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Draft: January 2024
Historical overview to provide BOD members full understanding of HEPOA financial situation as of 2024
Executive Summary
The initial Board did not clearly distinguish between the HOA and the developer’s roles. The developer had Restrictive Covenants tailored specifically for their purposes. The transition to the HOA should have involved drafting new Restrictive Covenants for the HOA, eliminating provisions unique to the developer. HOAs and developers are subject to different state statutes. For instance, this clause from the developer’s Restrictive Covenants:
“The initial road maintenance fee shall be Two Hundred ($200) Dollars per lot per year; provided, however, that in the event two or more lots are combined and one residence is constructed on the combined tract, the combined tract shall thereafter be considered as one tract for road maintenance fee purposes.”
pertains to the developer’s road maintenance fee, not the HOA’s annual assessment.
By law, the HOA must propose a budget that accurately reflects its operational costs for approval by its members. Adjustments in operating costs or plans for new acquisitions require a revised budget and a vote from the members. Initially, our HOA mistakenly used the developer’s road maintenance fee as the basis for our operating budget. A year after forming the HOA in 2009, they decided part of this 1999 road maintenance fee would be used for reserves, then in 2013 added $100 per lot for the reserve fund, without any assessment of our actual needs. This method was not legal or suitable for determining the annual assessment. As a result, the funds raised were insufficient for our operational needs, leading to dependence on volunteer efforts, the developer’s remaining road fee funds, and later, reserve funds to support the operating budget.
For years, the long-standing treasurer misled members and the Board into believing that HEPOA was governed by a Trust Agreement at the bank, rather than state statutes. This supposed Trust Agreement, along with special IRS rules for “Small HOAs” that differed from those for regular HOAs, supposedly mandated operating from a money market account, writing a maximum of three checks per month, using personal credit cards for expenses, and prohibited earning interest on reserves. The treasurer’s annual financial reports consistently showed surplus operating funds, suggesting that we had more than enough for operations.
However, the financial records and situation were unclear to members and Board members due to a record-keeping system that made it difficult to track the amount of assessments collected each year, how funds were spent, and the balances of operating and reserve accounts. The necessary amounts were also unknown. The digitization and reorganization of financial records, along with a review of insurance policies, revealed that from 2009 to 2021, HEPOA mistakenly spent or failed to collect $35,675, used up the developer’s road maintenance savings, and then diverted an additional $24,000 from the reserve fund to the operating budget. This resulted in approximately $35,000 being spent on operations beyond what was collected for that purpose.
It has only recently come to our attention that using the developer’s road maintenance fee as the foundation for our annual assessment was both insufficient and incorrect. Digitizing financial records also allowed us to determine that some members interpreted the clause shared above to mean that any member could combine lots and stop paying annual assessments. Similar to the owners of Heritage Estates (the for-profit company) not needing permission to move lot lines, these members did not seek permission from the Board to move their lot lines. From the developer’s Covenants:
“The owners and developers of Heritage Estates reserve the right to change the property line to any unsold lot in said subdivision for the enhancement of said lot without consent of existing lot owners.”
During our 2021 transition, we overlooked the importance of a clause tailored for the developer and failed to remove it. However, altering the Covenants is not necessary for aligning the operating budget with the actual operational needs. According to state law, the operating budget must be based on the HOA’s needs and receive member approval, ensuring that the HOA adequately operates and maintains common property.
The Board must determine whether to inform our members about these historical missteps to garner support for updating the Covenants, removing clauses that pertain exclusively to the developer. Additionally, the Board has the responsibility to establish policies and procedures that will safeguard against similar mismanagement by future Board members, thereby protecting the assets and interests of all members.
Historical Context
The original HOA board did not differentiate their role from that of the developer, leading to the use of the developer’s bank account until 2021 (which kept the Developer’s tax ID # until 2012) and maintaining the Developer’s corporate insurance policy (until 2022).
In alignment with their confusion regarding Developer versus HOA attributes, they adopted the developer’s road fee as the annual assessment amount. North Carolina law requires HOAs to present an operating budget (based on actual expenses) for member approval. The HEPOA board failed to comply with this statutory requirement. A significant oversight related to continuing confusion occurred when developer-specific clauses were not removed from the Covenants during the HOA’s transition. That transition did not occur until 2021. These errors continued the mistaken belief that the hard-wired road fee in the developer’s declaration was the default annual assessment amount once the HOA came into being. A corollary was that HOA expenses were adjusted to fit this fixed annual income, rather than the annual assessments being determined by member-approved expenses.
Key realizations emerged over time:
- Annual financial reports did not convey what funds were collected for the calendar year operations, the actual yearly expenses, or the actual amounts collected for operations.
- Total funds reported as surplus were misleading, as operational expenses generally exceeded the amounts collected for operation.
- As a result, the funds the developer had collected as a road fee were being used to subsidize the HOA’s operational costs.
- Maintenance needs were also unclear. Funds intended for maintenance (the reserve) were redirected to cover operational deficits once the developer’s road fund was depleted.
In 2009, without conducting a reserve study, the Board allocated a portion of the developer’s road fee, all of which had been repurposed as the HOA’s operating budget, into a reserve fund. This resulted in an initial per-lot division of $120 for operations and $80 for road maintenance, which later proved to be insufficient. Starting in 2013, an additional $100 per lot was levied for road maintenance, but the rationale for this increase was not communicated to the members. By 2014, these practices had depleted the balance supplemented by the developer’s road. By 2022, over $24,000 earmarked for road maintenance under this allocation strategy was redirected to cover operational costs.
Digitized Records Leads to Clarity
In 2022, newer Board members transitioned the paper financial records to a digital format to clarify the financial situation. This process involved organizing and categorizing all past financial data, including sorting expenses by year and type and correctly aligning assessments with the years they were due. The result created a transparent understanding of our financial status. It became evident that the annual assessments were insufficient for operational needs. Through this detailed record analysis and consulting professional guidance on road maintenance, we also developed a better understanding of the necessary reserve funds. This evaluation indicates that the collected funds to date are not adequate to meet our ongoing needs and future requirements.
The Challenge of Deciphering HEPOA Financial Records
Digital records revealed that the annual treasurer reports could not be deciphered for budgeting or long-term planning purposes.
Using the financial report for 2017 as an example, click here,
- The $14,010 reported as 2017 Annual Dues was recorded on a cash basis and therefore doesn’t reflect the income from that year’s assessments. This amount fails to include 2017 assessments received before January 1, 2017, while incorporating payments for 2018 assessments received before the start of 2018.
- Our shift to digital records in 2022 also highlighted a historical reduction in the number of lots paying assessments. Originally, 54 lots were assessed, but by 2017, only 52 lots were assessed. This change occurred without the Board of Director’s action or any documentation. Perhaps reflecting the ongoing confusion between the developer’s and the HOA’s rights, one Board member exempted two of their lots from assessments.
- From our digital records, we can now tell that: In 2017, $8,316 was spent on operating costs. The treasurer’s report shows $14,240.19 as the operating expense amount for the year. The total was arrived at by including the funds transferred to reserves.
- The formula that members thought we were using for the allocation of assessments between operating and reserve funds would have resulted in $9720 going to the reserves for the year, yet only $6120 was transferred to the reserve account.
- Although the actual operating expenses exceeded operating income, the treasurer’s report shows a balance of $11,013 in the operating account at year’s end.
- The digitized records show that in 2017, $4,900 was spent on mowing although no mowing costs are reported in this particular annual report. Although landscaping maintenance would come from the reserve account, while mowing would be an operating expense, in some years (but not all) these two expenses are combined as a single line item in the report.
In short, the 2017 annual report does not make it apparent that the assessments designated for operating expenses were inadequate to meet the costs, nor does it reveal that HEOPA was progressively failing to accumulate sufficient funds for the maintenance of roads and common properties. As more assessments were extinguished in 2018 and 2021, the treasurer’s reports continued to indicate surplus operating funds at the end of each year, even though our annual deficit continued to grow.
Financial Strategy Moving Forward
The HOA’s financial strategy through 2022 did not reflect the actual costs needed for operation and maintenance. Instead, still basing the annual assessment on the developer’s 1999 fixed road fee, the HOA annual budgets used reserve funds to cover operational shortfalls. Rather than understanding that we could increase the annual assessment amount via an annual member-approved budget, more work was done by volunteers.
Other revelations shown by the digital records
The late fee for overdue payments was set at 10%, but in practice, it was only applied in about 25% of the instances where it was applicable. Uncollected late fees from 2008 – 2021 amounted to $9,320.
HEPOA did not have a liability insurance policy, because they mistakenly thought they were covered by premiums being paid to maintain the developer’s corporate policy. Not only did this put HEPOA at risk, but from 2008 – 2021, $3,554 was spent on an insurance policy for a company that had been dissolved.
The HEPOA D&O Insurance application stated that the average residential unit value was $32,000, vacation rentals were not allowed, and 93% of the lots were built. Reviewing the policy in 2023, the insurance agent informed us that this false information nullified the policy and that the low cost was based on this false information. From 2014 – 2021, $6550 was paid for D&O insurance that was not valid. The invalid policy was much less expensive than a policy that is based on actual correct information ($761 vs $1,211 per year).
Assessments of 9,900 were not collected. With interest, the loss is $13,770
Up to 2022, we contributed $1,300 to a charity from our operating fund. The offer a member volunteer to create and maintain the website free of charge was declined for several years. Instead, HEOPA paid a Board member $1,271 for costs of a website that was not completed.
Additionally, we could have invested the reserve fund but were told by the treasurer that this was not allowed.
Navigating Financial Complexities
The financial management of the HOA was not only marked by confusion and lack of transparency but also further obscured by the authoritative (but inaccurate) explanations provided by the long-serving treasurer. These explanations added layers of confusion to an already challenging financial situation. The former treasurer had frequently informed the Board that HEPOA’s financial operations were guided by a Trust Agreement at the bank. She also asserted that HEPOA held a unique status under IRS regulations for a category designated “Small HOAs” which were held to different state and federal requirements. Her directives to the incoming treasurer included strict rules: depositing checks within four days of receipt, operating solely from a money market account with a limit of three checks per month (necessitating personal credit card use for additional expenses), and a prohibition on earning interest on reserve funds. Additionally, she claimed that annual charitable contributions were mandatory to maintain non-profit status and advised using reserve funds for operational expenses due to inadequate operating funds.
With the transition to digital records, the new treasurer faced the task of discerning the accuracy of these claims. Crucial clarification came from the bank manager, offering much-needed insight into the actual stipulations governing HEPOA’s finances: here.
Where Are We Now?
We now understand that HEPOA’s operational costs should not be limited to the amount the developer was collecting as a road fee in 1999. Instead, operational costs ought to be based on current expense estimates. When adjustments are necessary, a new budget proposal should be presented to members for approval. HEPOA should budget for necessary work, rather than relying on volunteers. The Reserve Study is intended to determine the funds required for maintaining common property and roads, with the annual depreciation rate guiding these calculations.
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Due to past oversight, we anticipate a shortfall of $40,000 by 2035 for road resurfacing. Additionally, there’s currently a potential legal risk from members who extinguished their own assessments. With 54 billable lots, $100 more per lot/year would eliminate this shortfall. If existing self-extinguishments are upheld, up to 12 more assessments might be similarly extinguished increasing the shortfall.
It is important that all Board members have full knowledge of our financial situation, potential legal risks, and awareness of our individual and collective responsibilities. As such the Board should discuss next steps to address these issues, including communication with members.
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