Budgets must contain reasonable reserves

Q: The last reserve study for our condominium was done about 20 years ago. Contributions to the reserve fund are based on this reserve study, and have not changed year to year, despite the fact that we continually draw down our reserves for various projects. Are there any regulations that would require an association board to update its reserve study?

A: In a condominium, Section 9(c)(1) of the Condominium Property Act provides that all budgets must provide for reasonable reserves for capital expenditures and future maintenance, repair or replacement of the common elements.

To determine the amount of reserves appropriate for a condominium association, that section of the Act provides that the board needs to take into consideration the following:

• The repair and replacement cost, and the estimated useful life, of property 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.

• The cost of any independent professional reserve study 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.

• The ability of the association to obtain financing or refinancing.

While consideration of these factors is mandated for condominium associations, it is a good guide to follow for all types of homeowner associations.

Establishment of reasonable reserves may be one of the more important of the fiduciary responsibilities of an association's board of directors. While the Act does not mandate that the board obtain an independent professional reserve study, in my view, a professionally prepared reserve study is the foundation of the establishment of a reasonable reserve fund, and the most critical component of this process.

Importantly, funding of a reserve in reliance on a professionally prepared reserve study also helps insulate the board from a breach of fiduciary duty claim, if an owner contends that the amount of the reserve is not reasonable.

Some states require that a reserve study be done every so many years (e.g., every three years or every five years). These requirements recognize that the condition of a property, and the remaining useful life of the property, for which a reserve fund is established is fluid. That said, the Act does not mandate that the reserve study be updated in Illinois. Nonetheless, it would seem prudent to update the reserve study from time to time, and to adjust contributions to the reserve account accordingly.

A 20-year-old reserve study is of questionable reliability and the board should seriously consider having it updated.

Q: Our townhouse-style condominium association of fewer than 10 units is completely dysfunctional. Can the owners eliminate the condominium?

A: It is possible, from a legal perspective, to eliminate the condominium form of ownership. This would require that the property subject to the condominium declaration be removed from the provisions of the Condominium Property Act. This is governed by Section 16 of the Act.

That section provides that all of the unit owners may remove the property from the provisions of the Act by an instrument to that effect, duly recorded with the recorder of deeds. However, the holders of all liens affecting any of the units must consent thereto or agree, in either case by instruments duly recorded, that their liens be transferred to the undivided interest of the unit owner.

Upon such removal, the property is deemed to be owned in common by all the owners. The undivided interest in the property owned in common would be the percentage of undivided interest previously owned by such owner in the common elements.

As a practical matter, it is unlikely that the holder of a mortgage on an individual unit is going to agree to release their mortgage in favor of a lien against their borrower's newly created undivided interest in the entire property. Further, removing the property from the Act, under the circumstances you describe, may only lead to greater dysfunction. As a condominium, the owners have a structure provided by the condominium declaration and the Act.

• David M. Bendoff is an attorney with Kovitz Shifrin Nesbit in the Chicago suburbs. Send questions for the column to him at CondoTalk@ksnlaw.com. The firm provides legal service to condominium, townhouse, homeowner associations and housing cooperatives. This column is not a substitute for consultation with legal counsel.