Understanding reserve and operating accounts

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Operating expense

The IRS considers painting an operating expense, according to one CPA. (Getty Images / August 20, 2013)

Well-run community associations keep two pots of money. One is the operating account, used for the day-to-day costs of running the association and maintaining the property. The other is the reserve account, which is earmarked for the repair and replacement of big-ticket common elements.

It's not always obvious which bills get paid from which account.

Reserve specialist John Poehlmann, principal at Reserve Advisors Inc. in Milwaukee, said that to be categorized as a reserve expense, an element must meet four criteria: it must be an association responsibility versus a homeowner responsibility; it has to have both a limited useful life expectancy and a predictable remaining useful life expectancy; and the cost must be above a minimum threshold as set by the association.

Many declarations and bylaws define an association's common elements and maintenance obligations, although some are more detailed than others, said certified public accountant Chris Nyborg at Nyborg & Co. in Batavia.

Some associations assume responsibility for limited common elements, which are those that benefit only one owner, and others pass the responsibility to those owners, she said.

The minimum cost threshold varies from association to association.

"In a very small association, it might be $1,000 or $2,000," said Poehlmann. "In a very large association with a multimillion-dollar budget, it might be $10,000 or more."

Elements that are usually excluded from reserve studies include underground pipes, sewer systems, electrical wiring and building foundations, Poehlmann said.

"They don't last forever, but they have extremely long lives," he said. "Reserve studies are a 20- to 30-year forecast. The engineer has to be able, with a high degree of confidence, to predict how many years are remaining. When you go out 50 or 60 years, it's not predictable when these things will fail."

Another expense not covered by reserves is painting, Nyborg said.

"The IRS is clear that painting, even though it can be a very large expense for a large suburban association that has a lot of wood trim or a high-rise with lots of hallways, is an operating expense," she said.

However, if painting is part of a major renovation, it can probably be justified as a reserve expense, she said.

Poehlmann said that landscaping has traditionally been considered an operating expense. However, in recent years an invasive beetle called the emerald ash borer has destroyed millions of ash trees nationwide and is going strong. Some associations with large numbers of ash trees are reserving for their eventual removal and replacement.

Consulting fees can be either operating or reserve expenses, depending on the outcome of the consultation.

"Suppose the association says we have to hire a consultant to look at whether we need to replace the roof, and it wants to know if they can pay for it out of reserves," Nyborg said. "My advice is yes, if you go forward with the roof replacement. You can tie the cost of the consultant to the project. But if the association does not replace the roof, now you've just hired a professional to give advice or information. You have to pay it from the operating fund."

Proper routine maintenance and regular building inspections, which are operating expenses, will stretch reserve dollars by extending the life of the common elements, said James Tomlin, president of Optimum Design Construction in Westmont and a community association manager.

Perhaps the biggest threat to a building's long-term viability is water penetration. It can be caused by numerous small defects including loose or broken shingles, faulty interfaces between the roof and siding, broken capstones and even moss or other organic material. All are easily remedied.

"Many leaks don't show up inside," Tomlin said. "If you don't notice the water penetration, it becomes a bigger issue when you have X amount of dollars set up for reserves and the project costs 20 percent more."

ctc-realestate@tribune.com

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