There are two reasons why a tenant’s security deposit could change hands during the course of their tenancy. One is a change of ownership of their rental property. The other is a change of the property manager. Either change requires all parties to address the security deposit and document who is now in possession of these funds. Over the years I have learned that the handling of the security deposit in these situations can be poorly documented. It is not unusual to have a tenant end their lease expecting a return of their security deposit. After assuming the lease, the owner and property manager may both believe they do not hold the deposit. If they are deserving, somebody is going to have to make the tenant whole.
Until proven otherwise, these security deposit funds actually belong to the tenant. They are not the owner’s funds. Extra care should be taken by all parties to protect these funds. The problems begin when these funds are forgotten when a property is sold or management changes. As a protection to tenants, most state laws require a security deposit to be held in a separate bank account subject to audit. Ultimately, the funds should be safe sitting in a bank account. It is easier to locate the security deposit during the changes than after.
Lets take a look at how a security deposit can get lost. More importantly, how to prevent any misunderstandings or problems.
Ownership Change
There are a couple of different ways that a property may change ownership during a tenancy.
Sale
I am surprised at how often I see a sale settlement statement for a rental and none of the parties addressed the security deposit. Or the credit is given to the buyer in the settlement statement but the buyer does not understand or remember. Occasionally the seller claims they paid these funds directly to the buyer and the buyer claims to not have received the funds. I can’t say it enough…these are the tenants funds and there is a fiduciary duty in how they are managed!
The security deposit needs to be treated with a lot more care! Not only by the buyer and seller, but also their agents. I can almost excuse an owner as they may not practice real estate daily. The service providers have a duty to confirm the credit of these funds to the new owner.
Sometimes the selling agent fails to address the escrow funds in the title company’s instructions. This mistake tends to occur when rental owners use different agents for the sale than their property management company agents. The possible outcome of not accounting for these funds at closing? The new owner, at a later date, ends up funding the security deposit themselves.
The security deposit funds are held in trust. The seller should give the buyer a credit in escrow at closing. How these security deposits are handled should be a part of the purchase agreement. I also recommend that the tenant acknowledge that they are aware their security deposit is changing hands. Even if the law does not require it, it is still a very good practice to have the tenant’s acknowledgement.
Foreclosure
Recently, one of our owners lost their investment property to foreclosure. Due to the Protecting Tenants in Foreclosure law, this change in ownership (from individual to bank) should have little to no impact on a tenant.
Even if a bank demands the security deposit be handed over to them, there are steps a property manager should take to protect the tenants funds. Our recommended solution below is the proper way for the new institutional owner to receive credit for holding these funds.
Change of Property Manager
When an owner makes the decision to change property managers, there must be a discussion of how to handle any security deposit held by the former manager. It may seem simple enough that one manager just write a check to the new manager to transfer these funds. That approach is just not enough.
Recommended Solution
You have a fiduciary responsibility if you are transferring ownership or managers of a rental. Care should be taken to handle the security deposit in a manner that honors the tenant’s interests. Tenants have the right to be made aware that a request has been made to change who is holding their security deposit.
The correct way to handle a change in the holding of a security deposit is to:
Utilize a letter explaining the transition. This letter should be generated by the new property manager or owner. All parties, including the tenant should sign their acknowledgement.
If a check is issued for the transfer, another option is to make it payable to both the tenant and new owner or manager. The tenant’s endorsement also serves as acknowledgement of the notice of a change of owner or manager.
When taking over a rental management, we like to take this check or letter to the tenant for endorsement. We deliver it with an introductory letter. In this way we are able to introduce ourselves as the new manager and answer any questions. We also walk away with a written record of acknowledgement that the tenant has been informed of a change of holder of their security deposit funds. Those funds are then deposited into our escrow account.
Always keep in mind that security deposit funds are the tenant’s until proven otherwise. The holder of those funds has a fiduciary responsibility to care for those funds and provide complete documentation of their location and dispersal.
