Replacement reserve law as it applies to condominiums can be complex. We’ll navigate through its history, legal requirements, tax issues accounting and calculation.
The definition of “replacement reserves ” is defined in the law as “… funds for the upkeep, repair, or replacement of those parts of the property, including but not limited to roofs, walls, decks, paving, and equipment, that the association is required to maintain.”
The funding of replacement reserves by condominiums is required as a matter of law. There is no replacement reserve requirements for other types of homeowner associations, i.e. Cooperative Housing Corporations (Ch. 421 I); Planned Community Associations (Ch. 421J); and, Time Sharing Plans (Ch. 514E).
On January 2, 1995, the Hawaii Real Estate Commission formally adopted rules on replacement reserves. Prior to that time many, perhaps most, associations used special assessments to fund major projects. For these associations the prevailing thought ran along the lines of “why should I give my money to the association when I can invest it and make some additional revenue. I will pay for the improvement when it is required”
Of course, this kind of thinking proved nonsensical because most owners still grumbled whenever a special assessment was declared by the board. In addition, the use of special assessments was especially troubling for new unit owners. In several cases, new owners were hit with special assessments amounting to thousands of dollars within a year or two of taking title. Their complaints were based on fairness; their argument was “how come I, as the new owner, have to pay to upgrade the plumbing system, or roof replacement, painting, electrical upgrades, etc.) when the deterioration occurred over decades?”
When the State legislature mandated that all condominiums institute funding for the replacement reserves only the percent funded method was allowed. This method required that the amount required to be funded each year was a minimum of 50% of the estimated liability. This was a huge burden for many condominiums, especially those that had relied solely on special assessments to fund larger projects.
In many cases, the replacement reserve calculation, especially for older buildings and smaller associations, ended up being significantly more than the regular maintenance fee. As a result, there was substantial non-compliance with this section of the law. After a couple of years, the State legislature allowed the use of the Cash Flow method that is used by most condominium associations today.
A copy of the relevant law is provided in the attached Appendix – Ch. 514B-148, Association fiscal matters; budgets and reserves. Following is a brief synopsis of the State law dealing with replacement reserves as well as commentary by the author:
Funding of the replacement reserves is mandatory. The law imposes a fiduciary duty on the directors to comply with the law. Failure to fund the replacement reserves could constitute gross negligence which may not be covered by the association’s Directors and Officers liability insurance policy.
The law states that “No association, or unit owner, director, officer, managing agent, or employee of an association who makes a good faith effort to calculate the estimated replacement reserves for an association shall be liable if the estimate subsequently proves incorrect.”
In the author’s opinion all associations (except for the very small) should use outside consultants who specialize in association reserve studies. The initial reserve study is complex and requires the use of specialized software.
A simple example will highlight this point: An estimate of the cost to repaint the association’s common areas requires the ability to read blueprints in order to calculate the square footage of the area to be repainted; in addition, the cost to repaint depends not only on the quality of the paint used but the region where the buildings are located. These reserve studies should be performed at least every 5 years.
- The law only allows two methods to fund the replacement reserves: 1) Percent funding and, 2) Cash Flow plan. An association can switch between the two methods of funding each year.
- The percent funding method means that each year the association has to have cash on hand in the amount of at least 50% of the estimated replacement reserve liability. For most associations this is simply not workable.
The following example will serve to illustrate why this method is seldom used. Assuming that an association is at least 50% funded each year for the past 7 years, has $800,000 in replacement reserves and decides to repaint the buildings in the 8 year at a cost of, say, $500,000. The cash in the replacement reserves in the 8″ year will only be $300,000. This means that the percent funded is now less than 50% and the association would be in noncompliance.
- The cash flow method is easier to calculate and understand. This method requires a 20-year projection of the cash needed to fund the replacement reserves without requiring the use of special assessments or loans except in the case of an emergency. In order to satisfy the requirements of the cash flow method, there must be at least a $1 cash balance at the end of each year projected over a 20-year period.
Tax Issues (FAQ’s)
The most frequently asked questions concerning taxes include the following:
Is the gross income from funding the replacement reserves subject to Hawaii’s General
The answer is NO because the funding for the replacement reserves is in the nature of an assessment which is excluded from the GET.
Is the net income from the replacement reserve fund subject to federal and/or State income taxes?
The answer is NO because the IRS treats this this type of receipt as a contributions to capital/equity and not as an income item. Hawaii follows the same tax rule as the IRS in this regard.
Is there an income tax issue if operating cash is transferred to the replacement reserve fund?
The answer is YES because the cash in the operating accounts may be made up of both membership and non-membership income with its own set of tax rules. The solution to this dilemma is simple – when preparing the budget for the next fiscal year, simply decrease the maintenance fee and increase the replacement reserves by the same amount.
Is there an income tax issue if excess funds in the replacement reserves are transferred to the operating cash account(s)?
The answer is YES if the monies are never paid back. The answer is NO if the transfer is in the nature of a loan/promissory note and actually paid back.
For more information on the taxation of homeowner associations, please see the blog topic Taxation of Homeowner Associations.
Accounting for Replacement Reserves
The accounting for the replacement reserves should be straightforward process as long as proper accounting procedures are followed. Following, are some common sense principles:
The cash in the replacement reserve account(s) can only be held by financial institutions (i.e. banks, credit unions, investment, trust companies and the U.S. Treasury) located in the State of Hawaii and insured by an agency of the federal government.
One of the biggest problems in accounting for the replacement reserves is the determination of the beginning cash balance. The solution to this is to segregate the cash in the replacement reserve account(s) from the operating cash account(s).
The accounting is done on the cash basis of accounting using the following format: Beginning cash balance + replacement reserve assessments – expenditures for reserve component items – ending cash balance. This should be done monthly and included with the financial statements.
The resident/site-manager/managing agent must place the proper accounting code whenever an expenditure is made from the replacement reserve account. Otherwise, the expenditure will be misclassified as an operating expense in the financial statement.
- The cash in the replacement reserve account(s) are usually misclassified on the balance sheet under “Current Assets.” Current assets are defined as assets that will be utilized in one year or less. Clearly, the cash in the replacement reserves will be spent over a period of many years. It should be classified as “Other Assets.”
Calculating the Replacement Reserves
There are only five (5) variables that affect the calculation of the replacement reserves:
- “Minor’ Variables: 1) interest earnings are needed to calculate the growth in the cashbalance and, 2) Inflation rate each year is needed to estimate the increase in the replacement cost of each reserve component item.
- “Major’ Variables: 3) the estimated replacement cost of each reserve component; 4) the estimated life of each reserve component and, 5) the estimated remaining life of each reserve component.
Please request exhibits of DMI’s calculation of both methods of funding the replacement reserves. The schedule consists of three (3) sections:
- Section I: Statutory Replacement Reserve Funding – Calculation of Cash Flow Method and Percentage of Liability Method (page 1). This summary sheet shows both the cash flow and percent funded methods in an easily understood format. All numbers, except for the owners’ assessment (line 1), flows from Section II.
- Section II: Statutory Reserve Funding – Estimated Cost of Replacement in Scheduled Year (pgs. 2-4). This schedule lists every reserve component item by description, the estimated useful life; the estimated remaining life; the estimated current cost to replace; and the year in which the item will replaced. All the numbers in this section flow from Section III.
- Section III: Statutory Reserve Funding – Analysis of Major Components (pgs. 5 – 11). Every reserve component is listed with the same information as contained in Section II.
At first glance, the replacement reserve requirements for condominiums under Chapter 514B can be intimidating. However, an understanding of the law and its proper and consistent application will assist the directors in making informed decisions for the benefit of all owners.
Prepared by Ronald A. Kawahara, CPA, CVA, CPM, PCAM President
Destination Maui, Inc. For examples of replacement reserves, or a presentation to your community association, contact Destination Maui, Inc., (808) 244-9021 or firstname.lastname@example.org.
(514B-148) Association fiscal matters; budgets and reserves.
(a) The budget required under section 514B-144(a) shall include at least the following:
(1) The estimated revenues and operating expenses of the association; (2) Information as to whether the budget has been prepared on a cash or accrual basis; (3) The total replacement reserves of the association as of the date of the budget; (4) The estimated replacement reserves the association will require to maintain the property based on a reserve study performed by the association; (5) A general explanation of how the estimated replacement reserves are computed; (6) The amount the association must collect for the fiscal year to fund the estimated replacement reserves; and (7) Information as to whether the amount the association must collect for the fiscal year to fund the estimated replacement reserves was calculated using a per cent funded or cash flow plan. The method or plan shall not circumvent the estimated replacement reserves amount determined by the reserve study pursuant to paragraph (4).
(b) The association shall assess the unit owners to either fund a minimum of fifty per cent of the estimated replacement reserves or fund one hundred per cent of the estimated replacement reserves when using a cash flow plan; provided that a new association need not collect estimated replacement reserves until the fiscal year which begins after the association’s first annual meeting. For each fiscal year, the association shall collect the amount assessed to fund the estimated replacement for that fiscal year reserves, as determined by the association’s plan.
(c) The association shall compute the estimated replacement reserves by a formula that is based on the estimated life and the estimated capital expenditure or major maintenance required for each part of the property. The estimated replacement reserves shall include:
(1) Adjustments for revenues which will be received and expenditures which will be made before the beginning of the fiscal year to which the budget relates; and (2) Separate, designated reserves for each part of the property for which capital expenditures or major maintenance will exceed $10,000. Parts of the property for which capital expenditures or major maintenance will not exceed $10,000 may be aggregated in a single designated reserve.
(d) No association or unit owner, director, officer, managing agent, or employee of an association who makes a good faith effort to calculate the estimated replacement reserves for an association shall be liable if the estimate subsequently proves incorrect.
(e) Except in emergency situations or with the approval of a majority of the unit owners, a board may not exceed its total adopted annual operating budget by more than twenty per cent during the fiscal year to which the budget relates. Before imposing or collecting an assessment under this subsection that has not been approved by a majority of the unit owners, the board shall adopt a resolution containing written findings as to the necessity of the extraordinary expense involved and why the expense was not or could not have been reasonably foreseen in the budgeting process, and the resolution shall be distributed to the members with the notice of aSSCSSnCnt.
(f) The requirements of this section shall override any requirements in an association’s declaration, bylaws, or any other association documents relating to preparation of budgets, calculation of reserve requirements, assessment and funding of reserves, and expenditures from reserves with the exception of:
(g) Any requirements in an association’s declaration, bylaws, or any other association documents which require the association to collect more than fifty per cent of reserve requirements; or (2) Any provisions relating to upgrading the common elements. Such as additions,improvements, and alterations to the common elements. (g) Subject to the procedures of section 514B-157 and any rules adopted by the commission, any unit owner whose association board fails to comply with this section may enforce compliance by the board. In any proceeding to enforce compliance, a board that has not prepared an annual operating budget and reserve study shall have the burden of proving it has complied with this section.
(h) As used in this section: “Capital expenditure” means an expense that results from the purchase or replacement of an asset whose life is greater than one year, or the addition of an asset that extends the life of an existing asset for a period greater than one year.
“Cash flow plan” means a minimum twenty-year projection of an association’s future income and expense requirements to fund fully its replacement reserves requirements each year during that twenty-year period, except in an emergency; provided that it does not include a projection of special assessments or loans during that twenty-year period, except in an emergency.
“Emergency situation” means any extraordinary expenses: (1) Required by an order of a court; (2) Necessary to repair or maintain any part of the property for which the association is responsible where a threat to personal safety on the property is discovered; (3) Necessary to repair any part of the property for which the association is responsible that could not have been reasonably foreseen by the board in preparing and distributing the annual operating budget; (4) Necessary to respond to any legal or administrative proceeding brought against the association that could not have been reasonably foreseen by the board in preparing and distributing the annual operating budget; or (5) Necessary for the association to obtain adequate insurance for the property which the association must insure. “Major maintenance” means an expenditure for maintenance or repair that will result in extending the life of an asset for a period greater than one year.
“Replacement reserves” means funds for the upkeep, repair, or replacement of those parts of the property, including but not limited to roofs, walls, decks, paving, and equipment that the association is obligated to maintain.
RONALD A. KAWAHARA, CPA, CVA, CPM, PCAM CREDENTIALS & AFFILIATIONS as of 1/1/2015
Certified Public Accountant (CPA), State of Hawaii, Licensed 10/11/74.
Certified Valuation Analyst CVA*), National Association of Certified Valuation Analysts, Licensed 3/18/99. Certified Property Manager (CPM”), Institute of Real Estate Management, Licensed 5/2/76.
Professional Community Association Manager (PCAM*), Community Associations Institute, Licensed 5/15/02. Real Estate Broker, State of Hawaii, Licensed 4/12/82.
Kawahara + Co., CPA’s, LLC. A Certified Public Accounting firm. Established June 1970. Destination Maui, Inc. Specializing in property management of homeowner associations. Est. June 1974. Destination Maui Realty, LLC. A real estate brokerage firm formerly a division of DMI. Established 1/1/15.
University of Hawaii, Bachelor of Business Administration (BBA), 1968.
U.S. Army, HHD 19th Aviation Battalion, 1965-67, Honorable Discharge.
Haskins & Sells (now Deloitte & Touche, an international public accounting firm). 1968-70.
Currently Held Positions in Professional, Business and Community Service Organizations:
American Institute of Certified Public Accountants, Member. Chaine de Rotisseurs, Vice Chancelier-Argentier, Maui Chapter. Community Associations Institute, Professional Community Association Manager (PCAM°). Hawaii Association of Public Accountants, Member. Hawaii Society of Certified Public Accountants, Member. Institute of Real Estate Management, Certified Property Manager (CPM(R). Lahaina Restoration Foundation, Director Maui Jim, Inc., Director. National Association of Certified Valuation Analysts, Certified Valuation Analyst (CVA”). National Society of Public Accountants, Member. Realtors Association of Maui, Member. Valley Isle Sport Shooters, Treasurer.
Past Offices Held:
Affordable Housing Corporation of Maui County, Treasurer. Art School at Kapalua, Treasurer. Cost of Government Commission, Vice-Chair. Hannibal Tavares for Mayor Committee, Treasurer. Lahaina Rotary Youth Foundation, Treasurer. Lynn Britton for County Council/State House Committee, Treasurer. Maui Chamber of Commerce, President & Treasurer. Maui County Board of Tax Review, Chairman. Maui County Council Boy Scouts of America, Vice-President. Maui Economic Development Board, Chairman. Maui Estate Planning Council, Board Member. Maui Redevelopment Agency, Chairman. Maui United Way, President. Rotary Club of Lahaina, President, Secretary and Treasurer. State Board of Taxation Review, Second Taxation District (Maui), Director. University of Hawaii Maui College, Accounting Advisory Committee Member West Maui Advisory Committee to the Mayor, Board Member. West Maui Improvement Foundation, Treasurer. West Maui Whalers Toastmaster Club, President. West Maui Taxpayers Association, President.
Maui Chamber of Commerce – T.S. Shinn Award Small Business Administration (SBA) – Maui County Accounting Advocate for the Year 2002