Economics Should Determine Security Deposit Decisions

The resident moved out, but still owes a balance.  You send out the security deposit disposition informing the resident that you will be withholding the full deposit.  The resident disputes the charges by sending you a seven day demand letter.  This scenario is played out countless times.  Because resident demands for the return of security deposits is a common scenario, onsite personnel need to be highly proficient in handling and evaluating a resident’s demand for the return of a security deposit.  Analyzing the economics of security deposit refund demands is the key to properly evaluating these claims.

Security deposit economics are all about getting on the right side of zero.  Your right side of zero is when the resident owes above and beyond the security deposit (debit balance after applying the deposit).  Your wrong side of zero is a credit balance for the resident.  If the court finds that the resident has a debit balance after applying the deposit, you win.  If the court finds that the resident has a credit balance before some or all of the deposit needs to be applied, you lose.  For example, if the resident has a $175 deposit and owes three months rent of $950, the resident is still going to owe after application of the deposit.  In a case where the resident is so far away from a credit balance (an entitlement to a security deposit refund), you have little to no risk in withholding the deposit.

If we change the facts, this risk can shift or increase significantly.  For example, the resident’s deposit is $500, but you withhold the entire amount because you claim the resident didn’t give proper notice.  Based on this, you claim a month’s rent, withhold the entire deposit, and claim the resident owes you $450 on top of the deposit.  The resident claims that he did give proper notice and thus doesn’t owe the $950.  If the court finds that the resident did give proper notice, the bottom line on the resident’s ledger goes from a -$450 balance owed to a $500 credit.  The court’s finding that you received proper notice has dramatically altered the outcome of the case.  Now instead of the resident owing you $450, you owe the resident $1500 ($500 x 3), plus you may have to pay the resident’s attorney another $4000 in fees, for a total downside of $5500, over keeping a $500 deposit.

You will never be surprised by this type of outcome if you ask yourself the right questions before you’re in a lawsuit.  In this case, you should have asked “if the judge rules against us on the notice issue, what is the worst possible outcome for the property”?  If this question had been asked, then you would have known the answer was $5,500.  At least at that point, when deciding whether or not to take the risk, you will know how much you are risking.  In evaluating a resident security deposit demand, you have to review each and every line item on the disposition.  If enough line items are above challenge and when added together result in a debit balance even after crediting the deposit, the risk of keeping the deposit is small.  Anytime it’s possible to end up on wrong side of zero (resident has credit balance), you should proceed with caution.  The chances of being on the wrong side of zero are much greater with large deposits, and when one or more large line items are factually disputed, and thus will be determined by the judge.

Security deposit economics are simple.  If you win a security deposit case, you get to keep the deposit, plus any amount the resident owed on top of the deposit.  If you lose a security deposit case, the resident may win three times the amount of the deposit, plus attorneys’ fees and court costs.  Your potential liability for three times the security deposit and the resident’s attorneys’ fees is triggered when the resident sends you a seven day demand letter.  At that point, if you don’t refund the deposit within seven days, Colorado law makes you liable for three times the deposit plus the resident’s attorneys fees if you lose in court.

Property managers either aren’t aware or tend to minimize the impact of attorneys’ fees on the economics of security deposit litigation analysis.  This is a mistake.  If you lose in court, the property could easily be paying the resident’s attorney $4,000 or more in a security deposit case.  If the resident’s deposit is $175, your downside isn’t 3 x $175, or $525.  Rather, the worst case nightmare scenario is $4,525 when attorneys’ fees are properly considered.  If you receive a seven day demand, you should consider all options and possible scenarios.

If you receive a seven day demand for return of a deposit, you have several options.  One, refuse to return the deposit.  You should do this only after you have carefully evaluated the potential risk of being on the wrong side of zero.  Two, return the deposit within seven days, and write off any balance.  You may want to exercise this option for small balances owed.  Your time is worth a lot.  If the resident owes $125, you’re probably better off writing it off then spending six hours in court over $125.  Third, you can return the full deposit within seven days, but you can still sue the resident if you contend that the resident owes you a balance.

Many managers don’t know that they can return the deposit within the seven day period to avoid treble damages, and still sue for damages.  The disadvantage of this option is that you have to give up the money, and then chase the resident.  The advantage of this option is that it significantly lowers your financial risk and makes the economics of the case more favorable to you.  In the example discussed above, if the $500 deposit was returned, and you tried to collect the $950 for improper notice and lost, you simply lose the case.  You’re not out the $1500 on a security deposit claim.  More significantly, you’re also probably not going to get stuck for $4,000 in attorneys fees.  Since you returned the deposit, there is no security deposit case for an attorney to get involved in.  The resident might get attorneys’ fees under your lease, but residents are much less likely to have attorneys in collection cases as opposed to security deposit cases.  In short, by exercising this option, your risk was reduced from a $5500 loss to just not being awarded $950.

Don’t increase your financial exposure by failing to timely respond to a resident’s security deposit refund demand.  Take seven day demand letters seriously.  Unfortunately, all too often clients forward the seven day demand letters to us after the deadline has expired.  Not responding to a seven day demand within the time frame can severely limit your options.  In some cases where the deposit should have been returned, we have been successful in getting the resident to accept the deposit amount.  However, once the seven days expires, the resident or his attorney can hold your feet to the fire, and insist on nothing less than 3x the deposit amount.  This is Colorado law.  Don’t put yourself at the mercy of the resident or his attorney.  You should always timely deal with seven day security deposit demand letters.

Similarly, for various reasons, many management companies have procedures that make it difficult to return a deposit within seven days of demand by a resident.  Again, if the resident sends you a seven day demand letter, and you don’t return the deposit within seven days, you now are potentially liable for treble damages and attorneys’ fees.  At this point, you only have two options.  One, litigate the case in court.  Two, pay the resident the deposit.  Again, you are now at the mercy of the resident or his attorney, and the resident can insist on three times the deposit amount in order to go away.  To avoid this situation, you should review your ability to rapidly generate a check and return a deposit.  Specifically, could you generate a check and return a deposit within a day or two if you had to?

Finally, always remember that under the security deposit statute you have the burden of proof.  You must prove that your retention of the resident’s security deposit is justified.  If there are significant charges make sure that you collect and preserve the evidence.  If the carpet is destroyed, cut out a few representative samples of the cigarette burns or wine stains, and photograph the rest. In security deposit litigation, pictures are worth a thousand words.  In today’s digital age, all onsite managers should have a camera to document damage to units.  Similar to onsite personnel, vendors deal with a large number of units.  The likelihood of the carpet vendor remembering a specific job two years ago is slight.  If the resident destroyed the carpet, your carpet vendor replacing the carpet should document in writing his professional opinion as to why the carpet had to be replaced.  This writing can later be used to refresh the carpet vendor’s memory, and is much more powerful evidence than a simple invoice and vague testimony that he replaced the carpet.

View Resource »