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.  

 Most financially savvy individuals, homeowners, property management firms, and  association board members started feeling the effects of the economic downturn  in 2006, when property values began falling from the record highs enjoyed in  the early 2000s. The fall of housing prices cut deeply into home building and  home purchases. The corresponding sharp rise in foreclosures resulted in the  loss of hundreds of billions of dollars among the nation's leading banks and a  tightening on credit options. Association boards and property managers faced  the daunting task of keeping HOA budgets balanced in the face of drastic  reserve losses and rising operating expenses.  

 Tough Times

 The bad news is that foreclosures and budgets remain a significant concern for  many homeowner associations, unit owners and managers. Despite this reality,  many boards still realize a budget surplus. Too much money is never a problem,  how best to manage it is, explains David Ferullo, CPA for the Red Bank-based  The Curchin Group. “It is not common to have large current year operating surpluses since unit  owners would begin to question the board’s budgeting and start to question the need to do annual assessment increases,” says Ferullo.  

 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 snowstorm prepared people for a forecasted severe 2012  winter season; however, there were hardly any other major snow events.  

 “For the last several years many associations increased their snow removal budget  and, for good reason,” says Jules Frankel, CPA with the East Brunswick accounting firm of Wilkin & Guttenplan, PC. “The problem is if a board uses that surplus for another reason and there is an  unusual amount of snow in November and December of that year, there is no money  to pay for the services requiring a possible special assessment.” Frankel adds, “It’s also important to note that it is only considered a budget surplus if the  board planned it, otherwise it is a surplus at the end of the year, which are  two different things.”  

 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. “Much of this is driven by the bylaws of the organization as well as the  application of state law,” says Jim Mulrop, CPA and a partner at the New Brunswick-based  WithumSmith+Brown, P.C.  

 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.  

 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. While the  aforementioned are reasonable options, Korn says that experienced boards should  be well-versed with the concept of a budget surplus. “In my view, it’s not ‘might’ a board have a budget surplus, it’s more so that they ‘should’ have a budget surplus,” he continues. “The reason for this is that condominiums, co-ops and homeowner associations are  budgeting on a cash/break-even basis, but they ought to also budget for a  capital reserve fund with a built-in cushion, just in case.”  

 Ferullo suggests 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. “They can also transfer all or a portion of the surplus to restricted funds such  as the Replacement Reserve Fund, Deferred Maintenance Fund or any other  restricted fund the association may have established,” says Ferullo. 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. “Refunding all or part of the surplus to the unit owners is rarely done and  generally not a good idea,” says Ferullo.  

 Conversely, Frankel explains that many boards will budget to make up for a  number of years operating in a deficit. “It is relatively uncommon to have significant surpluses,” says Frankel. “With that said, an association should always strive not to have zero dollars in  the bank because you can’t run a business—an association—with nothing in the till.”  

 Board Responsibility

 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.  “It is extremely important for the board to communicate to unit owners the  financial stability of the association including the reason for any surplus and  the actions needed to be taken to eliminate any operating fund deficits,” says Ferullo. “Unit owners are also entitled to a copy of the association’s monthly and annual financial statements and the board needs to be ready to  respond to the unit owner questions.”  

 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.  

 “A board has to speak with its accountant and determine if they in fact need to  do a surplus resolution to carry the money forward,” says Frankel. “The next question is how best to transfer funds to a reserve fund without tax  jeopardy.”  

 Forward-thinking progressive boards that act proactively are those that  essentially plan for a rainy day. “The primary benefit of an association having an operating fund balance surplus  is to demonstrate financial stability,” says Ferullo. “A strong financial statement with adequately funded reserves demonstrates a  well-managed association and can contribute to higher market value of the units  and the ability of new buyers to obtain mortgages more readily.”  

 Investing in the Future

 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. “Not communicating the reasons for a current year surplus or deficit or an  operating fund balance surplus or deficit is a mistake,” says Ferullo. “So is not explaining how the surplus is to be used or not explaining how an  operating fund balance deficit is to be corrected.”  

 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. “When boards are setting their upcoming budget they have to have realistic  projections as to what might happen in the coming year,” says Frankel. “They also have to have money set aside for any projects that are related to  common elements. A number of associations fail to take these steps and it comes  back to bite them many times over.”  

 In the final analysis, the best way to determine upcoming budgets (as related to  economic conditions) boils down to informed logic. “If you go to the supermarket today, food costs more than it did five years ago.  If you go to the gas station, gas costs more than it did five years ago,” says Frankel. “If you look at real estate taxes, they are more than they were five years ago,  so it is unrealistic to think that an association’s membership assessments and dues will not rise over time as well.”  

 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 New Jersey  Cooperator.