FAQ - Questions and Answers

Life and Cost Q and A

How do you determine useful life and replacement cost information as part of the reserve study?

There is no single method of determining these two critical factors as part of the reserve study.  Rather it is a combination of methods, and we may use several different methods on the same reserve study for different components.

As we perform the site inspection, we try to obtain as much information as possible about the association’s components, while always remembering, these are YOUR components.  The importance of this is that while you may have the same type of component as another association, you may experience different use, be affected by different climatic conditions, have different materials, or have a different maintenance plan.  Therefore, while we have general knowledge regarding useful life and cost parameters for such components, we have to consider your unique factors.

That means we ask questions regarding your maintenance plan of the component.  While you look to us as the outside expert preparing the reserve study, your maintenance staff or outside vendors have specific information that we can’t determine from simple observation.  The questions we ask are;

1)    when was the last time the component was serviced?
2)    what specific maintenance service was performed?
3)    what materials were used?
4)    did you use an outside contractor or your own maintenance staff?
5)    what was the cost?
6)    is there a warranty in place?
7)    what is your opinion of the quality of the work performed?
8)    what is your estimate of the useful life and remaining life?
9)    what are your future maintenance plans?
10)    do you have any bids for future work to be performed?
11)    have you obtained an engineering evaluation (usually considered necessary for items such as significant paved surfaces, dams, dredging projects)?
12)    are there any environmental considerations?
13)    do you have an outside vendor that provides regular (operational) maintenance services (such as pool service or elevator contract)?

If we are able to obtain this information as part of our site inspection, it helps us identify your specific costs and useful life information.  Where possible, this is what we incorporate into your reserve study, as we believe it provides the most accurate and reliable information.  It doesn’t do anyone any good to rely upon industry standards or manufacturer recommendations if your own experience differs from those standards.

When we can’t obtain the above information from your maintenance staff or others within the association, we contact you vendors to attempt to obtain the information.  An example is that the company providing your pool service already has good information regarding your pool equipment, and is an experienced professional that has specific knowledge that is very likely superior to ours.

Our next source is to contact local (to YOUR area) contractors or service providers to questions them regarding local cost and useful life information.  We operate nationwide and know that both cost and life information can vary significantly in different areas.  We always attempt to use vendors that are members of CAI (Community Associations Institute) or other trade organizations, as that tells us they understand the industry and are usually reliable vendors.  In most cases, we will provide you with this information as part of the reserve study.

The information we obtain through the above methods is also used to continually update our internal use cost database.

If we are unable to obtain the information we need from the above three methods, we next consult our internal cost database, as it is likely that we have already obtained cost and life information on similar components at another location.  Each component in our internal database contains data on the last date that we updated the cost on this particular component, for what geographic location the cost data was obtained, and the source from which we obtained the data through our own research.  Most items have links to websites accessed, and many to vendors contacted, so we can quickly update the data.

If all the above methods do not yield the information we desire, we finally turn to published cost database that we subscribe to, such as the Marshall & Swift valuation service.

Our site inspection and visual observations do allow us to estimate what we refer to as the “effective age” of components.  This may be different from their chronological age; either higher or lower.  Useful life recommended by a manufacturer or contractor (upon installation) may be exceeded or diminished by the maintenance plan, higher or lower use than expected, weather, or other factors.

Bottom line, the information we are able to obtain, influenced by our own experience with similar properties, will determine the cost and life information that makes its way into your reserve study.  Both of these factors are estimates only.  We are usually able to provide more accurate estimates for components that will be replaced in the next few years.  As replacement dates stretch out further into the future, the estimates can become less reliable.

I have often informed Boards of Directors during a presentation of the reserve study report that the study is built upon a series of informed estimates, few of which are likely to be “dead on the money.”  However, the purpose of the study is make sure that the association has approximately the right amount of money available at approximately the right time to perform the necessary maintenance activities.  Even if individual estimates are not exact (and it can’t be, because, after all, it is an estimate), the aggregation of all component estimates is usually more accurate than individual estimates.

Can capital improvements be included in the reserve study?

For purposes of this question we are defining capital improvements as the expenditure of funds for new, not previously existing, components.

Some associations want to include capital improvements in the reserve study. Most do not. In our experience the only reason that associations include capital improvements in their reserve study funding plan is because they do not have a separate capital improvements budget and it is a very rare occurrence that they will actually construct a capital improvement.

The association should look first to their governing documents to determine if there are any limitations on inclusion of capital improvements within the reserve funding plan. Secondly they should look at state law to see if state law prohibits either the accumulation of or expenditure of funds from the reserve fund for other purposes such as capital improvements.

Our recommendation is that it is generally preferable to keep capital improvements funding separate from the reserve study report.


For more Reserve Study Questions and Answers

Can painting be included in the reserve study?

For most condominium projects, painting is one of the largest expenditures that the Association will incur. Consequently it is logical that it should be included in reserves because it is not an annual maintenance expense. For most associations it will occur every 7 to 15 years.

So why does this question even arise?  In 1993 the IRS audited approximately 15 associations in San Diego, California that created a national furor within the inudstry.  The IRS audits dealt significantly with the concept of the inclusion of painting in reserves.  The reason this became such a big deal in the industry was because of the misunderstanding that occurred related to this issue.

You must realize that the IRS has its own rules, and that they really don't care what the homeowners association industry thinks.

  • The homeowners association industry generally refers to expenditures as being either operating or reserve in nature.
  • 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. It is common practice within the homeowners association industry to exclude reserve contributions from taxation because they are capital assessments. However, the IRS states that in order for assessment to be classified as capital in nature, the related expenditure must qualify as being capital in nature. Unfortunately there are numerous rulings and tax court cases which clearly state that painting is a non-annual maintenance expense, it is not a capital expenditure. Consequently, the reserve contributions that most tax preparers were excluding from taxable income on the association's tax return now become taxable income. That makes it very difficult for an association to accumulate the necessary painting funds without incurring a huge tax liability. The easy answer to this question is to have the association file income tax Form 1120-H and avoid this issue of capital versus noncapital expenditures that exists only on Form 1120.

It is our position that the tax tail should not wag the economic dog. Determination of reserves should be made based upon economic considerations, state statutes, and governing document requirements. Taxes should not enter into that consideration. Consult with the association's tax accountant to find out ways to avoid the tax risks on this issue.

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.

Should the reserve study include a contingency factor? How is it calculated?

The question of whether or not to include contingency in the reserve study funding plan is one that is answered by each Association. There is no single answer that is appropriate for all associations. We generally favor inclusion of a contingency factor because our 27 years experience in preparing funding plans has demonstrated to us that associations rarely overestimate, but commonly underestimate future required expenditures.

There are two ways to include the contingency factor into a reserve study. One way is to create a line item, equivalent to a component, that appears on the face of the reserve study. Most associations that use this method of including contingency in their reserve study either calculate a flat amount per year or calculate contingency as a percent of each year's expenditures. The other way to include contingency in the reserve study is to spread the contingency factor amongst all components included in the study. An example of this would be that if a 2% contingency factor were applied to a $10,000 component to be replaced next year then the future replacement cost would be $10,200.