Unexpected things happen in our daily lives, and sometimes those things happen in our home. It is great, if possible, to save monies for a “rainy day” so that one major issue, or a series of issues, does not drain your resources. The same analysis applies in a condo association or common interest community. Having funds set aside for major items that need to be repaired or replaced will save the board of directors from having to special or additionally assess the unit owners, or at the very least, soften the blow of such an additional or special assessment.
There is also an equitable consideration when determining reserves. Setting an appropriate amount, and funding it over time, allows the unit owners who are utilizing the common elements that will need to be replaced to pay the cost. An example is that of a roof. If the roof has a 30-year life, and one unit owner lives in it for 29 years and moves out before it is to be replaced, it is more equitable for that unit owner who obtained 29 years of the life of that roof to pay towards the replacement cost and to not put the entire share on the new owner who just moved in.
Having a robust reserve fund will also make units easier to sell or for unit owners to refinance. Many lenders include in their questionnaires the amount of reserves set and ask for back-up as to how the reserves have been set. Additionally, as for condominiums, Section 22.1 of the Condominium Property Act requires all prospective purchasers to be provided a “statement of the status and amount of any reserve for replacement fund and any portion of such fund earmarked for any specified project by the board of directors.” The failure to have an appropriate reserve fund may make units less likely to be sold, not only because some prospective purchasers may be scared away, but because some lenders may not agree to provide a mortgage for the prospective purchase.
Another consideration regarding reserves is the fact that the board of directors will have a fiduciary duty to the unit owners in relation to the reserves. Illinois law provides that a cause of action can be asserted against the association if certain reserve-related requirements are not met, including failing to itemize reserves and commingling operating and reserve accounts. See, e.g., Palm v. 2800 Lake Shore Drive Condominium Ass’n, 2014 IL App (1st) 111290, ¶ 97, 10 N.E.3d 307; Henderson Square Condo. Ass’n v. LAB Townhomes, LLC, 2015 IL 118139, ¶ 41, 46 N.E.3d 706, 718, opinion modified on denial of reh’g (Jan. 28, 2016) (what constitutes reasonable budgeting for reserves was a question of fact for a jury or judge to decide).
Naturally, the next question that will arise pertains to how much should be set aside for reserves. Each community will be different, and the answer depends greatly on the nature of the community and the common elements throughout. For example, a 100-year-old condo building should probably have more in reserves than a new construction HOA. However, that may not be the case. If the new construction HOA’s common elements include significant private roads or other infrastructure, the repair and replacement cost may be great. As said, there is no magic amount that an association should set as reserves, and many times, it is suggested that a third-party expert perform a reserve study to assist in the analysis. This article will provide the general law in Illinois on reserves and factors for the board to consider when setting the amount of reserves.
How is The Term “Reserves” Defined by Illinois Law?
The definition of “reserve” is very similar between the Illinois Condominium Property Act and the Common Interest Community Association Act. Section 2 of the Condominium Property Act (765 ILCS 605/2) defines reserves as:
those sums paid by unit owners which are separately maintained by the board of managers for purposes specified by the board of managers or the condominium instruments.
those sums paid by members which are separately maintained by the common interest community association for purposes specified by the declaration and bylaws of the common interest community association.
How Are Reserves Set in Illinois?
The amount that an association sets for its reserve is not mandated by Illinois law per se. Many times, the declaration or other instruments governing the association will specifically identify the amount of reserves that must be maintained by the association. Although the Common Interest Community Association Act does not have a specific provision that governs the amount of reserves that must be set, Section 9 of the Condominium Property Act requires all budgets adopted by a board of managers in an Illinois condo to provide for “reasonable reserves for capital expenditures and deferred maintenance for repair or replacement of the common elements.”
Importantly, a condo association can waive the requirement to set “reasonable reserves” in very limited situations. The requirement can only be waived if the condominium instruments fail to include a specific provision requiring a set amount of reserves to be kept and the unit owners in the association must vote to waive the requirement by a 2/3 majority. The requirement to keep a reserve can then be reinstated by another 2/3 vote later. One critical item to keep in mind is that if the requirement is waived, that must be disclosed in the financial statements of the association, highlighted in bold print, and told to prospective purchasers of units. Additionally, if the requirement is waived, then unit owners cannot assert a claim against the board or the managing agent for failing to have adequate reserve funds.
Assuming that the reserve requirement has not been waived, Section 9 of the Condominium Property Act provides for five considerations for a board of directors when setting the amount of the reserves:
- the repair and replacement cost, and the estimated useful life, of the property which the association is obligated to maintain, including but not limited to structural and mechanical components, surfaces of the buildings and common elements, and energy systems and equipment;
- the current and anticipated return on investment of association funds;
- any independent professional reserve study which the association may obtain;
- the financial impact on unit owners, and the market value of the condominium units, of any assessment increase needed to fund reserves; and
- the ability of the association to obtain financing or refinancing.
Some of these factors may be difficult to analyze for a board, who depending on the nature of the condo, should consider hiring a third-party to perform a reserve study (#3 above). That study can provide invaluable information about items such as the useful life of the components of the building and the ability to obtain financing.
One of the items that a board of directors must decide is how to budget for the ongoing management and maintenance of common elements within the association. As part of that decision, the board should consider not only ordinary maintenance and management, but the cost of potential repairs and replacements of key elements, including, roads, mechanicals (plumbing, electrical, HVAC), roofs, balconies, and parking areas. However, as said above, each association is different, and sometimes, the financial wherewithal of the unit owners does not justify an immediate funding of a reserve account (if the amounts currently held are insufficient) and therefore, a gradual funding over time is the better avenue to take. Attorneys can assist with the process, especially as it pertains to understanding the board’s legal requirements related to reserves, but a board should consider bringing in a company that specializes in reserves studies to assist with the decision as to the amount of reserves, and funding of the reserves. This is one situation where proper planning can make the job of the board easier when a large issue arises.
Adam Toosley is a member at Hirzel Law, PLC and focuses his practice on real estate litigation, zoning and land use, construction, and financial services litigation. Over the course of his career, he has represented property owners, landlords, condominium associations, lenders, and all parties in the construction chain, handling all aspects of real estate-related disputes, including construction defect cases, payment, and landlord-tenant disputes as well as real estate foreclosures, mechanic’s lien cases and fraud and business tort claims in state and federal court as well as in mediations and arbitrations throughout the United States. He is licensed in both Michigan and Illinois. He can be reached at (312) 626-4535 or at firstname.lastname@example.org.