Financial Articles
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With the reserve fund growth comes the need for better reserve fund management (also known as good stewardship). With wise stewardship, member contributions are substantially reduced due to the miracle of compound interest. With properly applied investment principles, even a modest condominium of 50 units can generate several hundred thousand dollars in interest earnings over a 30 year projection period. This means that the members will need to contribute that much less out of their pockets. Good news indeed.

The board of directors has a fiduciary responsibility to make sure reserve funds are invested properly and safely. The board should not invest in anything that a prudent person would consider risky unless there is a broad consensus among the members that doing so is okay (better get that in writing). The investment strategy should also ensure that funds are available when needed.

To refine and define the HOA’s reserve obligations, a written Reserves Funding & Investment Policy is extremely important (for a sample, see the Reserve Planning section). That policy holds both current and future boards to a standard of accountability and helps prevent the Board from using reserves like a private piggy bank.

A good Reserve Plan puts the funding issue in proper perspective. While, say, $50,000 or more may seem to be a lot of money to an individual, it’s a pittance to an HOA when it comes to paying for major repairs and replacements like roofing, painting, siding and paving. Most reserve plans call for the accumulation of hundreds of thousands or millions of dollars. Even though the fund size seem large, it is rarely greater than what is necessary to cover real costs. To stay accurate, the Reserve Study must be updated annually to ensure that the HOA is on track and being adequately funded.

When the Reserve Study is funded properly, more money will result (Oh Joy!) but with that money comes the responsibility to invest it wisely. A Reserve Funding & Investment Policy will provide the philosophy but it’s up to the Board to see that the philosophy is implemented. The larger the fund, the greater the need for investment expertise. While your banker will doubtless have some convenient options, that convenience may be very costly since it can come with a below market rate of return.

A trained investments consultant can be hired to manage the reserve funds and maximize yields through safe and insured investments. If your reserve funds are substantial, this is a wise and profitable move. The added investment return will more than pay for the cost of the consultant.

Investment yield is directly related to the size of fund being invested. The more you have, the greater the yield. However, some banks don’t willingly offer their customers the better rates. As a matter of fact, your bank may not be the best place to invest reserves. For the best rates, you need to go shopping. Next stop, the internet. Bankrate.com is one of several online sources for local investment alternatives. You can search by state and city to locate higher CD rates right in your locale.

Fiduciary responsibility requires that directors handle reserves responsibility. When it comes to investing there are three considerations: safety, liquidity and yield.

Safety can be broken down into two categories: safety of income and safety of principal. Safety of income measures the likelihood that anticipated income from an investment will continue to be paid in the amount expected and at the time expected. Safety of principal refers to whether the principal value of the investment available at the outset will be available at maturity. Both categories of safety can vary in degree with specific investments.

Liquidity refers to investments that can be converted quickly into cash. Homeowner associations need a certain amount of liquid funds because major repairs can happen unexpectedly. However, with a proper Reserve Study, most repair events can be accurately predicted years in advance. If the repair schedule indicates 95% of reserves won’t be needed for three years, those funds can be obligated for at least two years with little fear of being caught short.

Yield is simply the return received on the investment. Generally, the longer the maturity period, the higher the yield. So, a three year CD yields more than a one year CD. Also, the safer the investment, the lower the yield.

A well planned reserves investment policy factors safety, liquidity and yield into the mix. These are the basics of good stewardship. When the reserves are funded according to a 100% funding philosophy coupled with these basics, the HOA will find a firm financial foundation for the future.  BACK

Boy Scout the IRS
An IRS audit can be both a nuisance and a financial setback for a homeowner association. But HOAs often set themselves up for scrutiny due to sloppy books and record keeping. The best way to avoid an audit is to play Boy Scout and be prepared. Here’s how:

HOAs may file taxes using either a Form1120-H (designed for HOAs and carries a taxrate of 30%) or Form 1120 (designed for corporations and carries a taxrate of 15-39%). The form issue becomes more relevant depending how the HOA deals with operating funds that otherwise might be taxable income, such as a cash settlement from a construction defect lawsuit.

IRS Revenue Ruling 70-604 allows an HOA to exclude excess membership income from taxation by returning the excess to its members. The HOA can make an annual election to return the excess either by refunding the excess to the members or applying it to the next year's homeowner fees. Documenting the HOA's specific action is essential. If the IRS can find no written record of the roll over election by the HOA members (not the board) made prior to the filing of the year's tax return, they may conclude that the funds are fully taxable. So, every HOA that has excess taxable funds should adopt a resolution at the annual meeting.

Using the 1120-H method is easy and poses little risk of an audit. The HOA simply refunds each unit owner's share of the excess membership income. However, using 1120 to report the roll over of excess funds from one year to the next is especially prone to IRS inquiries. The HOA should make sure that the amount rolled over is absorbed in the following year. In some cases, the HOA may treat part of it as a contribution to reserves. To do so, it must meet the following criteria:

• The financial records must delineate between operating and capital reserve activities
• The Reserve Study supports the need for capital improvements
• Cash accounts for operating and reserves are kept separate
• Tax returns clearly distinguish reserve from operating transactions

If you report interest income on the HOA's tax return, assume the IRS will be keenly interested in what expenses were allocated against it, and in other nonexempt or nonmember income to lower the taxes due. The IRS demands thorough records to substantiate expense allocation against various types of income. Consider an HOA with that, say, rents out the clubhouse to nonmembers for a fee. The IRS will require that these HOAs explain the basis for expense allocations (like, hours of janitorial services).

• Copies of prior year tax returns
• Financial books including general ledger, cash receipts, and cash disbursements
• Minutes of annual and board meetings
• Copies of excess income elections passed by the membership
• Copies of annual budgets
• Copies of account statements holding reserve funds
• Invoices and canceled checks to support expense deductions

When selecting a property manager or accountants, make sure they are familiar with applicable IRS rules which are continuously evolving. Your property manager needs to know how to allocate various expenses so your HOA can properly compute its taxable income and file the return.

Reduce the chance of an audit:
1. Review the return closely for errors and check all calculations carefully.
2. Include the Employer Identification Number (EIN)
3. File on time, even if you can't pay the tax.
4. Use the correct tax rates. Form 1120-H is a flat tax rate of 30% Form 1120 has a graduated tax rate ranging from 15 to 39%.
5. File a complete tax return and attach forms, schedules, supporting statements and explanations.
6. File all related tax forms like W-2, W-3, 1096, and 1099-MISC. Every HOA must file Form 1099-M1SC if it pays rents, commissions, or non-employee compensation of $600 or more to a person or partnership during the calendar year.
7. Pay taxes owed on time. Mail the payment with Form 8109 to a qualified depository.
8. Sign the return. The tax return must be signed and dated by the president or officer authorized to sign. The paid preparer must complete the required preparer information and sign the return in the space provided.
9. List your current address. If you’ve changed mailing addresses, check the "change of address" box.
10. Reply promptly to IRS inquiries.
11. Keep a copy of all tax returns and attachments for ten years.

If the IRS audits your HOA:

Leave adequate time to prepare. Scrutinize the audit notice to determine the various financial records that will be needed for the review process. Usually the IRS will reschedule to a more convenient time if you ask them to do so.

Hire an accountant to handle the audit. Those who prepared the tax return are most familiar with the return under review, and usually have prior experience with IRS audits.

Provide complete records to the accountant. The sooner the accountant receives the records, the better.

So there you have it. Boy scouts are drilled in the discipline of preparedness because one never knows what the future will bring. But those that are prepared generally can avoid the avoidable and IRS audits usually fall into this category. Those that pass this test qualify for the Audit Avoidance Merit Badge.     BACK

Hand in the Cookie Jar
An excerpt from a recent news story read: "Willie Dippentakit of Sheboygan stole more than $30,000 from the Nottacare Condominium. Thursday, he was sentenced to a year in jail, three years probation, and ordered to pay back the money.  He said he was sorry."

With reserve planning for homeowners on the rise (thankfully) comes increased amounts of cash which can add up to hundreds of thousands of dollars. With larger amounts of cash comes the unfortunate temptation to dip into the HOA’s cookie jar. Embezzlement can happen by either a board member or management company that has access to the funds. Usually, managers are restricted (or should be) from reserve accounts where most of the HOA’s money is. This leaves the HOA cookie jar under the control of the Board President and Treasurer.

When it comes to protecting against embezzlement and other forms of fraud, it’s best to have a number of controls in place that are designed to preempt the act. In other words, if there is a good chance an embezzler is going to get caught, the temptation is much less than if stealing is a piece of cake. Some of the basic controls include:

• Two Signatures Required Checks. Get checks that require two signatures. Of course, a forger would simply sign both lines and, frankly, the banks rarely check signatures for authenticity unless a substantial cash withdrawal is being requested, so no guarantee here..
• Duplicate Bank Statements. Getting two sets of bank statements, each mailed to a different party, reduces the likelihood of embezzlement. Of course, the two recipients could collude to embezzle but the odds are greater against collusion.
• Rotate Check Authority. Don’t always have the same person write, sign and issue checks. Rotate that authority so that several sets of eyes are looking at the checkbook.
• Bank Account Reconciliation. Having an outside entity that has no check writing authority, like a bookkeeping service, balance the checkbook each month places the check function at arms length.
• Secure Check Storage. All blank and canceled checks should be stored in a locked and secure location. A favorite ploy is to steal blank checks from the back of the stack so the theft won’t be immediately apparent. Canceled checks can be used to assist in forgery.
• Fidelity or Employee Dishonesty Insurance. While it won’t prevent theft, this kind of coverage will reimburse the HOA up to its limit for theft.

Getting caught with a hand in a cookie jar is no big thing if you’re five years old and the goal is a macaroon. But when the prize is the HOA’s cash, the Board needs to place aggressive measures in place to help keep those "certain someones" from helping themselves.    BACK

A Chilling Effect
In December 2007, Fannie Mae substantially revised its underwriting requirements for condominiums. While many of the changes resulted in streamlining the loan approval process (for example, delegating review of each condominium project loan to the local lender and reducing the legal requirements for condominium documents), a few changes resulted in the guidelines being much more stringent.

Among the new guidelines is a requirement that no more than 15% of the units may be delinquent for one month or more in the payment of common expenses. In addition, Fannie Mae requires that the local lender certify that the condominium budget is "adequate" and that there is a line item in the budget for reserves of at least 10% of the annual revenues.

Fannie Mae continues to be concerned about litigation which might materially affect the financial health of the condominium association. The concern about litigation relates to cases where the homeowners association is either plaintiff or defendant. Collection lawsuits, however, do not disqualify the association from complying with Fannie Mae guidelines.

Since the only parties subject to Fannie Mae’s guidelines are the local lenders, one might question how the new guidelines directly affect condominium associations. Fannie Mae buys a substantial number of loans from local lenders and so compliance with Fannie Mae’s guidelines may determine whether unit owners sell or refinance their units. The impact is profound.

In the past, local lenders were more relaxed in complying with Fannie Mae guidelines. Now, it appears that they have are more compliant because the lender may be required to buy back loans if they fail to meet Fannie Mae’s underwriting guidelines.

In one case, a small twelve unit condominium completed a lender affidavit form in connection with a loan to a new purchaser which stated that four out of the twelve units were delinquent (25%) by more than one month in the payment of common expenses. Since the delinquency rate exceeded Fannie Mae’s 15% maximum, the lender rejected the loan.

In another instance, a lender affidavit form reported that the condominium was a plaintiff in a construction defect lawsuit against the developer. The lender rejected the loan because of the possible financial impact on their borrower.

In the third case, the association was the defendant in a discrimination claim brought by a unit owner. Although the master insurance policy was defending the claim, the master insurer only agreed to pay legal defense fees but would not pay if there was a money judgment after a trial. Although the lawsuit settled quickly for a small sum, the lender had already rejected the loan.

These cases pose real concerns to condominium associations. In the case of delinquencies, associations should have and consistently enforce written collection procedures. For example, after ten days, a late charge should be charged and the unit owner advised of the delinquency. There should then be a procedure for subsequent notices and deadline when the collection will be subject to more aggressive measures (liens, wage garnishment, etc.) by the association attorney.

The issue of litigation is more complicated. It makes little sense for an association suffering from construction defects not to bring the suit for fear lenders would stop lending. In the matter of the discrimination claim, the association is forced to defend itself even if the lawsuit is frivolous.

While there are grave concerns relating to the rejection of condominium loans, in the three matters discussed here, the borrower simply went to another lender who did lend the money. However, with a banking system in crisis and lenders complying with stricter Fannie Mae guidelines, there will be a certain chilling effect which will prove interesting for condominium associations.

By Stephen M. Marcus, Esq. of Marcus, Errico, Emmer & Brooks P.C.   BACK

End of Life Issues
Dear Unit Owner,
The Board of ABC Condominium is saddened to inform you that our boiler has died. In lieu of flowers, please send a check for $2,000 which is your share of the replacement cost.
Sincerely,
Your Grieving Board

The ability to purchase a condominium with a down payment of less than 20% is evaporating quickly. There may be a time where no one can benefit, the buyer cannot find financing, the seller can't sell, the banks don't want a flood of condominiums that they will have to manage, and HOA boards are scrambling to maintain the commons with dwindling budgets. Once this occurs political pressures will pressure the agency to adjust their policies. The question is: Can condominium owners wait that long?  By Clifford Hockley  BACK

Article from Association Times. For a list of qualified reserve study providers, see Association of Professional Reserve Analysts at www.apra-usa.com  BACK

Collection Policy Scorecard
How effective is your homeowner association’s collection policy? Does it contain all the tools you need to collect the maximum amount your HOA is entitled to? Are your actual billing and collection practices consistent with your collection policy? Will the policy stand up in court? Take this simple test to find out how good your collection policy really is. Circle either Yes or No and tally the totals.

1. Policy states that a delinquent owner is responsible for payment of late fees for every month an account is delinquent. Yes No
2. Policy states that a delinquent owner is responsible for payment of any management company service fees.  Yes No
3. Policy states that a delinquent owner is responsible for collection costs included returned check charges or processing fees. Yes No
4. Policy clearly explains when and how many late notices are sent, when liens are recorded against the property, and when the account may be turned over to an attorney. Yes No
5. Policy explains when late fees and interest will be imposed on delinquent accounts. Yes No
6. Late notice letters include warnings of any fees, costs or interest that will be charged to a delinquent account, and these warnings are consistent with the Policy. Yes No
7. Policy is consistent with your HOA’s Declaration. Yes No
8. Policy explains the order in which payments are applied: first to attorney’s fees, costs, interest, service and late fees, and last to payment of the principal. Yes No
9. Accurate statements including all costs, fees and interest are delivered to delinquent owners. Yes No
10. Policy provides that if an owner communicates via email, text, fax, phone or any other method, the owner authorizes the association and its agents to communicate via the same method in the future. Yes No
11. Policy requires delinquent accounts to be turned over to collection within 90 days of becoming delinquent.  Yes No
12. Policy requires that, immediately upon receiving notice of an owner’s foreclosure or bankruptcy, their account, whether or not delinquent, is turned over to the HOA’s attorney. Yes No
13. Assessments are due monthly provided the Declaration permits.  Yes No
14. Policy includes an acceleration clause of all assessments due for the fiscal year. Yes No
15. Policy includes a rent intercept clause which allows the HOA to collect rent from tenants if the owner becomes delinquent. Yes No
16. Policy includes a receivership clause which enables the HOA to foreclose its lien. Yes No
17. Policy explains why timely payment of assessments is in the best interest of the community. Yes No
18. Policy is delivered to all owners every year and available on the HOA’s website. Yes No
19. Policy provides that a security deposit may be assessed against a delinquent owner in the board’s discretion. Yes No

Grading Key:  (Number of Yes Circled)

15-19 Collection Policy is efficient.
9-14 Collection Policy may be vulnerable if challenged in court. Updating your policy could help you collect more money.
0-8 Collection Policy leaves the homeowner association at risk of a high delinquency rate.

by Amelia J. Adair, Esq. of www.HindmanSanchez.com    BACK

4 Reserve Investment Hurdles
HOA boards are faced with a challenge. They have limited time and resources, yet must meet the financial obligations of the reserve study by following a funding plan that provides adequate member contributions and additional revenue from prudent investment of reserve funds that reduce those member contributions. Here are four hurdles the board must jump when tackling reserves investment.

Hurdle #1: Failure to use the Reserve Study or not having one in the first place. Homeowner association boards have the duty to conduct long range planning to identify common elements, their current condition, their useful lives and current cost of repair or replacement. This exercise is called a Reserve Study. Some boards believe that a reserve study provides little benefit except to point out the obvious. These same boards either elect not to pay the cost of one or put the one they have in a file to gather dust. Both approaches are foolish because without a clear road map to follow, the board is bound to get lost in the maze.

Properly funding reserves for the standard 30 year projection period could amount to many hundreds of thousands of dollars. Larger HOAs with extensive common elements should reserve millions. Failure to fund reserves adequately results in unfair and sometimes uncollectible special assessments. Prudent investment of reserve funds could partially offset member contributions and reduce the risk of special assessments.

Hurdle #2: Failure to understand investment choices. Some boards are under the impression that FDIC insured money market accounts or CDs are the only alternatives for reserve fund investments. There are a number of alternatives. State laws vary but in Oregon, for example, HOAs are limited to direct investment in issues of the federal Government and/or FDIC bank accounts or CDs. HOAs are not permitted to invest in municipalities, mutual funds or indirect investments (investments to which the investor does not directly hold title, such as mutual funds, limited partnerships and Real Estate Investment Trusts). Non-FDIC insured money market accounts are not to be used for homeowner association reserve investments by law.

This creates an opportunity to invest in longer term federal bonds. As of the writing of this article, the going rate of a 10 year government bond is around 2.91% compared with bank checking accounts that average around 0.5%. This increased yield could go a long way to reducing the need for a special assessment. The challenge with investing in 10 year bonds is determining how much should be invested in them. Fortunately, the Reserve Study is very useful in determining the short and long term reserve cash needs.

Hurdle #3: Failure to utilize the Reserve Study when selecting investments. The first step in considering higher yielding investment opportunities is to put that Reserve Study to work. The Reserve Study can be used to match the repair schedule with the investments. This allows combining shorter term/lower yield CDs with longer term/higher yield Treasury Bills. This type of investment strategy is called a Duration Study. Even though a Duration Study costs money to perform, the extra interest return that can be earned by matching the investment duration to your specific HOA is well worth it. Duration studies and the investment mix need to be redone every time a Reserve Study is updated.

Hurdle #4: Not hiring a fiduciary. Regardless of how the board chooses to invest the HOA's Reserve Funds, time, expertise and professional ability are needed to manage them properly. It is in the board’s interest to find someone that has the HOA’s well being at heart, such as an investment advisory company that is a fiduciary to the board. By better managing your reserve funds, you avoid the hurdles described and improve reserve investment yields.

Leave the hurdling to the track stars. Use a trained financial consultant to optimize your reserve fund investments.

By William Meyer, CEO - Strategic Group www.reservefundinvestments.com  BACK