What You Should Be Doing with Your Replacement Reserves

by Hellmuth & Johnson PLLC
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Hellmuth & Johnson PLLC

Most association governing documents contain provisions requiring the association to establish and maintain one or more reserve accounts that are used to set aside funds for the future maintenance or replacement of components of the property that the association is obligated to maintain, repair and replace.

Legal Requirements for Reserves

For those associations that are governed under the Minnesota Common Interest Ownership Act (“MCIOA”), there are additional statutory requirements regarding replacement reserves. Minn.Stat. 515B.3-1141 provides that an association shall include in its annual budgets “replacement reserves projected by the board to be adequate, together with past and future contributions to replacement reserves to fund the replacement of those components … which the association is obligated to replace by reason of ordinary wear and tear or obsolescence”, subject to several exceptions. Associations must also reevaluate the adequacy of their reserves at least every three years.

Exceptions

The exceptions set forth in the statute exempt associations from having to reserve for:

  1. Components with a remaining useful life of more than 30 years;
  2. Components that will be paid for directly by the unit owners for replacement of limited common elements in accordance with the governing documents; or
  3. Components for which the replacement has been approved through an alternative funding program as set forth in the statute. The alternative funding program allows associations to vote not to reserve for components whose replacement will be funded by a special assessment, if authorized by statute or under the association’s governing documents. The vote of the members not to reserve for these components is separate and in addition to any vote or consent of the members that might be required under the documents to actually approve the special assessment.

Barriers to Fully Funded Reserves

Although MCIOA requires associations to fully fund their replacement reserves (subject to the above-noted exceptions), I can probably count on one hand the number of associations that I have run across or worked with over the course of my career that actually have adequate replacement reserve funds. The lack of adequate reserves usually comes from a combination of factors. Often, the initial developer failed to set up a proper budget or to provide for adequate reserves because it wanted to keep the assessments low in order to attract buyers. In some cases, the developer also failed to pay its assessments and/or failed to actually put the money collected from the other owners into the reserve account. The trend may continue when boards are hesitant to raise the assessments in order to cover the shortfall or they can’t get the votes from the members to do so if required under the governing documents. Many association board members also simply lack the understanding of what is required to fully fund the reserves as well as the expertise to accurately predict how much they will need to have saved up at any given point in time.

Your Reserve Study

Associations are not required to obtain a professional reserve study in order to comply with the reserve requirements under MCIOA. However, the vast majority of associations would benefit from spending the money to do so. In order to put together a proper reserve plan, the following steps should be taken, whether by a professional reserve company or by the board. First, the board should make sure that it has a good understanding of what components of the property are the responsibility of the association to maintain, repair and replace as well as what, if any, of these costs can or must be assessed back to fewer than all owners. It is recommended that associations get a legal opinion and/or have their attorney prepare a maintenance chart that outlines this information.

Once this is done, each of these components for which the association is responsible must be inspected to determine its condition and expected remaining useful life (i.e. how long it will last before it needs to be replaced). With a professional reserve company, the inspection will usually be done by an engineer or possibly a licensed contractor. A schedule is then put together outlining what components will likely need to be replaced when.

From there, the financial analysis is done to determine how much it will cost to replace each such component at the time that the component is expected to need replacing, and how much money the association will have at that time based on current reserve account balances, the amount of future contributions to reserves and the expected rate of interest or return on any investment vehicles in which those funds are invested. If it appears that the current reserve plan is inadequate, professional reserve companies will then typically make recommendations as to various adjustments that can be made in order to increase the funds available for replacing the various components when needed.

If you are not following all these steps to determine the adequacy of your replacement reserves, you are most likely not in compliance with MCIOA. While there are those special people that live for doing this kind of work and are quite good at it, I am one of those people who gets a headache just thinking about it and would thus personally much prefer to hire an expert to put together a reserve study that I know I can rely on, rather than stumble my way through the process of trying to do all the work myself or to risk liability for what would most certainly turn out to be a woefully inadequate and inaccurate plan, given my own lack of expertise in this area. But that’s me.

In addition to the requirements for determining and evaluating the amount that is being put into reserves, MCIOA also strictly prohibits associations from co-mingling replacement reserve funds with operating funds, and from using or borrowing from the replacement reserves to fund any operating expenses. This can trip up some association boards and professional reserve companies because they are used to reserving for large periodic maintenance items such as painting, staining, seal coating, etc. and now are prohibited from using the replacement reserve funds to pay for these items. If you are in this group, do not fret. There is nothing in MCIOA that prohibits an association from having more than one reserve account.

Associations can maintain the replacement reserve account as required under MCIOA, and can also have one or more operating reserve accounts. These would be separate operating accounts that are used to save up and pay for those large maintenance projects that the association must undertake every few years. Unless the association’s governing documents state otherwise, those operating reserve accounts can also be used for other purposes, including covering budgetary shortfalls or other unbudgeted operating expenses, without running afoul of MCIOA.

One final note about reserves: Although MCIOA does not require associations to reserve for replacements of limited common elements if the association plans to assess those replacement costs against the units that benefit by them, I usually recommend that associations do include these limited common element components in their reserve plans. The reason for this is that under most association documents, the association is responsible for performing and paying for the maintenance, repair and replacement of the limited common elements, but then assesses the cost back to the affected unit or units. Many associations do not have sufficient funds to pay for these replacements out of pocket or to cover the expense until such time as the homeowner(s) get around to paying the assessment. By including these components in the reserve plan, the association should have sufficient funds to pay for those components when they require replacement. Money collected from the assessed owners can then be put back into the replacement reserve account so that it is available to pay for future expenses.

This article originally appeared in CIC Midwest's News 2017 Fall edition and is republished with permission.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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