Condo Law in California

Several readers asked about insurance related to the washing machine flood:

Manager: What if the owner who caused the flood does not have insurance? Should we ban washing machines?

Board Member: We had a similar problem in our association. An owner installed a dishwasher using an uninsured handy man. The hose broke and flooded his unit. The owner went around the board and got $27,000 from the association’s insurance (over the board’s objections).

ANSWER: Insurance is a mystery. Carriers deny claims that should be covered, and pay claims that should be denied. The rules of coverage seem to shift from carrier to carrier and from claim to claim. Following are some factors that impact coverage:

Master Policies. If an association carries “bare walls” insurance, the carrier will not pay for an owner’s damaged cabinets, counters and carpets–it only pays for bare walls. However, some CC&Rs require coverage for unit improvements in addition to the common areas. This type of insurance is referred to “original builder’s specs,” or “all in†policies. In that case, the association’s insurance will cover the owner’s carpet, cabinets and fixtures even though he caused the loss.

Sometimes CC&Rs are irrelevant. Some master policies provide broader coverage than required by the governing documents. As a result, even when CC&Rs exclude unit improvements and require owners to carry their own insurance, carriers will confound boards by covering a negligent owner’s loss. This encourages more claims by negligent owners and drives up insurance premiums.

Submitting Claims. Many boards try to keep premiums under control by managing which claims are submitted and which are not. Unfortunately, some CC&Rs allow owners to make claims directly against the association’s policy. This encourages owners to go uninsured and file claims, no matter how small, against the association’s policy. The higher the claims history, the higher the premiums.

Deductibles. One of the best methods for controlling claims is to increase the deductible. Association deductibles used to be in the $500 to $2,500 range. Now they commonly vary from $5,000 to $25,000 with most at $10,000. If negligent owners are made responsible for the deductible, and the deductible is high enough, owners will be less inclined to file claims or “run naked,” i.e., be uninsured.

RECOMMENDATIONS. Boards should have their insurance broker compare the association’s insurance against their CC&Rs to make sure the policy meets or exceeds what is required by the governing documents. To keep insurance premiums down, associations should amend their CC&Rs to clearly assign maintenance duties, broadly define exclusive use common areas, add mitigation provisions, require owners to carry insurance, make owners responsible for losses originating in their units, and define liability for deductibles. In addition, boards should consider raising their deductibles to at least $10,000.

QUESTION: My neighbor’s washing machine hose burst in the middle of the night and flooded my unit and the unit below mine. The board said it’s not getting involved because the association was not at fault. I know it wasn’t their fault but I think the association still has a duty to get involved. Am I wrong?

ANSWER: There are two rules regarding floods; they always occur when they can cause maximum damage (nights, holidays and weekends), and the other owner will be uninsured. You are correct that the association has a duty even though it did not cause the flood.

Common Areas Affected. The association had a duty because the common areas are affected. Your unit is surrounded by common area walls, ceilings and floors, all of which the association is responsible to repair and maintain. This is true regardless of who caused the damage. Civil Code §1364(a) The board must make sure that everything is dried out as soon as possible so as to avoid mold in the common area walls. If the owner that caused the flood refuses to hire an emergency restoration company, the board should do so immediately.

Assess the Owner. Depending on your governing documents, the association can assess your neighbor for the clean-up and repair costs. If you or the other two owners delays the water clean-up and wall dry-out process, you will be responsible for all mold testing and remediation costs resulting from your delays. Repair and replacement of hardwood floors, carpet, furniture, etc. will be each owner’s responsibility rather than the association’s. Each of you will have a claim against your neighbor with the washing machine, but the association has no duty to get involved in your claims.

CC&R Provisions. If your CC&Rs do not have provisions regarding damage and reimbursement, they should be amended as soon as possible. Floods will certainly occur again and the association needs clear CC&R provisions concerning damage, mitigation of damage, and reimbursement of costs.

ASSOCIATION’S
MAINTENANCE DUTIES

Questions regarding maintenance duties are quite common. Operating through their boards of directors, associations have the following duties:

1. Duty to Inspect Common Areas. Boards must inspect the common areas every three years and prepare a reserve study listing all major components, the remaining useful life of those components and the cost to repair or replace them. Civil Code §1365.5(e)

2. Duty to Investigate Complaints. Whenever boards learn of common area problems, such as cracked sidewalks, roof leaks, plumbing backups, etc., they must investigate the problem. Corp. Code §7231(a) They don’t need to personally inspect it, they can rely on managing agents, plumbers, etc. to investigate and report back to the board. If an owner reports a flood inside his/her unit, the board must determine if the leak is originating from (i) the owner’s own plumbing, which is the owner’s responsibility to repair, or (ii) the common area, which is the association’s responsibility to repair. Civil Code §1364(a) Exclusive use common are will depend on your governing documents.

3. Duty to Repair. Regardless of fault, repairs must be made. If the leak is an owner’s responsibility and he/she refuses to repair the damage, the board has three options: (i) initiate daily fines until the owner repairs the damage, (ii) repair the damage and bill the owner for reimbursement, and/or (iii) go into court for an order that the owner either repair the damage or step aside and allow the association to repair it (and assess the owner for reimbursement). The severity of the damage will determine the steps taken.

4. Duty to Disclose. If repairs to the common areas are deferred, the board must disclose to the membership the deferral and the board’s plan for repairs. Civil Code §1365(a)(3)

Drowning is the second leading killer of children under the age of 14. On January 5, 2008, President Bush signed into law the the Pool and Spa Safety Act of 2007. The Act imposes mandatory federal requirements that:

• Prohibit the manufacture, sale or distribution of drain covers that do not meet new anti-entrapment safety standards;

• Create an incentive grant program for states to adopt comprehensive pool and spa safety laws;

• Establish a national drowning prevention education program; and

• Require public pools be equipped with anti-entrapment drains.

Associations. Even though the legislation does not directly impact homeowner associations, the insurance industry is adopting the new standard in its underwriting. St. Paul Travelers, umbrella carrier for many associations, is now requiring it for all pools. This will likely work its way through the entire industry so that all existing pools and spas will be required to meet the new standards.

RECOMMENDATION. Associations should immediately install anti-entrapment, anti-entanglement drain covers in all pools and spas. It goes without saying, the installer should be properly licensed and insured.

Thank you to Joel Meskin of McGowan & Company and Dorothy McCorkindale of Wells Fargo Insurance Services for alerting me to the insurance industry’s adoption of the new standards. Their contact information can be found under “Insurance” in the Service Directory

ALCOHOL AT THE POOL

QUESTION: Our association allows the consumption of alcohol at the pool/spa. What liability do we have in the event someone is injured while intoxicated at the pool? The board is reluctant to restrict alcohol because it would be unpopular with owners.

ANSWER: If anyone is seriously injured or dies in your pool or spa, the association will almost certainly be sued. Even if the association is ultimately found not liable for the injury/death, the claim will drive up insurance rates. When alcohol is added to the mix, the likelihood of an incident increases. If directors don’t mind stressful litigation and spending their time in depositions, they could look the other way when people bring alcohol to the pool.

READER COMMENT REGARDING
INSURANCE DEDUCTIBLES

COMMENT: Regarding your response about insurance deductibles. You are absolutely correct that deductibles do not belong in either operating or reserves. Basically, an association is a not-for-profit (or should be) entity which operates on a modified fund basis. It is very simple. Deductibles should be classified as a fund separate from reserves on the financial statements of the association, but in my opinion they may be kept in the same account as reserves. I would suggest that the balance sheet simply have an additional line, “Reserve for Insurance Deductibles.†The statement would show that the amounts in both reserves equals the total in the reserves account. -Barry M. Greenberg, Esq., CPA

ADRIAN ADAMS: I agree. Boards could put a line item in their budgets for “Insurance Deductible Fund” and build the fund over 2 or 3 years. If the insurance deductible is $10,000, boards could budget a modest $278 per month to the fund. At the end of three years, the insurance deductible would be fully funded. At that point, the contribution could be discontinued until an insurance claim is made, at which point the deductible would be replenished with new contributions.

In the alternative, the contribution could be permanent so as to avoid ups and downs in the budget. At the end of the three years, and thereafter, any excess funds in the deductible fund could flow into the reserves. This provides for a smoother budget and has the added benefit of building the reserves.

QUESTION: Regarding death of a resident, what if the son has permission from the deceased to enter the unit “any time”?

ANSWER: Once the owner dies, control shifts to the estate. As a result, prior authorizations are no longer valid. Only the estate’s executor can give new access authorizations.

PAYING
TAXES FROM RESERVES

Last week I wrote that taxes are operational expenses, not long-term reserve items, and belong on the operational side of the budget. I received a number of dissenting e-mails arguing it was okay to use reserve funds for taxes since reserves generate most of an association’s taxable income.

Despite their arguments, the law is quite clear. Except for borrowing, reserve funds cannot be used to pay taxes.

Civil Code 1365.5(f)(1) ["reserve accounts" means] Moneys that the association’s board of directors has identified for use to defray the future repair or replacement of, or additions to, those major components that the association is obligated to maintain.

Civil Code 1365.5(c)(1) The board of directors shall not expend funds designated as reserve funds for any purpose other than the repair, restoration, replacement, or maintenance of, or litigation involving the repair, restoration, replacement, or maintenance of, major components that the association is obligated to repair, restore, replace, or maintain . . .

Unallocated Interest. However, there is a solution for those who want to pay taxes from their reserve account without using reserve funds. Interest earned on reserve money is not part of the reserve fund until classified as such. Accordingly, interest accumulating in the account can be used to pay taxes up until it has been allocated to the reserve fund.

Boards that want to pay taxes from the reserve account must be careful to ensure that their reserve funding plan clearly allocates interest to reserves “net of taxes.” The unallocated interest can then be (i) transferred to operations for payment of taxes or (ii) paid directly to the IRS from the reserve account.

It should be noted that most associations avoid the problem by leaving all interest in the reserve account and paying taxes from operations.

I want to thank Gayle Cagianut, Gary Porter, and Steven Schonwit for their assistance. Contact information for their firms can be found under “Accounting” in the Service Directory

RESERVE FOR
INSURANCE DEDUCTIBLE

QUESTION: Because of the new Fannie Mae guidelines, our board wants to set up a fund for insurance deductibles. We have a disagreement, some want to put it in the budget and others in reserves. Where should the money go?

ANSWER: Good question. Insurance deductibles don’t fit comfortably into either category.

Operational Budget. Insurance deductibles do not fit into operations because they’re not an annual expense. The payout of a deductible depends on the filing of insurance claims and associations can go for years without a claim. I don’t like putting it in the budget means the deductible amount must be fully funded in the 12-month budget cycle, which may put a strain on some budgets. It also creates a surplus at the end of the year, assuming no claims are made. Nonprofit corporations are supposed to break even, not run planned surpluses.

Reserves. Because deductible payouts are periodic, they seem to fit into reserves. However, they don’t meet the definition of a reserve component. Their life-cycle is not predictable and may not involve repair or replacement of a major common area component. Even so, the reserve fund appears to be the better place for insurance deductibles–it allows funding over 2 or 3 years and avoids annual budget surpluses.

Special thanks to Mark Poindexter for his assistance with this question. Contact information for his firm can be found under “Accounting” in the Service Directory

RECOMMENDATION: Associations should use CPAs who specialize in community associations. They are more aware of the unique issues affecting associations, including tax considerations, the interplay between operations and reserves, proper internal controls, financial statement preparation, etc. For example, corporations in California pay an annual franchise fee of $800 for the privilege of doing business in the State. However, CPAs who specialize in our industry know that many associations qualify for an exemption from that annual fee. In some instances, the exemption may be retroactive, resulting in a refund of prior payments.

QUESTION: I’m president of our association. We have a secure building and our staff has keys for all units in case of an emergency. An elderly resident recently died in her unit. It was quickly discovered and once the authorities removed her body, the unit was locked. Her son contacted us the following day and wanted into the unit. I think we should let him in but the manager said it’s not a good idea. Don’t we have a duty to let him in?

ANSWER: Your manager is correct. Do not let him in. The deceased may have cut her son out of her will. She may have valuable jewelry, antiques and artwork that she willed to other family members or to charity. If you let her son into the unit and he loots it, the association could be sued. You should wait for the executor of the estate to authorize entry into the unit. It is the executor’s job to wind up the affairs of the deceased and distribute the estate to entitled beneficiaries.

CORPORATE TAXES

QUESTION: Is there is any tax benefit to an unincorporated association if it incorporates as a nonprofit mutual benefit corporation?

ANSWER: Both incorporated and unincorporated associations are required to file tax returns. There are no differences when it comes to federal taxes. An unincorporated association is treated the same as a corporation for tax purposes. There is a difference when it comes to state taxes. An unincorporated association is not subject to the $800 minimum corporate tax. However, if an incorporated association is exempt under Revenue & Taxation Code Section 23701t, then it is taxed the same as an unincorporated association.

*Thanks to CPAs Gary Porter and Steven Schonwit for their input. Their firms specialize in tax filings and year-end financials for community associations. You can find them in our Service Directory.

TAX ON RESERVES

QUESTION: Our association’s budget keeps interest on the reserves in our reserves. Out of fairness, shouldn’t taxes on the interest be paid with reserve funds? Otherwise, it’s an extra expense in operations that we can’t afford.

ANSWER: Taxes are operational expenses, not long-term reserve items. Unlike reserve components that require periodic repair or replacement, taxes are paid annually. Accordingly, they belong on the operational side of the budget.