What is the difference between a reserve fund and a sinking fund?

Many leases provide for a contribution towards a reserve fund or sinking fund as a service charge payment. The object of sinking and reserve funds is to make funds available when needed for major items of irregular expenditure. 

Sinking Fund: 

A sinking fund aims to guarantee that sufficient funds are available if major repairs or improvements are required. For example, the replacement of significant items, such as boilers, lifts and roof repairs, which may only be necessary once or twice during the lifetime of a building.

Typically, a sinking fund's assets are gathered from tenants over time, sometimes by recurring contributions or as stipulated in the lease. By setting aside money regularly, the landlord can ensure they have the necessary funds when the expense occurs, reducing the need to borrow or divert funds from other sources.

Reserve Fund:

A reserve fund is established to pay for recurring expenses related to the maintenance and management of a property, such as external decorations which may need attending to, not annually, but every four or five years. In this example, the estimated decoration cost will be collected over a period of five years, so the tenants are not faced with a hefty bill every time decoration is required.

A reserve fund's primary purpose is to guarantee the property's continuous operations and financial stability. Reserve funds are also frequently used to ensure resources are available for unanticipated events.

As long as the lease allows it, landlords should collect service charge payments to create reserve funds. All money received from service charges must be kept "on trust" for the benefit of the leaseholders for the duration of the development, per legal requirements.

The reserve fund should not be used to pay for ongoing service fee costs or to mitigate the effects of underbudgeting. When daily service charge expenses exceed estimates during a financial year, leases usually permit additional money—known as a balancing charge—to be collected from lessees to make up for the excess. Overspending from the reserve fund reduces the amount of money available for larger projects that need to be completed.

Some leases, common in retirement properties, specify that a portion of the selling proceeds from each lease sale must be contributed to the reserve fund. This contribution is frequently expressed as a percentage of the purchase price or the appreciation since the sale. Such leases delay reserve fund contributions until the leaseholder receives a capital reception in an effort to maintain more controllable monthly (or annual) service charge costs.

Whether a reserve fund is established through regular contributions or selling, there is no guarantee that adequate money will be on hand when needed. If enough money isn't saved when improvements are required, leaseholders might still have to make additional one-time payments.

Before entering into a lease, prospective tenants should ask about the reserve fund balance as of right now and how it relates to the scheduled works for the next few years. They should also determine how the projected contributions are determined and whether they are based on an accurate evaluation of the building's state.

It is important to remember that at the end of a lease, the outgoing tenant will not receive a refund of reserve or sinking funds. Therefore, the tenant's unused contribution to the sinking fund or reserve fund is non-refundable. In the end, though, tenants benefit long-term from having a sinking fund or reserve fund since it protects them from having to pay large, unexpected bills all at once.

The benefits of these funds include the availability of funding for these large-scale projects when needed and the absence of significant annual variations in the service charge. However, establishing such funds requires careful consideration, and many challenging issues will need to be resolved during the drafting phase. Who is to own the fund? Is it to be held absolutely or on trust? What happens if the landlord sells the property, and what happens to the fund? What will happen when the lease is terminated? Additionally, there can be significant tax drawbacks.

In summary, setting aside money for particular goals is a common practice for both sinking and reserve funds; nevertheless, the primary distinction between the two is the type of expenses the funds are meant to pay for. Reserve funds are more all-purpose and act as a safety net for unanticipated circumstances or emergencies, whereas sinking funds are designated for known, future financial needs or capital expenses.

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