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19th November 2019

Tools of the trade: Rent Deposits

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Rent deposits for commercial leases are a useful tool for a landlord. Usually a cash sum deposited with the landlord for a minimum period and sometimes for the entire term of the lease, they provide a safety net against breaches by tenants. Although known as a “rent deposit” the agreement will usually allow the deposit to be used to cover other losses incurred by the landlord as a consequence of the tenant’s breaches of any obligations in the lease such as disrepair, failure to decorate, etc.

When taking a deposit, there are a few things to consider:

  • How much. If a landlord takes a sum equivalent to 3 months’ rent then that will cover one quarter’s rent payment if the tenant fails to pay the rent, but it may not cover service charge, insurance or for any dilapidations which the tenant is liable to pay if they leave the property in poor repair or fail to reinstate alterations which have been carried out.
  • Add VAT. Although VAT is not payable on a deposit sum (there is no taxable supply at this point) it is important to add a sum equal to VAT so that at the point where a landlord needs to make a deduction the money is there to pay for the VAT (if the landlord has opted to tax). Even if no option has been made the rent deposit needs to allow for a top up if the landlord opts to tax in future, and also in the event that the VAT rate increases. Deposits generally do not provide for the return of any monies if the VAT rate decreases.
  • When it is to be returned. This point is up for negotiation between the landlord and tenant. With an untested tenant the landlord may want to keep the deposit in place for the duration of the lease – this is the best way to protect a landlord against a potential claim for dilapidations at the end of the term of the lease. The parties could agree a partial return of the deposit if there has been continued compliance with lease terms. There are also other relatively standard formulae for calculating an early return date including one which is linked to the tenant producing accounts showing consistent net profits year on year.
  • Interest.
    If using a standard type of rent deposit which charges the sum held as a deposit, the money belongs to the tenant (even if held by the landlord), and so does the interest. Whilst interest rates are very low at the moment landlords need to consider whether they wish to be obliged to place the money in an interest-bearing account (there may be costs involved) and how often interest is to be paid out. Tax on the interest is to be paid by the tenant.
  • Notice.
    A tenant will usually want to be given notice before a deduction is to be made from the account. This is an additional administrative burden on the landlord and can cause delay but it would also allow the tenant to make a payment in the meantime in case it was not aware of the of the sum owed.
  • Topping up the deposit. A landlord will want to include provisions to require the tenant to make good the shortfall if any sums are withdrawn from the rent deposit whilst the lease is continuing and to require this to be increased following rent review.
  • Costs. The landlord will want to make provision to cover the costs of notices under the deposit arrangement and to deduct bank charges.
  • Bank mandate. The bank must be informed if the monies deposited with them belong to the tenant. This is important to ensure that monies are not claimed in an insolvency of the landlord.

Whilst the deposit provides the landlord with a pot of money to which the landlord has relatively easy access, it isn’t all plain sailing. Numerous complications can arise where a lease is assigned or where the landlord’s interest is sold.

Where there is an assignment of the lease a landlord will usually be obliged to return the deposit to the assignor. If the landlord then requires a deposit from the assignee quite often the landlord will keep hold of the monies in the account and a transaction will happen in the background whereby the equivalent sum is passed from the assignee (the new tenant) to the assignor (outgoing tenant) as compensation for not receiving the monies from the landlord. If this is done then it is important that the landlord obtains a receipt from the assignor acknowledging that they have received the sum by way of compliance with the landlord’s obligation, otherwise there is little or no proof that this obligation has been complied with.

On the sale of the landlord’s interest the obligations of the landlord under a rent deposit deed will pass to a buyer of that interest. For technical reasons it is good practice to enter into a deed of covenant so that the buyer agrees to abide by the terms of the rent deposit, the benefit of the charge created by the rent deposit deed is assigned to the buyer and also to obtain a release from the tenant for the outgoing landlord. This will help to clarify the obligations of the parties.

If you are buying an investment property where there is a rent deposit deed in place it is important to check that the seller has complied with its obligations before completion, a buyer does not want a claim from the tenant after completion that it is owed interest which has not been paid or that it has not received a partial refund which was due under the terms of the deposit.

It is important to note that this note only applies to leases of commercial premises. In the case of residential tenancies, there are detailed statutory regulations which must be complied with and limits on the amount of deposit that can be demanded.

For more information on the items discussed in this article please contact Susanne Hinde by clicking here.