This article discusses the different rules for residential and nonresidential landlords who receive and refund security deposits, and the residential tenant’s right to a pre-termination inspection.

Requirements for residential and nonresidential landlords

An investor, primarily in nonresidential income-producing properties, is acquiring his first residential rental property.

The residential rental property is a large apartment complex consisting of furnished and unfurnished units.

The investor retains a property manager with experience in managing apartment buildings of comparable size and quality in the local rental market.

Initially, the property manager inspects the units and, with the investor, reviews the impact of the local residential rental market on rents and security deposits.

As a result, rents and security deposits to be charged are established based on the size of the units, the maximum number of occupants for the various sizes of units, amenities each unit offers, the unit’s location within the complex and whether or not the units are furnished.

The investor is aware he must rent to families with children whose credit and background qualify them as tenants. However, the investor is concerned about the excessive wear and tear children might cause to the units. Excessive wear and tear brought on by a tenant and remaining unrepaired when the tenant vacates is a breach of the lease, called a default. As a result, the landlord will incur additional cleanup expenses.

If a unit will be occupied by a family with children whose background check indicates they will likely place an excessive burden on the unit, the broker can recommend the rent be adjusted upward to cover the additional wear and tear brought about by the increased number of occupants.

However, the investor would like to impose a larger security deposit equal to one-half month’s rent for each child who will occupy a unit since the increased deposit would either discourage large families from renting or provide funds to restore the unit for re-renting when they vacate.

The property manager informs the investor security deposits charged to tenants of residential units are controlled by statute calling for nondiscriminatory, equal treatment, unlike security deposits negotiated by landlords and tenants of nonresidential property.

Thus, the investor is warned he cannot require higher security deposits for tenants with children than for tenants without children. Any increase in a security deposit for families is a prohibited discriminatory practice. [Calif. Government Code §12955(a); 24 Code of Federal Regulations §100.65]

Also, other limitations are placed on the upfront charges for rent and security deposits. In addition to the collection of one month’s advance rent, the maximum amount which a residential tenant may be required to pay as a security deposit to cover defaults during the period of occupancy is limited to:

  • two months’ rent for unfurnished units; and

  • three months’ rent for furnished units. [Calif. Civil Code §1950.5(c)]

Thus, if supported by the local rental market, the investor may require of all tenants, an advance payment of the first month’s rent and either:

  • the last month’s rent and a security deposit equal to one month’s rent; or

  • a security deposit equal to two months’ rent.

The property manager informs the investor a security deposit equal to one month’s rent, together with one month’s advance rent, is all the market will currently bear for his units. If he demands more, the units will not readily rent.

Security against nonperformance

Both nonresidential and residential landlords traditionally require tenants to deposit money in addition to rent. [See first tuesday Forms 550 §1.1 and 552 §1.2]

The additional deposit is security for any default in the tenant’s future performance of obligations the tenant agrees to in the lease or rental agreement. Tenant obligations include paying rent, reimbursing the landlord for expenses incurred due to the tenant’s conduct, maintaining the premises during the occupancy and leaving the premises in the same level of cleanliness it was in when leased to the tenant, less ordinary wear and tear.

However, for residential rentals, all money paid to the landlord in addition to the first month’s rent, screening fee and waterbed administrative fee is considered a security deposit. Security deposits include any funds received for the purpose of covering defaults by the tenant under the lease/rental agreement, no matter the name given to the funds by the landlord, such as a nonrefundable deposit or last month’s rent. [CC §§1940.50; 1950.5(b), (c); 1950.6]

Thus, any funds legally recharacterized as a security deposit are refundable when the tenant vacates, less deductions for unpaid rent or costs incurred by the landlord, such as for the repair of damages caused by the tenant or for the cleaning of the premises. [CC §§1950.5(b); 1950.7(c)]

The amount a nonresidential landlord will ask for as a security deposit should be based on the risk of loss the tenant’s business success poses for the landlord.

For nonresidential tenancies, a small services firm may pay an amount equal to one month’s rent as a security deposit, while a photography studio which uses chemicals in its film processing may be asked to pay an amount equal to two month’s rent.

Editor’s note — A photography studio tenant or other users of chemicals may also be required to provide insurance coverage.

In a market downturn, aggressively competitive landlords are less likely to require a security deposit in exchange for maintaining current rental income (occupancy), and thus expose themselves to an increased risk of loss should the tenant default.

Like all other terms in a nonresidential lease, the security deposit is negotiated between the nonresidential landlord and the tenant prior to entering into the lease.

Unlike nonresidential tenants, residential tenants, as a matter of public policy, are perceived as lacking bargaining power when they negotiate a lease or rental agreement. Thus, limits are imposed by law on the amount of security deposit a residential landlord may require.

Last month’s rent

When unfurnished residential vacancies are low, landlords often require the maximum permissible amount of advance payment, which includes the first and last month’s rent, plus a security deposit equal to one month’s rent to eliminate the less solvent tenants.

Editor’s note — Legally, this is recharacterized as one month’s advance rent and a security deposit equal to two month’s rent. [CC §1950.5(c)]

Nonresidential landlords also generally require an advance payment of both the first and last month’s rent on a lease.

However, the local rental market conditions may prevent a residential or nonresidential landlord from requiring:

  • a security deposit in addition to first and last months’ rent; or

  • a security deposit equal to two months’ rent and advance payment of one month’s rent.

Now consider a tenant who pays the first month’s rent and a security deposit equal to one month’s rent on entering into his lease.

When the last month’s rent becomes due the tenant does not pay, knowing the defaulted payment of rent will be deducted from his security deposit, a permissible use of the security deposit by the landlord on the tenant’s default in the last month’s rent payment.

On expiration of the lease, the tenant vacates the unit. Due to excess wear and tear on the unit by the tenant, repairs and replacements are required before the unit can be re-rented.

However, after deducting the unpaid last month’s rent from the security deposit, no security deposit remains to reimburse the landlord for the cost of the repairs.

Since the landlord did not require an advance payment of both the first and the last month’s rent, as well as a security deposit (or a security deposit equal to two months’ rent), his recovery of the repair costs is limited to a demand on the tenant, and if unpaid, a small claims court action to enforce collection.

A similar result may occur if the landlord requires advance payment of the first and last month’s rent, but no security deposit.

Editor’s note — The landlord could promptly serve a 3-day notice to pay or vacate on expiration of the grace period before delinquency, and on expiration of the 3-day notice without payment or vacating, file an unlawful detainer (UD) action.

Residential deposits

A residential landlord must require the same security deposit for all units, such as an amount equal to one month’s rent, or base the amount of security deposit on each tenant’s creditworthiness.

Editor’s note — If a landlord sets the security deposit amount based on a tenant’s creditworthiness – the greater or lesser risk of a loss due to a prospective tenant’s failure to perform on lease provisions – he must establish clear and precise standards for his different levels of creditworthiness and apply each level’s credit standards equally to all prospective tenants who fall into that level of credit. [24 CFR §100.60(b)(4)]

A residential landlord has limited authority to require an additional pet deposit if the tenant is permitted to keep one or more pets in the unit.

However, the total security deposit received from a tenant with a pet may not exceed the maximum security deposit allowed, such as an amount equal to two months’ rent for an unfurnished unit or three months’ rent for a furnished unit.

However, these security deposit limitations may be exceeded when a tenant maintains a waterbed on the premises. The residential landlord may then require:

  • an amount equal to one-half month’s rent, in addition to the maximum security deposit; and

  • a reasonable fee to cover administrative costs of processing the waterbed arrangements. [CC §1940.5(g)]

Also, if the term of a residential lease is six months or more, the landlord and tenant may agree to the tenant’s advance payment of six months’ rent or more, instead of one month’s rent. [CC §1950.5(c)]

Thus, advance payment of only two to five month’s rent is prohibited.

Should the landlord and tenant agree to an advance payment of six months’ rent on the lease of an unfurnished unit, the landlord may also require the maximum security deposit of two months’ rent.

Any money handed to a residential landlord by a tenant on entering into a lease or rental agreement must be characterized as one of the following:

  • a tenant screening fee for processing an application;

  • a waterbed administrative fee;

  • rent; or

  • a security deposit. [CC §§1940.5(g); 1950.5(b); 1950.6(b)]

Holding security deposits

Funds held by residential and nonresidential landlords, which are intended to cover defaults in the tenant’s performance of his obligations on the lease or rental agreement, are called security deposits. The funds belong to the tenant who deposited them. [CC §§1950.5(d); 1950.7(b)]

However, a landlord may commingle security deposits with other funds in a general business account. No trust relationship is established when a landlord holds a tenant’s security deposit. [Korens v. R.W. Zukin Corporation (1989) 212 CA3d 1054]

Since no trust relationship exits, the landlord’s receipt of a security deposit imposes no obligation on him to pay interest on the security deposit for the period held.

However, some local rent control ordinances require residential landlords to pay interest to tenants on their security deposits (and the legislature has been actively thinking about extending this to all residential landlords).

For example, the city of San Francisco requires residential landlords to pay simple interest to tenants on security deposits held by the landlord for one year or more as long as the rent is not subsidized by any government agency. [San Francisco Administrative Code §49.2]

Joint pre-termination inspection

A residential landlord must notify a tenant in writing of the tenant’s right to request a joint inspection of his unit within two weeks prior to the date the tenancy terminates due to:

  • expiration of the lease term; or

  • a notice to vacate initiated by either the landlord or the tenant. [CC §1950.5(f)(1)]

The purpose for the joint pre-termination inspection, legally called an initial inspection, is to require the landlord to advise the tenant of the repairs or conditions he needs to correct to avoid deductions from the security deposit.

If a residential tenant requests the pre-termination inspection, the landlord or his agent must complete the inspection no earlier than two weeks before the tenant is to vacate the unit.

Ideally, the notice advising the tenant of his right to a joint inspection should be given to the tenant at least 30 days prior to the end of the lease term or, in the case of a rental agreement, immediately upon receiving or serving a notice to vacate. A period of 30 days will allow the tenant time to request the inspection and provide two full weeks in which to participate in the inspection and remedy any repairs or cleaning the landlord observes during the inspection which might constitute a deduction from the security deposit.

On the landlord’s receipt of the tenant’s request for an inspection, the landlord must serve a 48-hour written notice of entry on the tenant stating the date and time of the pre-termination inspection. If the date and time cannot be mutually agreed to, they are to be set by the landlord. [CC §1950.5(f)(1); see first tuesday Form 567-2]

However, if an acceptable time for the inspection is within 48 hours, a written waiver of the notice of entry must be signed by both the landlord and tenant. [CC §1950.5(f)(1); see first tuesday Form 567-2]

If the waiver is signed, the landlord may proceed with the inspection, whether or not the tenant is present at the premises, unless the tenant has previously withdrawn his request for the inspection.

On completion of the pre-termination inspection, the landlord must give the tenant an itemized statement of deficiencies specifying any repairs or cleaning necessary to be undertaken by the tenant to avoid deductions from his security deposit. The itemized statement of deficiencies must contain the contents of subdivisions (b) and (d) of Civil Code §1950.5.

The pre-termination inspection statement must be served by either:

  • giving the statement directly to the tenant if he is present at the inspection; or

  • leaving the statement inside the premises if the tenant is not present. [CC §1950.5(f)(2)]

The purpose for the inspection and statement of deficiencies in repairs or cleanliness is to give the tenant time in which to attempt to remedy the identified repairs before vacating the premises.

Alternatively, the tenant may choose not to request a pre-termination inspection, in which case the landlord or his agent will not have to conduct an inspection or prepare and give the tenant a statement of deficiencies.

However, the notice of the tenant’s right to request a pre-termination inspection must be given to the tenant.

If the tenant chooses to withdraw after requesting an inspection, the landlord should send a memo to the tenant confirming the tenant’s decision to withdraw. [See first tuesday Form 525]

Editor’s note — The completion of a pre-termination inspection by the landlord does not bar the landlord from deducting from the security deposit for the costs of:

  • any damages noted in the joint pre-termination inspection statement which are not cured;

  • any damages which occurred between the pre-termination inspection and termination of the tenancy; or

  • any damages not identified during the pre-termination inspection due to the tenant’s possessions being in the way. [CC §1950.5(f)]

Regardless of whether or not the tenant requests a pre-termination inspection, the final inspection after the tenant vacates and the itemized statement for the refund of the security deposit less any deductions must still be completed and mailed within three weeks after the tenant vacates the residential unit. [CC §1950.5(g)]

Residential refund requirements

Within three weeks after a residential tenant vacates, the residential landlord must:

  • refund the security deposit, less reasonable deductions; and

  • provide the tenant with an itemized statement for any deductions from the security deposit. [CC §1950.5(g)]

If the last month’s rent on a lease is prepaid, it is considered a security deposit since it has not yet been earned. Prepaid rent must be accounted for as a security deposit if the tenant vacates before expiration of the lease (and the arrival of the month for which rent has been prepaid).

Reasonable deductions from a residential tenant’s security deposit include:

  • delinquent rent;

  • costs to clean the premises after the tenant vacates, if the tenant agreed to and failed to leave the unit in the same level of cleanliness as when he took occupancy;

  • costs of repairs for damages caused by the tenant, excluding ordinary wear and tear; and

  • costs to replace or restore furnishings provided by the landlord if agreed to in the lease. [CC §1950.5(b)]

Unpaid late charges incurred on a proper demand may be deducted from the security deposit since they are a form of rent in that they are amounts due the landlord under the lease agreement.

The landlord may not deduct from a tenant’s security deposit the costs he incurs to repair defects in the premises which existed prior to the tenant’s occupancy. [CC §1950.5(e)]

Tenants seeking to recover security deposits retained by landlords may make unfounded claims that the excessive wear and tear existed when they took possession of the property. To best avoid claims of pre-existing defects, a joint inspection of the unit (landlord and tenant) and written documentation of any defects should be completed before possession is given to the tenant. [See first tuesday Form 560]

Itemized security deposit statements

When a residential tenant vacates, the landlord itemizes the deductions from the tenant’s security deposit on a security deposit disposition.

If a landlord is required by local rent control ordinances (or state law) to pay interest on security deposits, the landlord may also use the itemized statement to account for interest accrued on the security deposit.

A residential landlord who, in bad faith, fails to comply with security deposit refund requirements may be subjected to statutory penalties of up to twice the amount of the security deposit. [CC §1950.5(l)]

A residential or nonresidential landlord also delivers an itemized statement to tenants on the sale of the property, indicating the amount of the security deposits, any deductions and the name, address and telephone number of the buyer. [CC §§1950.5(h); 1950.7(d); see first tuesday Form 586]

Nonresidential refund requirements

A nonresidential lease does not need to set forth:

  • the circumstance under which a tenant’s security deposit will be refunded; and

  • a time period within which a landlord will refund a tenant’s security deposit.

Other than its receipt, a nonresidential lease does not even need to contain a provision addressing when the security deposit will be returned. [See first tuesday Form 552]

However, if unpaid rent is deducted from a security deposit after a nonresidential tenant vacates, the landlord is required to refund the security deposit within two weeks from the date he takes possession of the property.

Also, if a nonresidential landlord deducts amounts from a security deposit to cover the costs of cleaning or making repairs to the premises, any remaining portion must be refunded no more than 30 days from the date the landlord receives possession. [CC §1950.7(c)]

If a refund period is not agreed to and the nonresidential landlord does not take any deductions from the security deposit, the landlord must refund the security deposit within a reasonable time period.

Thirty days from the date the nonresidential landlord receives possession is a reasonable refund period since the landlord is allotted 30 days to determine whether repairs are needed. After 30 days, no good reason exists to continue to hold the deposit.

Unlike the residential landlord, the nonresidential landlord is not required to provide tenants with an itemized statement of deductions when the security deposit is refunded.

However, a prudent nonresidential landlord provides tenants with an itemized statement when they vacate, unless a full refund is made.

An accounting avoids the inevitable demand for documentation which arises when a tenant does not receive a full refund of his security deposit.

A nonresidential landlord who, in bad faith, fails to comply with the refund requirements is liable to the tenant for up to $200 in statutory damages. [CC §1950.7(f)]