TAXES ON RESERVE INTEREST

QUESTION: Our association's budget keeps interest on the reserves in our reserves. Out of fairness, shouldn't taxes on the interest be paid with reserve funds?

ANSWER: Taxes are operational expenses, not long-term reserve items. Unlike reserve components that require periodic repair or replacement, taxes are paid annually. Except for borrowing, associations cannot use reserve funds to pay taxes.

Civil Code 1365.5(f)(1) ["reserve accounts" means] Moneys that the association's board of directors has identified for use to defray the future repair or replacement of, or additions to, those major components that the association is obligated to maintain.

Civil Code 1365.5(c)(1) The board of directors shall not expend funds designated as reserve funds for any purpose other than the repair, restoration, replacement, or maintenance of, or litigation involving the repair, restoration, replacement, or maintenance of, major components that the association is obligated to repair, restore, replace, or maintain . . .

Unallocated Interest. However, there is a solution for those who want to pay taxes from their reserve account without using reserve funds. Interest earned on reserves is not part of the reserve fund until classified as such. Accordingly, interest accumulating in the reserve account can be used to pay taxes up until it has been allocated to the reserve fund.

Boards that want to pay taxes from the reserve account must be careful to ensure that their reserve funding plan clearly allocates interest to reserves "net of taxes". The unallocated interest can then be (i) transferred to operations for payment of taxes or (ii) paid directly to the IRS from the reserve account.

RECOMMENDATION. Allocate all interest to the reserves and pay taxes from a budged line item in the operational account. This is how most associations handle the issue. This allows the reserve account to grow at a faster rate--an important consideration since most associations have underfunded reserves.

For a list of CPA firms and reserve study companies that specialize in community associations, go to our Service Directory

Updated by ADAMS KESSLER 6/14/2008