Recently we experienced an unusual request from a new tenant. A young couple had been given funds from a Grandparent that was to be used for rent. The Grandparent had requested that the funds pay for a year of rent. The reasons for making the request were entirely personal. From an accounting perspective, funds paid like this are called prepaid rent. It is great news for an owner. Most owners though, are surprised to learn that those prepaid rent funds are not just moved into their account for their immediate use.
After performing our normal background checks on the applicants and determining they would be approved, we needed to discuss with the owner the prepaid rent funds. We correctly expected that the owner was going to request all of those prepaid rent funds, less our management fee. While this seems fair and reasonable, there are reasons why the funds can’t be handled in the requested manner. It is not difficult to understand why an owner will want to deposit the full year of rent in their bank account. If they were managing the property themselves they would have those funds. Yet, even if they had those funds, they would still be faced with the same issues facing us as a property manager.
Prepaid Rent And Fiduciary Responsibility
There really is not a problem with prepaid rent unless it is not processed and distributed correctly. The basic issue is that these funds are pre-paying for a service not yet provided. I have heard the argument that we have a similar arrangement monthly when we receive rent. The key is the recognition of these funds is for a much shorter period of time. It still creates a contract that the service will be provided. One year is a much longer period of time to guarantee the service for a property.
When a property owner hires a property manager, the manager should hold a real estate license. Our real estate license, not to mention the Realtor Code of Ethics, creates a fiduciary responsibility to guard funds given to us in trust. This is why security deposits must be held in a separate fund (and not utilized) and rents are handled from an account separate from our company operating funds.
Prepaid Rent and Accounting Principles
Basic accounting principles also play into the correct handling of prepaid rent. These prepaid funds are a liability until each month arrives where they can then be applied to Rent Due. No management fees are earned until the event of the obligation occurs (rent collections or time due). The same concept applies to owner distributions. They should not occur until earned. Monthly owner distributions should occur as they are earned.
Prepaid Rent and Property Expenses
The temptation is there to utilize these funds for repairs. Even if a large repair is needed to the property, these funds need to be segregated and only applied as rent. There are several ways that releasing prepaid rent funds early in the form of repairs could end up a huge problem for a manager fiduciary. We still have owners who enter foreclosure and lose their home. The protections tenants use to have in a foreclosure are gone. The mortgage holder may or may not honor their lease. They also may demand rent be paid when due. If the prepaid rent is used to pay for a major repair a few months earlier, and no longer exists, this becomes a huge problem for the tenant. It is even a larger legal problem for the licensed fiduciary.
Prepaid Rent and A Tenant Release
Similarly, if the tenancy ends for reasons related to the tenant, (such as death, lease violations or evictions) it is possible a court might order the full prepaid amount returned to the tenant. Or at minimum offset with funds owed by the tenant related to the early termination. These funds legally should stay untouched until the month they were applied to rent.
Our company policy is that we do not prepay funds to owners. Payment will come when it is due. If after explaining this to an owner, they still insist on payment of the funds, I would be concerned. It is in everyone’s best interests that funds in any transaction are handled in a manner that is fair and transparent. The owner has the assurance their rent will be paid each and every month. There should be some significant piece of mind in knowing the rent is already collected and ready to be disbursed each and every month.