How to Handle Interest on Security Deposits

As an assisted site owner or manager, you must collect security deposits from all households when they move in. The security deposit is a dollar amount that’s intended to protect you by covering damage to the premises beyond normal wear and tear, and by cushioning the financial blow if a resident skips out early on the lease without paying.

However, handling security deposits incorrectly can cost you. HUD imposes strict requirements on how you collect and maintain security deposits. Once collected, what happens to these security deposits depends on the type of site you own or manage. Specific sites of various housing programs must place the security deposits in interest-bearing accounts and the Handbook details the rules on how to calculate and handle the interest.

When HUD auditors visit your site, they will check that you have followed all of these rules. If you haven’t, you could be charged with serious offenses, such as “equity skimming” and “misappropriation of funds.” Disregarding the rules will result in fines and court-awarded damages—sometimes double or triple the amount of interest you owe—along with attorney’s fees and court costs.

To help you avoid trouble with HUD and the courts, we’ll tell you which sites HUD says must pay interest on security deposits and how to comply if you’re one of them. And we’ll tell you which sites get to keep the interest and deposit it into site accounts.

Amount of Security Deposit

It’s first important to know the security deposit amount that should be collected from the household. The deposit you can charge to your residents depends on several factors, including the type of assisted site involved, the date the housing assistance payment (AHAP or HAP) contract was signed, and the amount of the resident’s total payment. We’ve provided a chart, Amount of Security Deposit to Collect from Resident (see link at the end of the article), that lists all the HUD housing programs and the security deposits you should charge for the different types of assisted sites.

Payment of Security Deposit Interest Required

Once the security deposit is collected, where are you supposed to deposit it? Keep in mind that owners must comply with state and local law as well as HUD rules regarding interest on security deposit accounts.

This can be tricky because the rules differ for the various types of assisted sites and conflicts may arise. Each state and many municipalities have their own rules regarding security deposits and whether they go into interest-bearing accounts.

According to the Handbook, whichever rule is most beneficial to the resident is the one that prevails. Owners must comply with any state and local laws regarding investment of security deposits and distribution of any interest earned thereon. And if state law is silent, or if HUD regulations are more demanding, owners must comply with HUD’s regulations [Handbook 4350.3, par. 6-17(A)].

In addition, interest to the tenants must be computed in accordance with state or local law. When state or local law is silent, the actual rate earned on the security deposits must be computed and credited to each tenant’s portion of the security deposit [Handbook 4350.3, par. 6-17(A)].

HUD rules require the following sites to invest security deposits in an interest-bearing account and pay the accrued interest to households at move-out [Handbook 4350.3, par. 6-17(A)]:

• Section 8 New Construction with AHAP executed on or after Nov. 5, 1979;
• Section 8 Substantial Rehabilitation with AHAP executed on or after Feb. 20, 1980;
• Section 202/8 sites;
• Section 202 PAC sites;
• Section 202 PRAC sites; and
• Section 811 PRAC sites.

Editor’s Note: The AHAP is the Agreement to enter into a Housing Assistance Payments contract. The purpose of the AHAP is to create a formal agreement between the housing authority and the site owner before construction begins. The AHAP gives the owner assurance that the housing authority will provide project-based vouchers when construction is completed, and it gives housing authorities assurance that the owner will follow all required federal regulations prior to and during construction.

Type of account. The security deposit must be kept in a bank account that’s separate from your site’s operating accounts and separate from the security deposits of other sites you own or manage [Handbook 4350.3, par. 6-17(B)].

In addition, the balance in the security deposit account may not exceed the FDIC insurance limit. Therefore, if you collect more than the FDIC limit in security deposit funds at a particular site, you will have to open security deposit accounts at more than one bank to ensure that the account balances remain below the FDIC limits. Also, because the security deposit account balance is constantly changing as residents move in and out throughout the year, you must remain watchful and make sure that the balance doesn’t go over the FDIC limit at any time [Handbook 4381.5, par. 6.47; Handbook 4370.2, par. 2-9].

How to calculate refund. If your site must pay interest on security deposits at move-out, take the following three steps to calculate the total security deposit refund:

Step #1: Calculate the interest earned on the deposit. HUD says you should compute the interest at the rate specified in state or local law. But if your state doesn’t specify an interest rate, compute interest using at least the passbook rate. If your state law requires you to pay households the interest periodically as it accrues during the tenancy (for instance, annually), then follow the state law on when to pay the interest.

For example, as of Jan. 1, 2014, the applicable interest rate on security deposits for renters in Chicago and Evanston, Ill., is .013 percent. The rate of interest applies to all residential rental agreements that become effective on or after Jan. 1, 2014. Interest on security deposits must be paid in cash or credited to the rent each and every year. In addition, the City of Chicago code requires that a general summary of the Residential Landlord Tenant Ordinance (RLTO) and a separate summary on security deposits, including the required rate of interest, be attached to each newly executed 2014 lease.

Also, when you calculate the interest depends on what type of site you own or manage. HUD requires Section 202/8 and Section 202 PAC sites to keep a record of the amount of interest attributable to each resident and allocate this interest to the resident’s security deposit balance annually, even if state law doesn’t require these sites to pay the interest annually [Handbook 4350.3, par. 6-17(C)]. HUD also says it’s a good idea for other sites to do this, but doesn’t require them to do so [Handbook 4350.3, par. 6-17(D)]. If these sites don’t allocate the interest to residents’ security deposit balances annually, they may do it when each resident moves out.

Step #2: Add the interest amount you calculated in Step #1 to the security deposit; and

Step #3: Subtract any unpaid rent or other permissible charges (such as late charges or damages) from the Step #2 total.

Section 202/8, Section 202 PAC, Section 202 PRAC, and Section 811 PRAC sites may deduct from the amount of accrued interest any administrative costs associated with computing the allocation of that interest to the resident’s security deposit account. But for Section 202/8 and Section 202 PAC sites, administrative costs may not exceed the accrued interest allocated to the resident’s balance for the year [Handbook 4350.3, par. 6-17(B)].

Payment of Security Deposit Interest Not Required

You don’t have to place security deposits in interest-bearing accounts if you own or manage any other HUD-insured or -assisted sites, including the following older Section 8 sites:

• Section 8 New Construction with an AHAP executed before Nov. 5, 1979;
• Section 8 Substantial Rehabilitation with an AHAP executed before Feb. 20, 1980; or
• Section 8 State Agency with an AHAP executed before Feb. 29, 1980.

But you may decide to place security deposits in interest-bearing accounts anyway, even though you don’t have to pay interest on security deposits to residents. That’s because HUD rules require all sites to keep security deposits in a separate bank account from operating funds. So it’s a good idea to place them in interest-bearing accounts so you can earn—and keep—interest on the deposits. HUD says sites that aren’t required to pay security deposit interest to households should deposit the interest earned into the site operating account each quarter.

How to calculate refund. In this case, merely subtract the amount of any unpaid rent or other permissible charges from the amount of the security deposit. You don’t need to include the interest earned on the deposit in the refund to the household.

It’s important to note, however, that even if HUD rules permit you to keep the interest on security deposits, you won’t be able to keep it if your state law says otherwise. Remember to follow your state’s law on investing and distributing interest on security deposits. Some states require sites to pay interest on security deposits to residents, either during the tenancy or when they refund the security deposit. Some states don’t require it, or require it only under certain conditions such as requiring payment of interest earned after the first five years of the tenancy, or requiring only larger sites to pay interest.

Check with your attorney on what the law in your state says about investing and distributing interest on security deposits.