One of the most exciting things about investing in real estate is receiving money from other people. Rental property owners receive rent payments and security deposits from tenants, and general partners of an LLC or group investment receive funds from members to purchase rental property portfolios or rehab and reposition large development projects.
However, there are also potential risks involved when rental property owners accept money from other people, especially when the funds are not handled correctly or used for the wrong things.
In this article we’ll discuss how commingling in real estate and theft by conversion work, and the rules to follow when receiving money from tenants and other real estate investors.
What is Commingling in Real Estate?
The dictionary definition of commingling is to mix or blend, which is how most people who don’t work in real estate think of commingling. In real estate, commingling has a slightly different nuance.
The legal definition of commingling in real estate refers to how money received from one party such as a tenant or limited liability company (LLC) partner is deposited by the party receiving the funds, such as the tenant’s landlord or property manager, or the LLC’s managing partner.
Commingling occurs in a landlord-tenant relationship if the landlord places the tenant rental security deposit in the same account with the landlord’s personal or business funds. In an LLC, commingling takes place when money from all members of an LLC is pooled in the LLC’s business operating account before investing the funds received in the manner described in the LLC operating agreement.
In both of these examples the party receiving the money is known as the fiduciary and the party giving the money is known as the client. When a rental security deposit from the tenant is received by the landlord, the landlord owes the tenant a fiduciary responsibility to properly care for the tenant’s security deposit.
Is Commingling Legal?
Commingling in real estate can be legal or illegal, depending on the situation, and you may wish to consult your legal advisor to clarify. Let’s look at two examples, one where real estate commingling is legal and another when commingling in real estate is illegal:
Legal commingling in real estate is a fairly common occurrence.
For example, joint venture partners or members of an LLC intentionally pool their money together to invest in a portfolio of rental properties, purchase and renovate a small multifamily building, or develop a new rental project from the ground up.
Real estate investment trusts (REITs), crowdfunding, and other types of group real estate investments are also examples of when commingling is legal. With Roofstock One, accredited investors can buy shares of an individual rental home for as low as $5,000 to earn potential net rental income, appreciation and tax benefits.
Legal commingling in real estate can be a good way for investors to:
- Own part of a full passive investment with professional management;
- Generate potential income from rents and long-term appreciation; and
- Diversify across multiple properties and geographic areas with less capital per individual investment.
In all of these situations where commingling in real estate is legal, the fiduciary has the right (and obligation) to commingle the funds received from different clients to invest in income-producing real estate.
One of the most common examples of illegal commingling in real estate has to do with the tenant rental security deposit.
When leasing a home, a tenant gives the landlord a refundable rental security deposit as a guarantee that the tenant will pay the rent in full and on time, not cause damage beyond normal wear and tear, and abide by the terms and conditions of the lease.
As long as the tenant does everything they promise to do, the rental security deposit is returned to the tenant at the end of the lease. That’s one reason why the rental security deposit is posted as a liability on the property’s balance sheet, and not booked as rental income on the property profit and loss statement (P&L).
If a tenant’s rental security deposit is deposited in the owner’s operating account or personal account and mixed with other funds such as rent payments or pet fees, illegal commingling has occurred.
Other examples of illegal commingling in real estate include:
- Depositing the tenant’s rental security payment in the owner’s personal bank account;
- Personal or business funds deposited in the trust account created to hold a tenant rental security deposit; and
- Unlawfully withdrawing or transferring funds from the security deposit trust account to the owner’s operating account.
Some state landlord-tenant laws require a rental property owner to create a separate trust account that is only used to hold the tenant rental security deposit. But even if the laws in the state the rental property is located in do not require a separate account for security deposits, it can be a good idea to create one to avoid accusations of theft by conversion.
Commingling Real Estate vs. Conversion in Real Estate
While commingling refers to how funds are deposited by the fiduciary on behalf of the client, conversion is a term used to describe the act of using the client’s money for a purpose other than what the funds were intended for.
Generally speaking, conversion is a form of theft when the fiduciary lawfully receives funds from a client, then uses those funds for the fiduciary’s personal or business use without the permission of the client.
Here’s an example of how commingling can lead to theft by conversion when a landlord lawfully receives the tenant rental security deposit, the places the deposit in the landlord’s account used to pay property operating expenses:
|Owner working capital||$500||$500|
|Tenant rental security deposit||$1,500||$2,000|
|Tenant 1st month rent||$1,000||$3,000|
|Leasing fee paid||-$1,000||$2,000|
|Property management fee paid||-$100||$1,900|
|Repairs and maintenance||-$200||$1,700|
Based on the above cash flow statement, the landlord has converted (or stolen) $300 of the tenant’s rental security deposit and used the money to help pay the monthly mortgage. We know this because the bank account balance of $1,200 is less than the $1,500 rental security deposit received from the tenant.
The landlord legally received the $1,500 rental security deposit from the tenant as a guarantee that the tenant will abide by the terms and conditions of the lease. However, the tenant never gave the landlord permission to use their security deposit to pay part of the mortgage, or any other property operating expenses, for that matter.
How to Avoid Commingling in Real Estate
Properly tracking and accounting for security deposits, rent receipts, and property operating expenses can be confusing even for investors who own just one rental.
That’s why many real estate investors use Stessa to automate income and expense tracking, to create a paper trail record of real estate transactions, and keep track of property performance and finances all in one place.
In addition to signing up for a free account with Stessa to make tracking real estate investments simple, other ways to help prevent illegal commingling in real estate include:
- Setting up an LLC for each rental property to add a layer of protection between business and personal assets;
- Creating a new bank account for each rental property and using a debit or credit card linked to that account to pay for property expenses;
- Keeping the tenant security deposit separate from business and personal funds by setting up a security deposit trust account;
- Not using money in a business account to pay for personal expenses;
- Avoid frequently transferring funds back and forth between business and personal accounts without a clean paper trail;
- Keeping clear records of all security deposits, income, and expenses using an online rental property financial manager system;
- Organizing and storing transaction receipts and all real estate documents online using bank-grade security to protect data;.
- Utilizing best accounting practices to document relevant details about deposits and payments;
- Taking time each month to review the property income statement, net cash flow report, and capital expense report; and
- Placing funds in a dedicated escrow account managed by a third-party such as a property manager.
Commingling in real estate occurs when a tenant security deposit or funds received from members in an LLC are deposited with the landlord or managing partner’s business or personal funds.
There are times when real estate commingling is legal, such as buying a share of a rental home with other investors. Commingling in real estate can also be illegal, such as violating state landlord-tenant laws by depositing a tenant security deposit into the landlord’s operating account.
Commingling can also lead to theft by conversion when money is legally received from a person, then used for purposes other than what the money was intended for.