How to Handle Security Deposits Properly

What’s a Deposit?

Since the dawn of time, landlords have been taking “security” or damage deposits from tenants to insure against potential property damages.

Centuries ago, a tenant could offer a promissory note against crops, livestock, or even children as a damage deposit. (Imagine that!)

Now, however, landlords require tenants to provide the money up front, usually one or two month’s worth of rent. This money is then held by the landlord until the end of the lease, and returned if there are no damages.

Problems with Commingling Funds

Technically, the security deposit money does not belong to the landlord. It’s on loan, while the tenant lives in the rental property.

The landlord must keep it safe until it is time to either to offset damages or return it to the tenant.

When a landlord keeps the deposit in the SAME account as his/her personal funds, or other deposits, three common issues arise:

Problem #1: Lack of Tracking

The deposit becomes almost impossible to track and validate in a court of law. In many states, commingling of funds can forfeit a landlord’s right to claim any of the deposit.

Problem #2: Accidental Spending

The deposit might accidentally get spent on a haircut for the landlord’s fluffy toy poodle, Louis Vuitton.

Problem #3: Interest Accrual

Since the security deposit does not belong to the landlord, many states require that a landlord collect interest on behalf of the tenant. This becomes nearly impossible to calculate if the deposit is commingled with personal funds.

Some states, such as Pennsylvania, allow the landlord to keep part of the interest as an “administrative fee,” but other states require every penny that the deposit earns in interest be given back to the tenant.

The Solution: Separate Accounts

Most independent landlords don’t realize the importance of this basic accounting technique.

I have a bank account for each property. I ONLY use these accounts to hold money that does not belong to me, such as deposits.

Remember, when a tenant gives a deposit, the landlord has a responsibility to hold it for safe keeping, and sometimes even collect interest for the tenant.

Structuring the Bank Accounts

There are a dozen ways to organize your bank accounts. Because I manage my own properties (and only my own), the method that has worked best for me is to have one rental operating account for all my properties, and then a separate account for each property’s current security deposit.

With that said, I’m not an accountant or a lawyer, but this method satisfies most state laws that I’ve seen.

For example, if you own three rental properties, you might have the following bank accounts:

1. Personal Checking
   Date nights, personal mortgage, kids’ shoes, and haircuts for Louis.
2. Personal Savings
   Emergency fund for your family, vacation savings, orthodontia for the kids, etc.
3. Rental Operating Checking
   Repairs, maintenance, and mortgage expenses for ALL your rentals. You can track each property’s expenses in a separate ledger.
4. Rental Property #1 – Security Deposit Checking Account
   The only money in this account is the security deposit for property #1.
5. Rental Property #2 – Security Deposit Checking Account
   The only money in this account is the security deposit for property #2.
6. Rental Property #3 – Security Deposit Checking Account
   The only money in this account is the security deposit for property #3.

By keeping the security deposits in their own CHECKING accounts, you are able to issue deposit refunds directly from the appropriate account by writing a check – thereby keeping your books nice and clean.

I would not recommend keeping the deposits in savings accounts, because you would be forced to transfer money to and from a checking account in order to issue refunds via check. This defeats the purpose of keeping the money separate.

What Does the Law Say?

Florida, for example, specifically prohibits landlords from commingling funds.

In Kentucky, the landlord loses the right to withhold ANY money from the deposit if he/she doesn’t store it in a separate account.

Pennsylvania only dishes out interest to tenants after the 2nd year of tenancy is complete, but also gives landlords a piece of the pie.

In Washington, the landlord gets to keep the interest, but it’s still a good idea to keep the funds separate.