What is a Sinking Fund? A Comprehensive Guide for Body Corporates in Australia

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Tuan Duong

Body corporates have long employed sinking funds to allocate monthly money towards the settlement of outstanding debts or bonds, offering a greater capacity to lessen the financial impact when the debt comes due.

By adopting a sinking fund strategy, properties can also prepare for infrequent capital expenditures or sizeable acquisitions, eliminating the need to resort to credit card usage or dipping into an emergency fund from the savings account. 

They are a prudent measure to cover the necessary and reasonable spending set to occur throughout the year.

In this article, our specialists at Duo Tax will explain everything you need to know about sinking funds. You’ll discover what they are, why you need them, how to manage them, and, most importantly, how they can be a game-changer for property management.

First Thing’s First: What’s a Bond?

A bond is a debt investment where an investor loans money to an entity, usually a corporation or government. The funds are borrowed for a set period of time at a variable or fixed interest rate. 

When you buy a bond, you are essentially lending money to the issuer of the bond. 

What is a Body Corporate Sinking Fund?

A sinking fund is an effective financial tool that allows organisations like body corporates who have issued bonds as a form of debt to gradually accumulate money to avert a substantial one-time payment upon the bond’s maturity. The fund also provides resources to cover major repairs, replacements, and improvements to common properties such as swimming pools, roofs, lifts and building exteriors.

The bond prospectus—a guide about everything related to the actual bond—will note when a bond issuer can repay bonds early using the sinking fund. While the main purpose of the sinking fund is to ensure there are enough funds for bond repayment, it can also be used to buy back outstanding bonds or preferred shares. 

A laptop sitting on a wooden desk, observing sinking funds and financials.

The ‘sinking’ part of the name is quite literal—these funds are designed to cover imminent or predicted expenses that the regular budget can’t accommodate. Just as the government collects funds for its own sinking fund to cover the national debt, an owners’ corporation will collect a portion of strata levies (fees contributed by all property owners within a strata scheme) to set aside for this fund. 

A sinking fund will stand separate from other strata levies, such as the Administrative Fund Budget or Special Levies. The Administrative Fund typically covers regular maintenance, insurance, and the like, while Special Levies are more spontaneous and raised to cover unforeseen expenses. 

The Step-by-Step Guide on How to Create a Sinking Fund for Your Property

Once you’ve decided to proceed, establishing a sinking fund is quite straightforward. To initiate the process:

Step 1: Decide on the Purpose of the Sinking Fund Levy

Firstly, identify your saving goals. Will they relate to covering outstanding bonds and debt, or are they more aligned with major structural repairs underway in the financial year?

Step 2: Build a Sinking Fund Forecast

Having pinpointed your savings target, the next step is determining its price tag. You will need to know the exact figures related to your outstanding debt, as well as analyse the potential costs for any capital expenditures.

Step 3: Determine a Timeline

When will you need access to the money inside your sinking fund? For example, you might want to undergo new property improvements within the next six months. You will then need to divide the forecasted amount by six to ensure you have the minimum balance to cover the cost without withdrawing money from an emergency fund.

Step 4: Decide on the Financial Institution to Hold the Fund

Having established your budget and timeline, the next crucial step is choosing a suitable location to store your sinking fund. It’s generally recommended in the industry the use of a high-yield savings account as it guarantees ease of access to your funds when needed, and sinking fund interest received month-to-month.

Step 5: Rework Your Sinking Fund Budget

The next phase involves adjusting your budget to accommodate contributions to your sinking fund. It’s essential to stay grounded in reality—if it’s impossible to set aside the forecasted amount every month for your expenses, you might need to lengthen your timeline or contemplate a less expensive option.

How Many Sinking Funds Should a Body Corporate Have?

There is no ‘preferred’ number of sinking funds that a body corporate should create. It’s essential that you have at least one fund to cover capital and repayment expenses for the upcoming financial year. On the other hand, too many sinking funds can make managing your monthly budget difficult and saving money required for larger outlays.

Often, the number of sinking funds can depend on the size of the property and the predicted expenses for maintenance, future projects, insurance premium changes, debt repayments, regulatory obligations and so on.

What are the Types of Sinking Fund Accounts?

When considering a new sinking fund as a financial planning strategy, your next step is identifying the type of account best suited to your needs.

Here are a few savings account options you might want to consider for your sinking fund:

Checking account

A zero-fee checking account might present an ideal solution for your sinking funds. Freely accessible, a checking account allows you to tap into your reserves at any point. For example, if a significant purchase is on the horizon, why not dedicate a second account to accumulating funds for this purpose?

Traditional savings account

Another method to establish your sinking fund is by opening a savings account with your current bank or credit union. This way, it becomes convenient to move funds around when necessary. However, remember that traditional savings accounts may not offer attractive interest rates. This might not be the most suitable choice if you aim to earn an additional profit from your savings.

High-yield savings account

A high-yield savings account is a powerful tool offering a greater annual percentage yield (APY) than standard savings accounts, enabling your sinking fund to mature faster. This is due to the higher rate of interest, which assists you in achieving financial objectives more efficiently. 

Online banking platforms typically offer attractive, high-yield savings accounts due to their lower operational expenses than traditional financial institutions. Just note any restrictions related to accessing your funds.

The Advantages of Sinking Funds

Let’s discuss the upside of sinking funds for property owners and body corporates.

Financial Buffer for Unexpected Expenses

A sinking fund can act as a financial buffer for unexpected costs, such as insurance premiums or abrupt repairs. Instead of being caught off guard by these expenses, you can plan ahead, and set aside a small sum over time, mitigating the financial impact when these costs do arise. 

Spread Out Expenses Over Time

Furthermore, a sinking fund helps to spread out substantial purchases over a given period. By regularly contributing a certain amount to your sinking fund, you can accumulate the needed sum without bearing the burden of a hefty one-time payment. 

Avoiding Credit & Loans

A sinking fund also serves as an alternative to credit card usage or loans, which are often the first choice for sudden, large expenses. With a well-managed sinking fund in place, you can avoid potential debts and the accompanying interest payments. 

Generating Interest

Placing your sinking fund into a traditional or high-yield savings account can also generate a return on your savings. As your fund grows, the accruing interest can help you achieve your monetary goals faster. 

Prevent Impulsive Outlays

Finally, having a set plan and purpose for your funds can reduce impulsive spending. When large expenses are expected, and savings are set aside for these costs, it prompts mindful spending habits, saving you from unnecessary and costly purchases.

The Potential Drawbacks of Sinking Funds

Managing sinking funds isn’t always plain sailing. Although they offer many benefits, a community management company or owners’ corporation needs to be mindful of potential stumbling blocks.

Let’s delve into some of the drawbacks: 

Strata levies spent on debts

While sinking funds are designed for capital expenditures and improvements, they can sometimes be diverted to pay off debts instead, which can detract from the overall quality and value of the property.

Legal action to recover unpaid levies

If strata levies aren’t paid on time, the funds for the sinking fund may fall short, leading the owner’s corporation to pursue legal action to recover the unpaid levy. This can create tension and potential conflict within the corporation.

Budgeting complexities

Forecasting future outgoings accurately is easier said than done. There’s the challenge of predicting maintenance requirements, planned projects, changes in insurance premiums, and regulatory obligations. Misjudgments can lead to financial shortfalls.

Underestimation of maintenance costs

Substantial expenses like air conditioning, elevators, interior lighting, and hydraulic pumps can easily be underestimated or overlooked, skewing the sinking fund’s budget.

Chances to increase costs

If maintenance activities are left to luck rather than planned systematically, it could lead to substantial cost increases and higher levies.

Key Takeaways

As a property owner or member of a body corporate in Australia, managing your financial resources effectively is crucial for your property’s maintenance and overall state.

  • A sinking fund is a financial safety net predominantly used by body corporates to tackle significant or unplanned property expenses.
  • Creating a sinking fund requires careful planning, from the determination of its purpose to choosing the right financial institution to host it.
  • Body corporates usually only need one sinking fund, although multiple could be beneficial for larger complexes.
  • Sinking funds can be held in various types of savings accounts, each with their own benefits and drawbacks.
  • The benefits of a sinking fund include serving as a financial buffer, avoiding credit, generating interest, and preventing impulsive spending.
  • Drawbacks can include overspending, the risk of legal action, complex budgeting, underestimating maintenance costs, and increased costs.

Organising sinking funds can be difficult, which is why seeking professional advice can help make the process flow much smoother. For more information, get in touch with our Duo Tax team today.

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Disclaimer: Please note that every effort has been made to ensure that the information provided in this guide is accurate. You should note, however, that the information is intended as a guide only, providing an overview of general information available to property investors. This guide is not intended to be an exhaustive source of information and should not be seen to constitute legal or tax advice. You should, where necessary, seek a second professional opinion for any legal or tax issues raised in your investing affairs.

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Tuan Duong

Tuan is an award winning Quantity Surveyor and leads Duo Tax Quantity Surveyors – Australia’s fastest growing provider of Tax Depreciation.

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