A case of Mistaken Identity — Security Deposit vs. Earnest Money Deposit

The security deposit is paid by a tenant up-front to cover any default in the lease, including damage, whereas a buyer puts up an earnest money deposit at the time of the offer to purchase, to be forfeited in the event the buyer does not perform.

Security Deposit — Money deposited by or for the tenant with the landlord, to be held by the landlord for the following purposes: (1) to remedy tenant defaults for damage to the premises (be it accidental or intentional), for failure to pay rent due or for failure to return keys at the end of the tenancy; (2) to clean the dwelling so as to place it in as fit a condition as when the tenant commenced possession, considering normal wear and tear; and (3) to compensate for damages caused by a tenant who wrongfully quits the dwelling unit. The security deposit is not regarded as liquidated damages, but rather is a fund held in trust for the tenant that the landlord can use to offset damages caused by the tenant. A security deposit is not taxable to the landlord until applied to remedy any tenant defaults. Neither can the tenant take the deposit as a tax deduction. Some states require security deposit monies to be placed in an interest bearing account in trust for the lessee.

The tenant’s claim to the security deposit monies is superior to all claims of the landlord’s creditors. An exception is claims of a trustee in bankruptcy.

Under the Uniform Residential Landlord and Tenant Act, the security deposit may not exceed one month’s rent. The landlord must return the security deposit, less any authorized retained portion, to the tenant no later than 14 days after the termination of the rental agreement. The landlord must give written notice to the tenant setting forth the grounds for and evidence supporting any claimed retention of any portion of the security deposit. Certain states require landlords to return security deposits to tenants within a specified time period and to account for all claims to any part of the deposits; disputes over security deposits may be handled expeditiously in small claims court, which provide for penalties in the event a landlord fails to comply with the regulations. Difficulties in the accounting and administration of security deposits have led some authorities to advocate their abolition. Although the Uniform Residential Landlord and Tenant Act preserves the security deposit, it limits the amount (one month’s rent) and prescribes penalties for its misuse. The act does not limit the prepayment of rent, as distinguished from security deposits; nor does it require the landlord to pay interest on the security deposits.

The lease should clearly specify whether a payment is a security deposit or an advance rental. If it is a security deposit, the tenant is not entitled to apply it as discharge of the final month’s rent. If it is an advance rental, the landlord will have to pay taxes on it when received. Many state laws specifically state that the security deposit is not to be construed as payment of the last month’s rent by the tenant. When the lessor sells the property, the sales contract should cover the appropriate accounting of security deposit monies (i.e., debit seller and credit buyer).

Earnest Money Deposit — The cash deposit (including initial and additional deposits) paid by the prospective buyer of real property as evidence of good-faith intention to complete the transaction; called bargain money, caution money, hand money, or a binder in some states. The amount of earnest money deposited rarely exceeds 10 percent of the purchase price, and its primary purpose is to serve as a source of payment of damages should the buyer default. Earnest money is not essential to make a purchase agreement binding if the buyer’s and seller’s exchange of mutual promises of performance (that is, the buyer’s promise to purchase and the seller’s promise to sell at a specified price and terms) constitutes the consideration for the contract. Thought should be given to placing the money in an interest-bearing account for the buyer’s benefit, which can be done by the parties agreeing in writing to place it with a neutral third party such as an escrow company.

The deposit, or earnest money, is usually given to the broker at the time the sales contract is signed. The broker’s authority to hold this money on behalf of the seller should be specifically set forth in the listing, because such authority is not implied in law. The broker has the responsibility under the license laws to deposit this money into a client trust account or neutral escrow; or with the knowledge and consent of both parties, the broker may hold the earnest money until the offer has been accepted. The broker may not, however, commingle this money with the broker’s own general funds. When the transaction is consummated, the earnest money is credited toward the down payment. If the seller defaults, the broker should check with the buyer before returning the earnest money. The buyer may not want the earnest money returned directly to the seller if he or she wishes to sue the seller for specific performance.

There is some uncertainty as to exactly who owns the earnest money once it is put on deposit. Until the offer is accepted, the money is, in a sense, the buyer’s. Once the seller accepts the offer, however, the buyer may not get the money back, even though the seller will not be entitled to it until the transaction is completed. At this point, the money does not belong to the broker either, for it must be deposited in a special trust account maintained especially for such purposes. This uncertain nature of earnest money deposits makes it absolutely necessary that such funds be properly protected pending final decision on how they are to be disbursed.