What You Need to Know about Commingling in Real Estate
There are two different ways to define commingling within real estate: One, through the eyes of the agent or broker, and two, from the perspective of a real estate investor or a regular person. In this article, we will break down each definition, define what is legal and what is not, and of course, cover what you need to know on your real estate exam.
What is Commingling in Real Estate?
In real estate, commingling refers to the act of mixing the client’s funds with the broker’s own funds. Commingling can be both legal and illegal depending on the state and circumstance. Typically, from an agent’s perspective, commingling should be avoided at all costs. In fact, in most states, a licensee or broker who is found guilty of commingling their client’s funds with their business account or personal money might have their license suspended or revoked. Commingling can be legal in some circumstances, which we will cover later, but in most cases, as an agent or a broker, it’s best to avoid it.
What are Commingled Real Estate Funds?
Generally speaking, commingled funds are the funds commingled in real estate. From an agent’s perspective those funds are best defined as personal funds mixed with client’s funds. In most cases, this technique is regarded as a breach of your fiduciary duty and a type of fraud.
In real estate investing, commingled real estate funds are funds managers mixed from many sources to invest. With the provided funds, the fund purchases and administers properties directly. Value-add and opportunity funds, both of which pursue high-yield objectives, are subsets of commingled funds.
What is Commingling in Real Estate Investing?
If you choose to invest in real estate, commingling is the process of pooling investor assets into a single fund or investment entity. Most investment funds have commingling as a key component. A commingled fund is when a fiduciary or investment manager invests money from numerous customers into a single fund or group of investments simultaneously; this can be with or without other investors. Other examples include real estate investment trusts (REIT), crowdfunding, mutual funds, and pension funds.
In these situations for real estate investors, the fiduciary has the authority to commingle monies for the client’s advantage. Depending on the asset, buying more significant volumes of investment at one time can result in lower trading expenses or better pricing. If you decide to invest in a real estate property with others, there’s a good chance your investment will be classified as a security, which means you’ll have to comply with specific Securities and Exchange Commission requirements (SEC).
To eliminate the danger of commingling, some investors have been known to store their cash and mutual funds in dedicated escrow accounts or trust accounts managed by a third party, such as investment managers. For each of their properties, some investors open separate bank accounts. There is no ratio of personal funds to investment funds that you can reach that will make it lawful or assist you in any way when tax time comes around. Because of the restrictions that govern real estate investments, it just isn’t done.
Is Commingling in Real Estate Legal?
From an agent’s or broker’s perspective, commingling can be legal or illegal depending on the state and circumstance. For example, in Pennsylvania, it is illegal to commingle funds that are required to to be held in an escrow or interest bearing account. Take a quick look at the state code here:
“A broker may not commingle money that is required to be held in escrow-or interest earned on an escrow account-with business, personal or other funds.” Per 49 Pa. Code § 35.326.
So then, what is legal? Well, there are many legal uses for commingling funds. For example, it is perfectly legal to establish a commingled fund for a group of business partners that put their own money into a joint account to start or manage a company. Another example of legal commingling funds is when a couple joins into a marriage with one partner owning a home before the marriage, but both partners pay the mortgage out of a joint bank account. This uses each partner’s personal funds in the real estate transaction and is legal.
So is it legal or illegal? Generally speaking, commingling in real estate is lawful for real estate investing and ordinary circumstances. It is not permitted for most brokers or agents because they have a set of fiduciary duties they must uphold. Remember, brokers and agents, are acting under a set of codes and have to follow them strictly.
So how do you tell the difference? Well, it’s best to double, sometimes triple check your state-specific license law. In our case, since most of our readers are studying to become real estate agents, it’s critical to make sure you understand what’s legal in your state.
Commingling Real Estate Examples
Other than the examples listed before, there’s one textbook example we have to talk about; the concept of a security deposit. When a landlord deposits a tenant’s rental security deposit in the same bank account as the landlord’s personal account that is commingling funds. The deposit serves as a guarantee that the tenant will pay the rent in whole and on time, will not damage the property beyond regular wear and tear, and will follow the lease’s terms and conditions.
In this example, the fiduciary is the person who receives the money, and the client is the one who gives the money. Since the landlord of the rental property now has control of the client’s money, the landlord has a fiduciary responsibility to the renter to appropriately care for the security deposit and not use it for personal expenses. The security deposit should be refunded to the tenant at the end of the lease if the tenant fulfills all of their obligations.
Illegal commingling may occur when a tenant’s rental security deposit is used for personal purchases. Ideally, a landlord should have two separate funds, one for their renters security deposits and another for business related transactions (rent, repairs, etc).
What is the Difference Between Commingling and Conversion?
While commingling relates to how money is placed on behalf of the client by the fiduciary, conversion refers to the act of using the client’s money for anything other than what it was intended for. Conversion is a type of theft that occurs when a fiduciary lawfully accepts funds from a client and then utilizes those assets for the fiduciary’s personal or company purposes without the client’s approval.
Commingling can lead to theft by conversion if money is legally acquired from a person and then spent on something other than what it intended. Commingling funds go hand in hand with conversion if someone is not mindful of what they are doing. If one chooses to use the money they have received and chooses to spend it on, let’s say, a car payment, they are engaging in the act of conversion.
So in short; commingling refers to the act of mixing client’s funds with the broker’s own funds. Conversion is the unlawful misappropriation and use of a client’s funds by a licensee, see the difference? If your state allows commingling, and you misappropriate the funds that’s conversion. Its worth mentioning, both illegal commingling and conversation and lead to criminal penalties and severe consequences.
How to Avoid Commingling in Real Estate
To ensure you are avoiding commingling funds, it is important that the pooled monies are kept separate from your personal funds. Do not use your business account to pay for personal items, such as transferring money regularly between your personal and bank accounts without keeping track of it.
While you can fix this by refunding the account or appropriately categorizing the transaction in your bookkeeping software, it can develop into a harmful habit that, if left untreated, might be classified as commingling. While having a separate account for each investment property may not be necessary, you should ensure the money doesn’t get mixed up with your regular business or personal accounts.
It’s also critical to keep meticulous records. Any claims for commingled money should be disproved by proper bookkeeping records indicating deposits and payments made to or from the account.
What to Know for the Exam
Determining what is classified as legal commingling and what is not is essential for the exam and your future real estate career. Remember, commingling can mean different things depending on your state, your fiduciary relationship, and more. It’s best to be familiar with what is legal in your circumstance and always double-check with a lawyer, law expert, or real estate broker, if you have any doubts. Know this, and you’ll be successful come exam day and in your future real estate endeavors.