Have you acquired a property with tenants already in place? Did you review their existing leases and notice if a security deposit was being held? As the closing settlement was prepared, did you ask how to transfer security deposits? Or were the security deposits ignored thinking the tenants would go back to the former owner for their return?
Sadly, if you ignore how to transfer security deposits you have made a potentially costly mistake.
What Happens To Security Deposits At The Sale of A Property?
Security deposits should be conveyed in credit or cash at the closing. If they are not, you may be in a difficult position. Your new tenants have legal justification to look to you to settle and return the balance of their security deposit. Sending the tenant back to the old owner, simply because you did not transfer security deposits at closing, is likely not going to bring a resolution.
The security deposit in most rental property closings will be administered by the settlement agent in one of two ways:
- A credit for the security deposit to the buyer if the security deposit is owner held.
- Transfer security deposits by directly providing funds from the seller or their agent to the settlement agent. This method is preferred when the security deposit is held by a management company not being retained by the new owner.
How The Issue Does Not Become An Issue
Ideally the purchase and sale agreements will specifically address the conveyance of security deposits. The seller should declare the amount of security deposit funds held. The agreement should then declare how these funds will be transferred.
In over 25 years of reviewing these deals (after the fact) these details are often forgotten. Not only in private sales but also by sales facilitated with professional real estate agents.
Legally, the security deposits are neither the seller or the buyer’s funds. They are the tenants funds. The parties to the transaction hold a fiduciary responsibility to the tenant to make sure they are properly conveyed.
For this reason, I do not believe the proper way to convey these funds is with a credit on the settlement statement to the buyer. The security deposit funds should not be a part of the sales transaction. Security deposits are not funds owned by either the buyer of the seller.
With understanding of this issue, these funds can be conveyed separately between the parties. My recommendation is for the settlement agent to give the buyer a separate certified check after closing. This way, these funds are not a part of the transaction. Unfortunately, because the issue is so often neglected in the purchase agreements, the settlement agent is left to determine how to process the security deposit. A credit to the buyer is the simplest method for them to utilize.
Don’t Assume You Did Not Receive The Security Deposit
Pull out and review the settlement statement from your purchase. The credit for the security deposit may have been buried in all the settlement costs. You may be surprised to learn that you are responsible for the security deposit for settlement to your new tenants. Typically, if the buyer is not sure how the security deposit was settled with the purchase, this is the arrangement that has occurred Unfortunately, there are also plenty of cases where the security deposit is forgotten. In those cases, all you can hope is to find the seller and convince them they have these funds. Then ask the former owner to release them to you by reminding them that the security deposit funds belong to the tenants.
Another Example Of Why Professional Management Can Pay For Itself
With professional management, the first thing is to review the leases the buyer has inherited. Besides noting all the terms, professional management administers the security deposits. Having your property manager involved prior to closing may allow you to be aware of other questions that may be important to your acquisition.
Property managers should always keep security deposits segregated from rent funds. This is a reflection of the fiduciary responsibility to the tenant. If the former owner used management, and the buyer is also doing so, security deposit funds may be transferred between both property managers. The managers often inform the tenants of the transfer of funds. Our company will have the tenant sign a notice that they are aware we no longer holds their funds.
One Final Tip
When acquiring a new property, there is more than just addressing how to transfer security deposits. The buyer should also insist on the following items to help with the eventual settlement of the funds.
- Rent Ledger showing any funds due
- Move-In Inspection Report
- Move-In Pictures
These three items will allow the new owner to record charges against the security deposit funds. Without them, deductions for unpaid rent will be limited and any damages will be almost impossible to document. Without these items it limits the usefulness of the security deposit for the new owner.