How to Avoid Five Replacement Reserves Account Missteps

HUD requires most assisted housing sites to maintain a reserve for replacements account so funds are readily available to pay for repair and replacements of major systems and capital items. These are items that usually last more than one year, such as elevator systems or major appliances in units.

If your site has a reserve for replacements account, your auditor and HUD will be checking to make sure that you correctly followed the various rules that govern it. These rules are set out in the site’s regulatory agreement and/or housing assistance payments (HAP) contract, and the HUD handbooks. If you make mistakes in handling the reserves, you could face audit problems—and, potentially, HUD could require the owner or managing agent to repay the site from its own funds.

Reserve for Replacements Basics

HUD requires the following for these accounts:

Who must maintain. Most of the following types of sites must maintain reserve for replacements accounts:

• Sites with HUD-insured mortgages;
• Sites with HUD-held mortgages, such as sites with Section 202 direct loans; and
• Sites without a HUD-insured mortgage or HUD-held mortgage, but which get rental assistance from HUD, such as sites that get Section 8 assistance.

How to maintain. Most HUD-insured sites must establish a separate, interest-bearing account for their reserves with their lender or in a “safe and responsible depository” designated by their lender [HUD Handbook 4350.1, par. 4-2 and Handbook 4370.2, par. 2-7(B)]. Usually, the lender is in control of the account.

Most sites with HUD-held mortgages or sites without a HUD-insured or HUD-held mortgage but that get HUD rental assistance must set up interest-bearing accounts for reserves on their own [Handbook 4350.1, par. 4-2].

How much to deposit. Sites that are required to maintain reserves usually must make monthly deposits into their account [Handbook 4350.1, par. 4-2 and Handbook 4370.2, par. 2-7(C)]. The amount of the initial monthly deposit is usually spelled out in the site’s regulatory agreement. But after that, the amount of the monthly deposit is reviewed by HUD and adjusted when appropriate to be sufficient to meet projected future requirements.

Need for HUD approval. Most sites that are required to maintain reserves must get HUD’s prior approval before using the reserves [Handbook 4350.1, par. 4-2]. HUD also often requires sites that set up their own reserve accounts to sign an agreement with the financial institution that will hold the reserves, in which the financial institution agrees to release the reserves only after getting HUD approval.

How reserves can be used. Generally, HUD allows reserves to be used only for repairing or maintaining capital items, such as overhauling an elevator system or replacing refrigerators, ranges, and other major appliances in units [Handbook 4350.1, par. 4-9(A)]. Usually, HUD won’t approve the use of reserves for routine maintenance, like repainting a unit or making a minor roof repair [Handbook 4350.1, par. 4-9(B)].

How to invest. HUD normally requires sites to invest reserves in U.S. government-backed securities, such as a U.S. Treasury bill, or in an interest-bearing account at a financial institution insured by the Federal Deposit Insurance Corporation, National Credit Union Association, or other U.S. government insurance corporation. Monies held in the reserve for replacements accounts are not to exceed $100,000 per banking institution [Handbook 4350.1, par. 4-22].

FIVE MISTAKES TO AVOID

Mistake #1: Not Making Required Deposits

Some sites, especially those in financial difficulties, don’t make the required deposits to the reserves. If you fail to make these deposits (and you didn’t get HUD approval to suspend them), HUD could require the owner to repay the missing deposits with nonfederal funds.

Solution. If you can’t make deposits because there isn’t enough site revenue, you could:

> Reduce expenditures. Investigate whether you can eliminate other site expenditures so you’ll have funds to make the deposits.

> Ask for rent increase. If your site is eligible for a budget-based rent increase, review the adequacy of the reserves before making the increase request, and if needed, request increased funding for the deposits.

> Ask HUD for permission to suspend deposits. Consider asking HUD to temporarily suspend the requirement to make deposits to the reserves [Handbook 4350.1, par. 4-13]. This might be a good idea if you think the suspension will give your site a chance to improve its financial situation. Some of the conditions set by HUD for suspension of future reserve deposits include:

• Keeping a mutually acceptable minimum threshold in the reserves;
• Maintaining the site in good physical condition;
• Resuming deposits to the reserves when the reserve fund falls below the minimum threshold until the minimum threshold is restored;
• Asking the mortgagee to invest a substantial portion of the reserve fund; and
• Keeping all interest earned by investments of the reserve fund in the reserve fund [HUD Handbook 4350.1, par. 4-13(A)-(E)].

Mistake #2: Making Unauthorized Withdrawals

Even when HUD pre-approval is required for withdrawals from reserves, sometimes sites don’t get this approval. You may be more likely to make this mistake if you can make a withdrawal from the reserves without getting approval from a third party. This mistake can cause big audit problems, and HUD could require the owner or managing agent to reimburse the reserves with nonfederal funds or bar the managing agent from doing further business with HUD or replace the managing agent [HUD Audit Rept. 2005-CH-1012].

Also, if the withdrawal from the reserves involves the intentional misuse of the withdrawn funds or fraud, the owner or managing agent could face civil or criminal penalties.

Solution. Make sure you secure HUD approval before you make a reserves withdrawal, as required. If those reserves are in a financial institution, add a requirement to your agreement with the financial institution that it won’t release the reserves without HUD approval.

Mistake #3: Not, or Improperly, Investing Reserves

Some sites fail to follow the rules for investing reserves. If your reserves aren’t invested at all or they’re improperly invested and HUD auditors discover this, HUD will probably direct you to invest the reserves in accordance with its rules [HUD Handbook 2000.04, par. 3-5(D)(1)].

Solution. Pay attention to the investment of your reserves to be sure that you invest them in accordance with rules in the HUD handbooks and your regulatory agreement. Check banking institutions at least once a year to assure that they are earning the maximum interest for site owners.

Mistake #4: Committing Reserves to Investment for Too Long

Some sites invest the reserves in long-term investments, such as a five-year certificate of deposit (CD). But if the site needs some or all of the reserves before the investment time is up, the site may have to pay a withdrawal penalty for prematurely liquidating the investment. If that happens, HUD can require the site owner, persons with a controlling interest in the site, or the site’s sponsors to repay the lost principal [Handbook 4350.1, par. 4-21].

Solution. To avoid the owner or others having to repay lost principal, maintain some portion of the reserves in liquid assets such as saving accounts. Don’t commit too large a portion of reserves to excessively long investments, particularly if you suspect that your site will need major repairs soon [Handbook 4350.1, par. 4-21]. Be sure to monitor interest rates. In today’s market, interest rates are so low that you probably don’t want to invest for long periods.

Mistake #5: Not Analyzing Whether Reserves Are Sufficient

According to HUD, you should periodically assess the sufficiency of the reserves to meet your repair and replacement needs [Handbook 4350.1, par. 4-10]. Otherwise, you could end up under-funding them and not have funds to pay for your site’s future capital needs.

Solution. Don’t assume reserves are adequate for your site’s future capital needs just because you’re current on the required deposits. Once a year, analyze your site’s short-term and long-term capital needs and whether the reserves are adequately funded to meet those needs.

Older projects frequently encounter major problems that are not necessarily foreseeable that can quickly deplete reserve funds. As part of the annual budget process, the financial manager should prepare a capital improvement budget and provide the owner with an analysis of replacement reserve funding for the subsequent year.