why?  Painting is considered non-capital in nature.  Combining painting or contingency reserves with your capital reserves jeopardizes the entire capital contribution.  This is probably the most critical item in your reserve planning.  If you do not have these separate bank accounts, you should probably not be filing Form 1120, as your tax risk is too high.  This issue has been raised on virtually every IRS audit on Form 1120 on which I have consulted.

What this means is that most associations must maintain three different bank accounts – one for operating funds, one for capital reserve items, and one for noncapital reserve items.  Virtually no one is doing this.  This deficiency could potentially be overcome in an IRS audit if you have adequate accounting, but there is no guarantee.  This is one of those situations where, although it is a pain to comply, it is still easy to comply, and why have to fight the IRS over an issue that is so easy to comply with.

6)      Money must be actually EXPENDED FOR THE INTENDED PURPOSE.  This does not mean that if you assessed money for roofing that that exact amount must be expended for roofing.  It means that if you assess reserve monies for a capital purpose, it must be spent for a capital purpose.  Reserve bank accounts commingle various capital components (roofing, paving, fencing, etc.).  That dollar in the account does not know that it is a roofing dollar or a paving dollar.  That dollar does not know what kind of dollar it is, other than it is a capital dollar.  That is the only important criteria.

7)      Money must INCREASE THE CAPITAL ACCOUNT OF THE MEMBER or unit owner-stockholder.  This is effectively an automatic process with which the association normally need take no action.  The reason is that, as defined in other sections of the Code, a member’s “capital account” is presumed to reflect an increase in value for monies added to reserves.

What all of this means is that the association must be very careful in its handling of reserves IF IT IS FILING FORM 1120.  If you’re filing Form 1120-H, you can effectively ignore all of the above and still have a safe tax return.

If the association fails to comply with the above parameters established in tax law, THERE IS NOTHING THAT THE TAX PREPARER CAN DO TO MITIGATE YOUR TAX RISK.  The tax preparer’s responsibility is limited to properly presenting reserve activity in Schedules M-1 and M-2 of the association’s Form 1120 tax return.  Any errors at this level can generally be overcome during an IRS audit.