RENT PAID WITH A SECURITY DEPOSIT – COVID-19 CRISIS
In the wake of COVID-19, many residential and commercial tenants have failed to pay April and May rent. As summer approaches, the ability of tenants to pay their rent projects to become an even greater problem for landlords. Many tenants are requesting that their landlords apply the cash security deposits posted at commencement of the lease to their rent arrearage. Some states (but not Virginia, Maryland, or DC, as of the date of this article) are now requiring residential landlords to do just that upon a written request from the tenant. An example of this is found with the State of New Jersey pursuant to the Governor’s Executive Order #128.
This begs the question: Is it prudent for a landlord to draw on the security deposit before the expiration of the lease?
As an initial step, the landlord should review the lease agreement to determine if the lease permits the landlord to apply the security deposit to unpaid rent arrearages. Many leases only allow such application following a “default/event of default” of the lease, which may be a defined term in the lease. If the tenant is entitled to written notice and opportunity to cure before a “default/event of default” occurs, then the landlord is required to provide the requisite notice prior to applying the security deposit to the unpaid rent. Commercial landlords should also review their mortgage documents to determine whether application of a tenant security deposit is permissible under the circumstances (some lenders restrict use of tenant security deposits).
In Virginia, in the commercial leasing context, application of the security deposit is not governed by a specific statute and is entirely a matter of contract. In the residential context, both the written lease and the Virginia Residential Landlord Tenant Act (VRLTA) govern the application of the security deposit. The VRLTA states that it is permissible for a landlord to apply a security deposit to the payment of accrued rent and reasonable late fees as provided for in the lease. The landlord is required to provide written notice of the application to the tenant within 30 days of the deduction that is made. See Virginia Code § 55.1-1226.
As long as the application of the security deposit is permissible under the lease and made in accordance with the lease and applicable law, there is very little downside to the landlord’s application of the security deposit to the past due rent. In fact, this may be a prudent move in anticipation of a tenant filing for bankruptcy. Once the landlord has properly applied the security deposit to past due rent, the tenant loses any property rights in the security deposit. As such, if the tenant files for bankruptcy after application of the security deposit, it is no longer considered property of the tenant’s bankruptcy estate. If the tenant files for bankruptcy before the deposit is applied, then the deposit is considered property of the tenant’s bankruptcy estate. Pursuant to the automatic stay in bankruptcy, the landlord will be required to hold the deposit for a period of time and may or may not be required to pay the deposit into the bankruptcy estate. Even if the security deposit is applied prior to a tenant filing for protection under the bankruptcy code, there are limited circumstances for which the bankruptcy court may look back and require the landlord to disgorge the security deposit and pay it into the bankruptcy estate.
The obvious downside to early application of the security deposit is that the landlord will not have the deposit available to apply to property damage following termination of the lease. As such, early application of the deposit may only kick the proverbial can down the road with respect to the tenant’s indebtedness to the landlord. If the tenant is capable of paying the rent, then the landlord should not rush to apply the security deposit. However, in cases where it is clear that the tenant cannot pay the rent payment, or in cases where the landlord is in need of immediate cash due to its own financial circumstances, then early application may be advisable. Most leases require the tenant to replenish the security deposit upon an early application, therefore, the landlord may be able to recoup the applied security deposit later, when the tenant has returned to a better financial position.
As we have recommended since the early stages of the pandemic crisis, the best approach for both landlords and tenants is to work together in good faith to get through the crisis. The eviction and debt collection process will not yield immediate results given the current operating status of the courts. When the courts resume hearing these types of matters, tenants may be entitled to certain statutory relief, and the judges’ sympathies are likely to be with tenants and not landlords. The recommended approach is to document any early application of the security deposit by a written agreement which clearly establishes how the security deposit will be applied, how any remaining debt will be dealt with, and when (if at all) the security deposit will be replenished.