This article presents an insight into trust funds and their treatment.
Identification of trust funds
Brokers, while acting in their capacity as agents in real estate transactions, receive funds to be held in trust. These funds, called trust funds, include:
- deposits on offers to purchase and applications to rent or borrow;
- fees advanced for any brokerage services to be provided in the future;
- funds from sellers, borrowers and landlords as reserves to cover future costs;
- rental income and tenant security deposits;
- funding for a loan or the purchase of real estate; and
- proceeds from a sale or financing.
Trust funds are received by a broker, or by an employee acting on behalf of the broker, as part of a transaction in which the broker is acting as an agent. Employees acting on behalf of a broker include sales agents, associated brokers, resident property managers and office personnel. Trust funds include any item or evidence of value handed to the broker or the broker’s employee while acting as an agent in a real estate transaction. | Trust funds include any item or evidence of value handed to the broker in a real estate transaction. |
For example, a buyer enters into a purchase agreement. The buyer’s good faith deposit is in the form of a bag of gems which is handed to the broker. The dollar value of the gems will apply toward the purchase price on closing.
Must the broker handle the bag of gems as trust funds?
Yes! All items of value received by the broker as part of a transaction for which a real estate license is required, regardless of form, are trust funds subject to special handling. Trust funds come in many forms, including checks, precious metals, coins or stamp collections, promissory notes, the pink slip to a car and any other item or evidence of value. [Calif. Business and Professions Code §10145]
Managing the trust funds
Now consider a broker who enters into a property management agreement with an owner of income-producing real estate. Management services to be performed by the broker under his license include locating tenants, collecting rents and deposits, and disbursing funds for payment of operating expenses and installments on a trust deed loan encumbering the real estate.
The broker is further authorized to withdraw his fee and send any remaining funds to the owner.
The broker’s withdrawal of his fee before paying all other obligations is a conversion of the client’s funds to the broker’s own use. | The broker takes possession of the property under the property management agreement. The broker locates several new tenants and collects monthly rents and deposits. The broker deposits the rents and security deposits he receives into his general account. He then enters the amount of each transaction on the client’s subaccount ledger as trust funds held for the client. |
Although sufficient funds are held in the client’s subaccount to meet operating expenses and make the loan payment, the broker first withdraws his fee before fully performing his services, specifically before making the loan payment authorized by the owner. The disbursement of the fee reduces the balance on the client’s ledger below the amount needed to make the loan payment.
The broker then issues a check to the lender for the loan payment. The check bounces because of insufficient funds remaining in the broker’s general account. The owner is notified by the lender and contacts the broker who provides funds to cover the loan payment.
However, when the rents and security deposits collected from his client were deposited into his general account rather than into a trust account, the broker illegally commingled the owner’s funds with the broker’s personal funds – even though a subaccount ledger for the client’s trust funds was maintained.
Also, withdrawal of the brokerage fee before paying all other obligations the broker agreed to disburse on behalf of the owner is a conversion of the client’s funds to the broker’s own use, a breach of the agency duties owed to the client. The brokerage/management fee is to be paid last, after agreed-to services have been performed, including all authorized disbursements.
Further, the broker misrepresented the availability of immediate funds (a fraud which is grounds for the revocation or suspension of the broker’s license) by writing a check for the loan payment when he knew there were insufficient funds in the account to cover the check. [Apollo Estates, Inc. v. Department of Real Estate (1985) 174 CA3d 625]
Consider a broker who maintains a brokerage trust account that holds loan payments received by the broker while servicing loans on behalf of trust deed investors.
The broker pledges the trust account to secure a personal loan from the same bank that holds the trust account.
The broker defaults on the loan, and the bank seizes the trust account funds.
An investor seeks to recover his trust account funds from the bank, claiming the bank’s seizure of the funds is a conversion since trust funds cannot be taken to satisfy the broker’s personal debt.
The bank claims the seizure of the trust account is not a conversion since the bank exercised its right to an offset under the security agreement.
Is the investor entitled to recover his portion of the trust funds?
Yes! The trust funds belong to the investor and must be returned. The bank’s right to an offset for the broker’s personal debt to the bank does not extend to seizure of funds held for others in the broker’s trust account. [Chazen v. Centennial Bank (1998) 61 CA4th 532]
Handling cash and checks
Funds received in the form of cash or checks made payable to the broker while acting as an agent in a transaction are trust funds and must be:
| The broker must regularly account to the owner on the status, expenditure and location of the trust funds. |
Further, the broker has a duty to secure trust funds that are not in the form of cash or checks, such as gems, coins, notes or other personal property, from loss or damage after he receives them. Such nonnegotiable types of trust funds cannot be deposited in a bank account. Thus, the broker should place the nonnegotiable items in a safe or safe-deposit box for safekeeping until they are delivered to others.
Checks or cash received which are trust funds may only be used for expenditures authorized and incurred for the benefit of the owner of the funds.
Further, the broker must regularly account to the owner on the status, expenditure and location of the trust funds, called an owner’s statement.
Prior to the end of the third business day following the day the broker receives trust funds in the form of cash or checks, the broker, unless instructed in writing to the contrary, must deposit the funds:
- with the person or escrow depository entitled to the funds (as payee or by endorsement); or
- in a trust account maintained by the broker at a bank or other state-recognized depository. [B & P C §10145; Department of Real Estate Regulation §2832(a)]
Also, when an agent of the broker accepts trust funds on behalf of the broker, the agent must immediately deliver the funds to the broker, unless directed by the broker to:
- deliver the trust funds to the person or the escrow entitled to the funds; or
- deposit the trust funds in the broker’s trust account. [B & P C §10145(c)]
For example, when a broker negotiates the purchase or lease of real estate, he usually receives a check as a good faith deposit on an offer to purchase or lease.
The broker may hold the check undeposited until an event occurs, such as the offer is accepted or escrow is opened, if:
- the check is made payable to someone other than the broker; or
- the check is made payable to the broker with written instructions, typically from the buyer or tenant, to hold the check undeposited until acceptance of the offer or escrow is opened; and
- the person to whom the offer is submitted, usually the seller or landlord, is informed the check for the good faith deposit is being held by the broker when the offer is submitted. [DRE Reg. §2832(c)]
The instructions to hold the check undeposited until acceptance are included in the terms for receipt of the deposit contained in the offer to purchase or lease.
Also, after a buyer’s offer is accepted, the broker may continue to hold the buyer’s check for the good faith money instead of depositing it if the seller gives the broker written instructions to hold the check undeposited.
However, without instructions to further retain the check undeposited, the broker must deposit or deliver the funds by the end of the next business day after acceptance:
- to the payee entitled to the funds, such as a title company or escrow;
- into the broker’s trust account at a bank or other state-recognized depository, such as a thrift; or
- to an escrow depository on the broker’s endorsement, if the broker is the payee and does not want to deposit and disburse from his trust account to escrow. [DRE Reg. §2832]
Identifying the owner
A broker must at all times know who owns and controls the funds held in his trust account. Trust funds can only be disbursed on the authorization of the owner of the funds. Subaccount ledgers are set up to identify the owner of the funds and the amount held for the owner.
However, persons other than the owner of the trust funds may have an interest in the funds. If so, their authorization is also required to withdraw the funds.
For example, a buyer issues a check payable to a broker as a good faith deposit on an offer to purchase. The purchase agreement contains instructions to hold the check undeposited until acceptance of the offer.
The seller accepts the buyer’s offer and the broker correctly deposits the check into his trust account as funds held on behalf of and owned by the buyer.
A broker must at all times know who owns and controls the funds held in his trust account. | The buyer is unable to obtain a purchase-assist loan to fund the purchase. The buyer cancels the transaction, consistent with the loan contingency provision in the purchase agreement. However, the seller does not sign cancellation instructions or any other instructions to authorize the return of the buyer’s deposit. |
The buyer then makes an offer to purchase real estate owned by another seller, which is accepted.
To obtain funds to close escrow on the second transaction, the buyer makes a demand on the broker to transfer the buyer’s good faith deposit on the first transaction from the trust account to the escrow handling the second transaction. The broker refuses to withdraw the buyer’s good faith deposit from his trust account without further instructions from the seller under the purchase agreement cancelled by the buyer.
Did the broker act correctly when retaining the buyer’s good faith deposit?
Yes! When a buyer’s offer, which includes receipt of a good faith deposit, is accepted by a seller and the buyer’s good faith deposit is placed in the broker’s trust fund account (or the purchase escrow), the buyer’s funds may not be withdrawn without written authorization signed by both the buyer and seller. If funds are disbursed without mutual instructions, the broker is liable to the seller for losses due to an improper release of funds. [Mullen v. Department of Real Estate (1988) 204 CA3d 295]
Advanced costs are trust funds
A borrower retains a broker to assist in locating a lender who will make a loan to finance the acquisition of real estate. The borrower and broker enter into an exclusive right-to-borrow listing agreement.
The listing agreement assures the broker he will receive a brokerage fee when the loan he was employed to negotiate is placed with a lender.
The broker includes an advance cost addendum as an attachment to the listing. The addendum calls for the borrower to advance funds to cover itemized costs, such as an appraisal and credit reports, which will be incurred by the broker while arranging a loan to be secured by the property the borrower seeks to buy. The advanced costs are separate and unrelated to payment of the broker’s fee.
The borrower issues a check payable to the broker for the amount of costs the borrower has agreed to cover.
Can the broker deposit into his general business account part or all of the funds advanced by the borrower to cover costs which are yet to be incurred?
No! Funds received by the broker as an advance for costs to be incurred in the future are trust funds. They are held to pay the agreed-to costs in the advance cost addendum attached to the listing agreement.
As trust funds, they will be deposited by the broker in a trust account, separate from the account established to hold the broker’s personal or business funds. [B & P C §10145]
