Flush with Cash What You Need to Know About Surplus Funds

 In December 2008, the National Bureau of Economic Research announced that the  United States was in a recession that had started back in December 2007. The  official announcement was old news for most Americans.  

 As the dust continues to settle from the downturn, the silhouette of a reformed  economy is slowly becoming visible. In certain markets, real estate sales have  increased over the last 18 months, construction and capital improvements  projects that were put on hold have been green-lit, and the unemployment rate  in the metro New York area is receding.  

 That’s the good news. The bad news is that foreclosures and budgets remain a  significant concern for many homeowner associations, unit owners and managing  agents. Despite this reality, many boards still realize a budget surplus. Too  much money is never a problem, how best to manage it can sometimes prove  challenging.  

 Tough Times

 “A surplus should be rare if budgeting is based on a five year average of  expenses,” says Alvin Wasserman, director of Fairfield Property Services in Commack, Long  Island. “An influx of funds is more likely to come from refinancing or a certiorari  settlement,” he adds.  

 A number of variables could also contribute to a budget surplus. For example, a  capital improvement project budgeted from the previous year may have been  completed ahead of schedule and at a savings. Additionally, allotted monies for  snow removal might not have been used. This scenario played out last year. The  freak 2011 Halloween snow storm prepared people for a forecasted severe 2012  winter season; however, after that early surprise storm, there were hardly any  other major snow events.  

 “It seems like budget surpluses are rare these days—however they do occur,” says Richard Montanye, CPA with the Long Island-based accounting firm of Marin & Montanye, LLP. “Perhaps this past winter with its warm temperatures reduced expenses to create a  surplus, a real estate tax refund was received, or possibly a recent mortgage  refinancing reduced the monthly mortgage payment to create a surplus.”  

 Aside from weather events and budgeted projects, the recession and resulting  economic turmoil has left no industry untouched. This in turn is now impacting  how associations approach budgeting. “There are two considerations that happened over the past few years that have  been significant with regard to budgets,” says Barry Korn, CFA and managing director of the New York City-based Barrett  Capital Corporation. “One is that there are new federal guidelines required to receive Fannie Mae  approval, and while many buildings are not concerned with this issue, banks are  looking at these guidelines for guidance and are looking for 10 percent or more  of the overall budget to be dedicated to capital surplus,” says Korn. “That combined with the financial crisis has forced banks to look much more  closely at the condition of co-ops, condominiums and homeowner associations,  especially co-ops that use their line of credit as a piggy bank.”  

 Surplus Where’s and Why’s

 While it’s questionable whether or not a significant budget surplus is considered a  positive, seasoned board members have resources to answer questions should such  an event occur. “The first thing that must be done is to seize the opportunity to improve and  stabilize the finances of the building,” says Montanye. “In these trying financial times, it also must be determined if the surplus is  the result of a onetime event or if it will be an ongoing circumstance.” Industry experts recommend that an association have two to three months of  operating costs set aside in a reserve fund, which is not considered a surplus.  

 For a singular event, Montanye advises that an evaluation should be made of the  current working capital as well as available reserves for major repairs and  replacements. “Working capital should be determined first and if it is very tight, it makes  sense to start a working capital fund for those times when there are cost  overruns or unforeseen circumstances,” he says. “It is also an opportunity to accumulate some capital to help reduce costs. For  example, if a building regularly pays interest to finance insurance, perhaps  this fund can be used to pay the upfront premium and have payments made from  operations to repay the fund. In this fashion, interest expense is eliminated,  reducing overall costs for the building.”  

 If the board determines that the surplus will be continuous due to the reduction  of operating costs, a regular funding mechanism for capital reserves can be  established. “If the building is a condo, and there have been issues meeting Fannie Mae’s reserve requirements, now is a prime opportunity to add a line in the budget  for reserve funding,” says Montanye. “The board can have monthly payments made from operations to a reserve fund to be  used only for capital improvements or special repairs.”  

 More often than not, to the inexperienced board member, governing documents can  cause more confusion than clarity. As such, boards in the black might consider  investing or placing the excess money in a reserve fund. In this situation,  industry experts advise that boards should elect to have any surplus deferred  to the following year, which in effect uses the surplus to balance the  forthcoming year’s budget thereby minimizing or eliminating any increase to annual unit  assessments for that year.  

 Since most unit owners are keeping a watchful eye on their personal budget  post-recession, they may prefer to have the surplus put towards bringing down  their dues and fees in the short term, which experts believe is not advisable. “No tenant-shareholder shall be entitled, either conditionally or  unconditionally, except upon a complete or partial liquidation of the  corporation, to receive any distribution not out of earnings and profits of the  corporation,” says Wasserman. “A distribution would jeopardize the not-for-profit status of the corporation.”  

 Board Responsibility and Taxation

 In times both good and bad, a successful board is one that operates with  transparency. Equally, when a deficit or a surplus is realized, the  responsibility of the board is to inform unit owners and residents immediately.  “The board should communicate important information to the community,” says Wasserman. “Any surplus would first show in the operating account. Thereafter it could be transferred to savings. A surplus would also appear in  the independent accountant’s annual financial report,” he continues. “Reserves are usually segregated funds earmarked for specific purposes, different  from savings in a general fund.”  

 Associations, like citizens, are also subject to taxation. As such, homeowner  associations dealing with a surplus might need to file an 1120 H tax form,  which is optional and completed year by year. In this case, an association  might need to pass a “surplus resolution” requiring the filing of the tax form 70-604, a tax election stating that excess  membership income remaining at the end of the fiscal year is carried over into  the next year, or is refunded to owners.  

 If this route is taken, the association may instead be able to file form 1120  (rather than form 1120-H) for its federal taxes and pay tax at 15 percent on  the first $50,000 of taxable income opposed to 30 percent. Before taking this  step it is best to consult with an accountant, and if deemed appropriate, hold  a membership vote.  

 Investing in the Future

 Forward-thinking progressive boards that act proactively are those that  essentially plan for a rainy day. For those boards in good financial standing,  a sound investment strategy that protects the interest of the association is  often a suggested course of action when dealing with a budget surplus. “Assuming that the surplus will be added to the reserve fund and the funds have  not been designated for capital projects, the first and foremost consideration  for a co-op or condo board should be safety of its investments,” says Gary Kokalari, a senior financial advisor with Merrill Lynch.  

 Kokalari notes that there are two primary investment vehicles for associations  that offer “safe investments” with government guarantees, which are treasury securities and CDs. For the  former, it’s essentially a direct government guarantee, while CDs are guaranteed in the  form of FDIC insurance limited to $250,000 per institution. A smart investor,  he notes, will increase the FDIC coverage amount on its CD investments by  buying CDs from multiple institutions.  

 “Because CD yields are often higher than those of comparable maturity treasuries,  my recommendation is to go with the CDs,” says Kokalari. “A co-op or condo can buy CDs directly from issuing banks, but if the reserve  fund is in excess of $250,000, multiple accounts would have to be opened to  maintain FDIC coverage,” he continues. “This can become a headache for boards comprised of volunteers, particularly when  board members change and signature cards have to be updated, which can happen  every year in some buildings.”  

 While sound investing strategies are considered a positive step forward, there  are a fair amount of mistakes a board can make when determining how to handle a  budget surplus. A definite ‘don’t’ and a big mistake would be for a board to reduce maintenance or common charges  without thoroughly evaluating the long and short term budgets and financial  needs of the cooperative,” says Montanye.“There are good ways that windfalls can be used to enhance the financial picture  of the building which will improve values for everyone.”  

 Often times the best way to determine budgets, and potential surpluses, is to  work backward from conservative fiscal projections. This approach will prepare  an association for the upcoming year regardless of market fluctuations or  unexpected problems related to the building or property. In the final analysis,  the best way to determine upcoming budgets (as related to economic conditions)  boils down to informed logic.  

 “Communication is a stress point in every building whether a cooperative or a  condominium. However, I have seen where too much communication and too many  details put the board in a position of criticism when essentially they are just  doing the job they were elected for,” says Montanye. “In this case, if the surplus is from normal operating activities, the  information should just be included in the annual financial report to the  shareholders. If the event is sizeable, and is a onetime cash infusion, perhaps  it should be included in a newsletter along with other information.”  

 Managing surplus funds wisely is good advice. And to a co-op or condo owner,  protecting your building's financial stability is of paramount importance in  maintaining the value of your investment and your quality of life.   

 W.B. King is a freelance writer and a frequent contributor to The Cooperator.  

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