Let’s start off this article by discussing the difference between the reserve fund and the operating fund – including how to know when to use each one. First, the definitions:
Reserve Fund: the portion of the association’s budget set aside to cover any future capital improvement projects. The reserve fund is usually put into a savings account or other highly-liquid money-managing asset. Typically, most of the reserve fund is set aside specifically to maintain current assets, such as purchasing a new roof for the clubhouse, buying a new pump at the community pool, replacing and resealing streets, etc.
Operating Fund: the portion of the association’s budget used to pay for the day-to-day functions of the HOA. Like the reserve fund, the operating fund is often put in a highly-liquid money-managing asset; specifically, a checking account. The operating fund is used for everyday costs, such as paying insurance premiums, landscaping, gate repair, property management, accounting and legal fees, etc. Typically, it is not used to maintain physical features.
Board members are usually able to glance at the budget and tell which account should cover what costs. Sometimes, however, expenses can come up that are difficult to categorize. For example, to replace the broken treadmill in the gym, should you draw from the reserve fund or operating fund? While most experts in this specific instance would advise you to take it out of your reserve fund (particularly if the most recent reserve study indicates that the treadmill was nearing its replacement period), there can be a lot of room for judgement!
Additionally, an association’s governing documents will usually stipulate how the reserve funds are supposed to be spent. Before allocating a large amount of money toward a project, we encourage board members to check their documents.
If your documents are silent, or if you are unsure which account you should use for the expense, consider the following questions:
- Is this expense a long-term project? While the definition of “long-term” does vary somewhat, if the project will take longer than a day or two, it is likely a cost that’s been brewing for a while and, as such, should likely be paid for with the reserve fund.
- Is this expense going to come up again next month or next quarter? If the answer is yes, it is a recurring expense and should be taken from the operating fund.
- If this was a personal expense, would you use your checking account or your savings account? If you’re paying your next-door neighbor’s kid for mowing your lawn, you would use your checking account. Likewise, the board would pay for the association’s landscaping with the operating fund. However, if you want to update your kitchen, you will probably use your savings account to pay the contractor for his work. Similarly, if your board wants to renovate the clubhouse, that expense would probably be taken from the reserve fund.
- Is this an addition to the community (i.e., a capital improvement), or a repair or upgrade to an existing amenity? Most experts would say that separate financing is a must in these situations, and we agree. Reserve funds are primarily for the repair and replacement of pre-existing features.
But, what if your board decides they want a brand-new pool, gate, clubhouse, or park, and the HOA has not been allocating money into the reserve fund for that specific addition? The best practice is to alert your reserve analyst the next time you order a reserve study to have them factor the addition into the reserve over a period of years.
You can order a reserve study at any time. Like with other services, your management company should be able to provide you with multiple bid proposals, so you can shop around for the best price. If you choose to either raise assessments or levy a special assessment in order to pay for the new feature(s), we encourage you to alert your reserve analyst of the upgrade the next time you order a reserve study. Your new upgrade’s deterioration needs to be factored into your reserve fund needs! We also encourage you to reach out to your insurance broker to ensure your insurance needs haven’t changed with the capital improvement.
Asking these four questions will help make sure the association’s reserve funds are being used for their intended purpose. Ultimately, a reserve fund is for future expenses of line items that currently exist on an association’s budget, and the operating fund is for ongoing costs. If you have questions regarding the best use of your HOA’s accounts, your management company can help!
The good news is that once you have a plan in place for fixing existing amenities, the entire budgeting process becomes easier! Keeping reserve funds at a sufficient level by using them for their intended purpose will create peace of mind for the HOA board and homeowners alike.