Settlement considerations
Settling the case was the hard part. Spending the money correctly is next.
Don't run settlement money through the association's regular operating or reserve account. Open a separate account for it, spend it on the highest risk repairs first (active leaks, safety hazards), stay liquid and conservative until the work is done, and ask the association's CPA before assuming any portion is tax free. A settlement check is not a repaired building.
Put the money in its own account
The moment a construction defect settlement arrives, resist any instinct to fold it into the association's operating or reserve account. HOA accounting practitioners recommend opening a new, dedicated account for the funds and paying every repair related expense from it, rather than mixing the money with existing balances.
"When your association receives a settlement, it is not just receiving a monetary award, it is acquiring a fiduciary responsibility to manage those funds wisely."
Source: "After the Settlement: Fiduciary Duties and Safely Investing and Managing Construction Defect Funds", by Nico F. March, The March Group, LLC
Keep the funds liquid and conservatively invested until they are spent, and tell the membership how the money is being managed as the repairs proceed. A separate account also makes the eventual accounting simple: every dollar in, and every dollar out for repairs, sits in one place.
Spend it on the worst problems first
A settlement rarely covers every repair on the original list. When the money falls short, spend it where the risk is highest, not where the work is easiest to schedule or looks best to owners walking by.
"The first items that should be repaired are those presenting life safety concerns, such as fire suppression defects, structural concerns, mold mitigation, trip hazards."
Source: "Now What? Association Use of Construction Defect Settlement Funds", by Shane Fleener, Hearn & Fleener LLC
Active damage belongs in that same top tier, an ongoing leak that is still soaking framing does more harm every week it waits. Cosmetic work, repainting, landscaping, anything that will look the same in six months whether it is done now or later, goes last.
Know what might be taxable
A settlement that compensates the association for damage to the building is, in general, treated as a return of capital rather than taxable income, up to what the association put into the property. That general principle comes from older IRS rulings written for specific associations, not a rule a board should apply on its own.
"Punitive damages, these amounts would be taxable." "Interest, these amounts would be taxable."
Source: "What Are Some Accounting and Tax Issues of a Construction Defect Settlement", Newman Certified Public Accountant, PC
Legal fees and other costs of the case are generally deductible against the recovery. Exactly how this settlement should be reported, and whether any part of it counts as income, depends on how the settlement is structured and the association's own tax basis, a question for the association's CPA before the board files anything.
Check yourself
Answer before you read the explanation, recalling it is what makes it stick.
The association's construction defect settlement lands in the bank. What should the board do before spending any of it?
The settlement covers less than the full repair cost. An active roof leak and a faded exterior paint job both need attention. Which gets funded first?
The settlement check includes compensatory damages for the repair cost plus a separate award of punitive damages. How should the board expect these to be taxed?
Sources
- "What Are Some Accounting and Tax Issues of a Construction Defect Settlement", Newman Certified Public Accountant, PC
- "Now What? Association Use of Construction Defect Settlement Funds", by Shane Fleener, Hearn & Fleener LLC
- "After the Settlement: Fiduciary Duties and Safely Investing and Managing Construction Defect Funds", by Nico F. March, The March Group, LLC
- "Business Litigation Recoveries: The Capital vs. Ordinary Debate Continues to Smolder", by Robert W. Wood, Wood LLP
Construction Defects
Running short even after the settlement? See how boards fund repairs when the money runs out.
Whether any part of a settlement is taxable, and how funds should be allocated between common element and unit specific repairs, depends on the settlement's own terms and the association's finances and governing documents.