Commingling can easily happen in real estate whether you’re a fix-and-flip investor or a landlord. One of the most exciting things about investing is receiving funds from multiple sources. At the same, you have to be very careful with those funds.
So what is commingling in real estate, and is it legal? What are the things that you need to watch out for? Keep reading to understand the risks and learn how to protect yourself. In doing so, you can protect your business and your bottom line.
What Does Commingling Mean In Real Estate?
You may remember the word commingling from your local recycling program, in which case you would know that it means to mix or blend items together. In real estate, the term commingling takes on a more nuanced meaning.
The definition of commingling in real estate is the mixing or pooling of funds. These funds may be coming from different sources, or they may have been earmarked for different purposes. When running a business, it’s critical to understand where your funds are coming from and ensure that they are being used properly. This is especially true because there are cases where commingling in real estate could be illegal.
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Is Commingling Legal?
Commingling funds in real estate can be legal at times and illegal at times, depending on the situation and state laws. It’s recommended to consult a real estate attorney if you feel unsure regarding the legality of your financial activities. Below you will find explanations for when commingling in real estate is considered legal or illegal.
Legal Commingling
Commingling is most likely legal when the pooling or mixing of funds is intentional. For example, several investors might pool personal funds to invest in a single property. This is a common example of legal commingling.
Another legal example of commingling is when individual investors invest in a real estate investment trust (REIT) or a crowdfunding project. In each of these examples, the individuals providing funds are aware that their funds are being commingled and for what purpose.
When legal, commingling in real estate can be a great advantage. It can allow investors to:
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Own a piece of a passive income investment
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Diversify their investments across multiple properties
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Access more investment options than if they had invested alone
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Strike partnerships on larger projects with expanded potential
Illegal Commingling
Commingling funds can be a boon in real estate and often perfectly legal. However, it can quickly become illegal if you’re not careful. Illegal commingling most frequently occurs through honest mistakes in rental property investing.
Examples of illegal commingling in real estate include:
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Depositing security deposit checks into your personal bank account
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Depositing personal income or business funds into the designated trust account that holds tenant security deposit funds
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Transferring or withdrawing funds from the trust account for any purpose other than refunding a security deposit
Why are these financial activities examples of illegal commingling? We’ll expand on this next.
Commingling Real Estate Example
The unintentional mixing of security deposit funds with rental income is the most common example of illegal commingling in real estate.
When a landlord rents out a unit to a tenant, the tenant will pay the landlord a security deposit plus monthly rent. If the landlord deposits all of these funds into the same account, they are making a mistake. This is because the tenant has given the security deposit to the landlord as their fiduciary. They have a legal responsibility to take care of the funds and not use it for personal expenses.
When the tenant moves out, the landlord will owe them their security deposit less the cost of any repairs. The funds should be taken out of the designated fiduciary account. For accounting purposes, the security deposit should be treated as liability and not as income.
If you plan on owning and operating any income-generating properties, you are legally obligated to understand your state landlord-tenant laws. Some states require that you create a fiduciary account to hold security deposit payments. Other states do not require this, but it’s still a good idea to create a separate account to curtail any possibility of being accused of illegal commingling.
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Commingling Real Estate vs. Conversion in Real Estate
Note that there is a distinction between commingling and conversion in real estate. Commingling is the act of mixing funds together, and conversion refers to the act of using funds for a purpose other than what they were originally intended for.
For example, if the landlord were to deposit security deposit funds into the same bank account that holds his rental income, they would be commingling funds. If the landlord were then to take those funds and use them to replace the property’s roof, that would be an example of conversion.
In this example, the commingling of funds would be illegal and frowned upon. Luckily, the landlord could still course-correct and move the security deposit funds into a fiduciary account. However, if the landlord were to use the funds, then he would be committing theft. While inappropriate commingling is not good, conversion is even worse and should be avoided at all costs.
How To Avoid Commingling In Real Estate
The surest way of avoiding commingling in real estate is to consult a real estate attorney and follow their advice. Otherwise, the golden rule is to always keep investment and business funds completely separate from your personal funds. That way, there is no danger that you would inadvertently spend investment funds to pay for personal items.
Here are some strategies to help you avoid commingling in real estate:
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Set up an LLC for each of your investment properties to create separation between your personal and business assets
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Open up a bank account and credit card for each rental property that you own, and only pay for expenses for each property using their respective account or card
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Set up a separate trust account to hold security deposits separately from personal and business accounts
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Never use business funds to pay for personal expenses
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Conduct property bookkeeping for all of your business transactions and maintain a paper trail for each transaction
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Review your property income, cash flow, and expenses regularly to check for any errors
Summary
Commingling real estate funds is something that can happen easily. There are certain cases in which it is perfectly legal, while it can be illegal in other cases. The onus is upon you to understand your state laws and conduct proper business ethics and bookkeeping. The best way to protect yourself is to always keep your personal expenses separate from your business expenses. Further, don’t mix business funds if they are intended to be used for different purposes. If you own any rental properties, the most common thing to avoid is inadvertently mixing security deposit funds with your rent checks. Always keep these funds separate as they are intended for different uses. If ever in doubt, review your local tenant-landlord laws and consult an attorney.
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