A common misconception among rental property investors is that collecting a security deposit is a guaranteed safeguard against problems that arise down the line. Many intangibles come with receiving a security deposit. For instance, in some states, if you fail to hold the security deposit in an interest-bearing escrow account, you may not be able to claim any portion of the security deposit down the road, even in the event of damages to the unit. Every state has its statute that outlines security deposit rules and regulations. A state-by-state overview can be found here.
That said, security deposit disputes inevitably happen. Here’s what you need to know about how to handle security deposit deductions and any related disputes.
Be sure that deductions qualify. Most states allow a property manager to use security deposit funds to recover the costs of unpaid rent and damage to the unit above normal wear and tear. However, in some states, like Indiana, property managers can recover delinquent sewer and utility bills. Iowa law allows property managers to keep the security deposit to put towards the cost of recovering possession where the resident withholds “in bad faith.” In other states, eligible expenses are not governed by statute at all, but rather by the terms of the original lease agreement.
Document all damages. Interestingly, not all states require a walk-through inspection before claiming the security deposit. Even though it may not be necessary, it’s usually best practice to do so. If the resident has not yet moved out, try and arrange for the resident to be present at this inspection—this will go a long way toward minimizing security deposit disputes. Take pictures of all damages (ideally, you will have “before and after” photos of the unit to offer as a comparison in the event the resident disputes your claims). Also, keep a record of all unpaid rent, utility bills and other expenses that are not necessarily “damage” related, so you have that proof as well.
Prepare an itemized list of all deductions. The itemization should be in writing and state how the deposit will be applied toward back rent, cleaning, repairs, or other financial obligations required under your lease or rental agreement. List the item (such as repainting the living room or five days’ unpaid rent) and the dollar amount of the deduction. Attach receipts and invoices for all repairs, or include a reasonable cost estimate for those repairs. A template itemization form can be found here.
What to Do in the Event of a Dispute. No matter how meticulously you comply with the state’s security deposit laws, a resident might still try to sue you to recover his or her full security deposit.
Residents usually sue in small claims court where it’s relatively easy and inexpensive to file. Some states will require a resident to send you a demand letter before filing in court, and this offers you one last opportunity to settle things with the resident outside of court. Again, this is an excellent time to look back at your state’s statute to ensure you’ve dotted all your “i’s” and crossed your “t’s.” If you’re even one day over the deadline for returning the security deposit or notifying the resident of deductions, or if you failed to hold the security deposit in escrow as required by law, the resident may automatically win his or her small claims suit – even if the resident did, in fact, cause damage to the apartment.
If you’re sued and lose the case, you risk owing the resident the deposit and could be assessed hefty penalties or punitive damages. Your best bet is to try to stay out of court and work out a reasonable compromise with the resident.
If a compromise isn’t possible, and you feel confident that you have not erred in any way, then it’s time to start preparing for court.
Bring the following with you: a signed copy of the lease agreement; copies of any correspondence between you and the resident that discuss cleaning, damages, repairs or security deposit claims; any move-in or move-out inventories that were conducted, as well as the photographs and other evidence you kept regarding the damages; the security deposit itemization you sent to the resident; back up to the itemization (i.e. invoices from contractors, cleaning receipts); and anything else relevant to your case.
When you’re in court, you’ll want to be able to explain your case clearly and concisely to the judge. Again, this is the time to showcase how well you understand your state’s statutes regarding security deposits. Matters usually take less than 30 minutes for a judge to hear before making their decision.
If a resident’s security deposit does not cover the full breadth of the damages, you may also sue in small claims court. You’d follow the same steps—starting with a demand letter sent to the resident. Again, this is the worst-case scenario that most property managers should try to avoid. Unless the damages are extreme, property managers are usually better off taking the full security deposit and eating the rest of the costs. Suing in small claims court may be a futile effort, anyhow, if you are unable to locate a tenant who has since moved out of the area.
Of course, the best way to avoid a dispute over a security deposit is to prevent getting into that situation from the outset.
Our best advice to that end: Actively communicate with residents throughout their lease term. Set expectations from the outset. Who’s responsible for what maintenance and repairs? Who pays which bills? Then, keep lines of communication open – especially if there’s any sign of property damage or if you start to have concerns about your residents’ activity. It might require a bit more effort, but in the long run, you’ll be glad you did!