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RESERVE ACCOUNT EXPENSE VERSUS A CAPITAL IMPROVEMENT


There is much confusion regarding what a “Capital Improvement” is; this is typically due to the CPA utilized accounting definition of a Capital Improvement for tax purposes versus the definition for a Common Interest Community which is materially different.  For tax and accounting purposes a capital improvement: (i) enhances the value of a property, (ii) extends the useful life of an asset, or (iii) adds to its value. This definition covers all aspects of a building and site in a common interest community and should not be utilized in trying to determine what a capital improvement versus reserve account expense is; this definition is specifically utilized for accounting and tax purposes.

Definition for Common Interest Communities

Capital Improvement:  A capital improvement is any (i) material discretionary addition to the common areas, (ii) voluntary material upgrade to common area materials, or (iii) discretionary material alterations to the appearance of the development." 


This definition has been adopted in numerous states to comply with Governing Document Restriction.


Reserve Expenses

Reserve Accounts are created and should be utilized for current reserve component expenses in a common interest community. This will include items such as replacing the roofing, re-plastering the pool and laying a new overlay on the asphalt roads. These reserve expenses are paid for from the reserve account and are not typically subject to the membership vote, just Board approval.


A fiscally responsible Association should not be utilizing reserve account balances for improvements or “upgrades” to the community (there are some exceptions to this with regards to safety & code compliance). Removal of the funds from the reserve account is essentially penalizing the future membership of the community who will have to make up for the lack of funds in the reserve account at a future date. The Board has a responsibility to the current and future membership of a community and to protect the long term interest of the Association.


Capital Improvement

A Capital Improvement would be items that the common interest community does not currently have as common area components but are adding to the community. Examples could include a new clubhouse being constructed, construction of tennis courts in a community park and installation of park benches. These items are new common area components that will typically require an approval vote from the community membership (States differ on percentage requirements) and not just Board approval. Items that are also considered capital improvements could be significant upgrades to current common area components such as changing a chain link fence to a steel fence or paving trails which are currently gravel (costs is significantly higher but functionally they are serving the same purpose).


The actual construction of a capital improvement​ will typically need to be funded from a separate account (non-reserve account) that receives funds from the regular dues, special assessments or a bank loan. After construction of the common area component this common area then becomes a reserve account expense as it now has ongoing repair/replacement expenses that need to be reserved for.


Additionally, it is extremely important that a community takes into consideration the real long term costs related to capital improvements as over time as they can add significantly to the reserve account requirements of a community. A great example is a community which takes out a loan to build a clubhouse and then pays off the loan over the next 20 years but fails to allocate extra to a reserve account for the long term repair/replacement of the clubhouse. Twenty years down the road when the clubhouse has significant expenses related to its building components the membership may be in for a “surprise” special assessment or reliance on an additional loan to pay for the remodel/repair/replacement of different aspects of the building.


More on this can be found on the Davis-Stirling website which is the law firm which drafted the Davis Sterling Act.

 


Written by Joel L Tax - Professional Reserve Analyst - 02/17/2016