4 Tips to Avoid Penalties for "Commingling" Residents' Security Deposits
While collecting security deposits can provide financial protection to site owners from residents who cause property damage, security deposits can also become a liability to them if they aren’t handled properly. Owners must be careful about where they keep the money residents give them as security deposits. A security deposit is not in the same category as a rent check or other type of payment an owner may receive from a resident. Technically, the security deposit belongs to the resident. Although you hold it while the resident lives at your site, it’s not your money unless and until the resident moves out leaving unpaid rent or damage to the apartment.
Many states and cities have security deposit laws that say owners must keep deposits separate from other funds, such as rent and other payments. If you mix or "commingle" security deposits with personal or other business funds, you could lose the right to keep any security deposit money. You could also end up paying penalties of two or three times the deposit, plus attorney’s fees.
And even if there are no specific commingling laws where your site is located, you should still keep security deposits in a separate account. For example, if you pass on interest on security deposits to residents, commingling security deposits with other money will make it difficult to account for the interest on these deposits.
You should talk to your attorney about what your state or city law says on keeping security deposits. Some states impose additional requirements on owners, such as keeping the security deposits in federally insured and interest-bearing accounts. And some jurisdictions set the rate of interest that must be paid on security deposits for lease agreements.
Tip #1: Don't Keep Security Deposits with Personal Funds
While it’s okay to keep rent funds in personal bank accounts, it’s not okay to treat security deposits the same way. Keeping security deposits with personal funds is considered “commingling.” Failing to keep security deposits in an account separate from personal funds could therefore undermine your right to keep the deposit and expose you to a lawsuit and damages.
For example, a New York owner applied some portion of a resident's security deposit to unpaid rent and returned the remainder to her. The resident claimed that since the owner commingled the deposit with personal funds, the resident should be allowed to recover the entire deposit without regard to any purported breach of her lease as to rents due. The court determined that when an owner has violated state law prohibiting commingling of security deposits, the resident's right to the return of the security deposit is immediate. The court reasoned that to conclude otherwise would force tenants still in possession of their apartments to spend the time, money, and energy to sue their landlords in order to enforce the law, but allow the landlord to correct the issue at any time after the litigation commenced but before the tenant surrendered the apartment [Bartis v. Harbor Tech, LLC, May 2020].
It's relatively easy to prove if your site commingles security deposits with other funds. When a disgruntled resident walks into a lawyer’s office, the resident probably would be able to submit a cleared security deposit check, a cleared rent check, and the security deposit receipt. By examining the cleared checks, one can easily determine whether commingling has occurred because the backs of the checks indicate the accounts through which the checks cleared.
If the accounts are the same, the lawyer may have enough evidence to prove that the owner commingled funds. And if the tenant can’t produce these documents, a lawyer could make the owner produce them during the litigation process with discovery requests.
Tip #2: Don't Mix Security Deposits with Rent and Other Funds
Some owners make the mistake of depositing security deposits in the same account where they keep rent funds and other receivables. This mistake is easy to make because owners typically receive security deposits and the first month's rent at the same time. But this is also considered commingling. You must keep security deposits in an account separate from other business funds.
For example, a resident sued an Illinois owner to get back a security deposit. The resident claimed that the owner had illegally commingled the security deposit funds with general business funds. The owner denied the allegation and presented a manager's affidavit that stated that the security deposit was placed in a separate interest-bearing account. However, in a subsequent interview, the manager admitted that the standard operating procedure was actually to deposit residents' security deposits into one account and then to make a bulk transfer of those funds into a security deposit account at a later date. An Illinois court eventually ruled that the owner had illegally commingled funds in violation of the Chicago Residential Landlord Tenant Ordinance [Turner v. 1212 S. Mich. Partnership, January 2005].
Although you must not commingle security deposits with other business funds, you can keep a resident's security deposit in the same account with the security deposits of other residents. As long as the account contains only security deposit funds, you will be okay. But if you mix personal or business funds, you will be guilty of commingling. Therefore, you need to make sure you keep careful records showing that you keep only security deposits in the account.
Tip #3: Separate Security Deposit Increases from Personal, Other Business Funds
Many owners raise the security deposits and rents of residents who renew their leases. Generally, the security deposit is equal to one month's rent, so if the rent goes up, the deposit also goes up.
Even if you’ve been keeping the resident's security deposit in a separate account, it’s easy to make a mistake when the resident pays the extra amount to cover the security deposit increase. If you deposit the increase with personal or other business funds, you will be guilty of commingling. Make sure residents give you a separate check for the security deposit increase, and make sure you deposit that check in the same account where you keep the balance of the security deposit. Otherwise, you could be penalized as if you commingled the entire deposit.
Tip #4: Use ‘Tenant Lease Security Accounts’ Programs
Many bigger banks offer customized services for apartment owners to help process their residents' security deposits. As long as these accounts are utilized properly, participating owners automatically comply with all applicable laws in states where security account laws exist, as well as all IRS regulations. Here are some of the added benefits these bank programs may offer:
IRS compliance. When you use their Tenant Lease Security Services, the banks usually handle the tax paperwork and meet applicable deadlines. They will manage the tax issues and fulfill IRS reporting requirements, and at year-end, will issue all forms, including 1099s and interest checks, correctly and on time.
Monthly status reports. Owners can either access status reports online or have them sent to the managing agent for each property. The status reports will display each tenant's name, security deposit amount, and amount of interest earned.
Payment of interest. For the payment of interest and mailing of checks, owners can usually choose to have the banks send checks for the tenant's portion of the interest annually, at year-end, or have it held in the account until the tenant moves. All checks and IRS 1099 forms will be mailed directly to the residents.