Trust Funds, Escrow, and the Client's Money

PrepPass · Real Estate Broker Exam — National Portion · Chapter 2

Introduction

As a salesperson you held other people's money for about ninety seconds. A buyer handed you a check, you carried it to the office, and someone else deposited, posted, and reconciled it. If the month-end figures did not tie, that was a problem above you.

That is over. The trust account is now opened in your firm's name, under your license. When the bank balance and the ledgers disagree by fourteen hundred dollars, no one else will find the difference, restore it, or explain it to an investigator. The licensing authority calls you, and the fact that a bookkeeper made the entry will not move the conversation an inch.

The complaints that end brokerage careers have a family resemblance: a shortage nobody caught, a transfer that was supposed to be temporary, a deposit released to the side of a dispute the broker privately thought was right. The rules are not complicated; what is hard is running an office where they are followed on a Friday afternoon when payroll is due. Your exam tests this at the broker's altitude — not what earnest money is, but which of four items received in one week are trust funds, what to call a withdrawal the broker meant to replace, and who answers when an employee errs.

Learning objectives

After this chapter you should be able to:

• Identify which funds coming into the firm are trust funds and which are the firm's own income.
• Distinguish commingling from conversion and apply each to a fact pattern.
• Explain the narrow exception permitting a limited amount of the broker's own funds in trust.
• Perform and interpret a three-way reconciliation and diagnose what each mismatch means.
• Handle a disputed deposit lawfully, including the role of interpleader.
• Apply trust-fund rules to rents, security deposits, and unlicensed on-site staff.
• Separate the national principle from the figure or deadline your state sets.

Part A — What is a trust fund

A trust fund is money belonging to someone else that comes into your firm's hands in the course of the real estate business. That definition, not the label on the check, decides the question. Earnest money qualifies. So does a tenant's rent, a tenant's security deposit, and an owner's advance for a repair you have not made yet. Ownership creates trust status; no court order and no client instruction is required to bring it into being. Such money must reach the trust account promptly, and the number of days you have is set by your state.

The mirror image matters as much. A commission your firm has earned, or a franchise rebate received for its own account, is not a trust fund; it is firm income and belongs in the operating account. Depositing your own earned money into trust is commingling running the other way, and examiners charge it as readily.

Broker-level distinction: The tested question is rarely "is earnest money a trust fund." It is a mixed week — earnest money, a tenant's rent, an owner's repair advance, a rebate the firm earned — and you must sort four items, not recognize one.

The fiduciary duty of accounting is broader than the trust account. It reaches everything of value the client entrusts to the firm: funds, but also signed documents, instruments, and the keys in your lockbox drawer. The duty is affirmative — maintain the records and report without waiting to be asked, and certainly without waiting for a written request.

Part B — Commingling versus conversion

Keep these two words apart: the exam pays for the distinction and regulators punish them differently.

Commingling is mixing trust funds with the broker's own operating or personal funds. The classic fact pattern is innocent: an earnest money check deposited to the operating account by mistake. Nothing was spent, nobody profited, and it is still a violation. That is why offices build procedures — a single intake point, a receipt log, a deposit route that never touches the operating account.

Conversion is actually using trust funds for the broker's own benefit. Withdrawing $2,000 from trust to make payroll, fully intending to replace it next week, is conversion: not commingling, because the money was spent rather than merely mixed, and not a bookkeeping error, because the withdrawal was deliberate. An intention to repay is no defense. Prompt restoration may soften the sanction but does not undo the violation, and in the meantime a beneficiary's money is gone. Conversion draws the harshest discipline available.

One narrow exception is worth a question. Regulators commonly allow a broker to keep a small, documented amount of the broker's own money in the trust account to cover bank service charges or meet the bank's minimum balance, and that is not commingling. The permitted amount is set by your state. Two traps sit on either side: treating every personal dollar there as conversion overstates the rule, while parking a month of operating expenses there is the abuse the exception was written to prevent. No client waiver can authorize what the rules do not permit.

Part C — Records that survive an audit

The three-way reconciliation

Audit-ready trust records rest on a routine reconciliation that ties three figures to the same number:

1. The bank statement balance, adjusted for outstanding checks and deposits in transit.
2. The broker's control or checkbook balance — what your own books say the account holds.
3. The sum of all individual beneficiary ledgers — what the people you hold for are owed.

Each leg answers a different question, which is why two figures are not enough. Bank against book tests whether your records match the outside world; a mismatch there is normally timing — a check not yet presented, a deposit not yet credited — or a bank error. Book against ledgers tests whether the money has an owner; a mismatch there is a posting error or a real shortage, and no amount of bank reconciling will surface it. Bank against ledgers is what the examiner cares about: is there enough in the account to pay everyone who is owed?

A ledger per beneficiary

You need a separate ledger for each beneficiary — each buyer whose deposit you hold, each owner whose rents you collect — showing every receipt and disbursement for that person. One combined ledger of the account's running balance is the classic wrong answer: it shows the account but never who owns what, so a shortage in one client's money hides behind another's. A ledger per property is no better, because ownership rather than the building defines the beneficiary. Filing bank statements inside transaction folders scatters the record and defeats reconciliation.

How often you reconcile, who may sign on the account, and how long you keep the records are all set by your state.

Delegation is not delegation of accountability

An office bookkeeper posts a deposit to the wrong client ledger and one beneficiary is short at month end. The bookkeeper is not the regulator's licensee. You are. The account is yours, the shortage is yours to restore, and delegating the entry never delegated the accountability. Lack of intent may soften discipline; it does not excuse a shortage in a client's money — which is why a broker reviews the reconciliation personally rather than initialing a summary.

Producing records in an audit

A routine trust-account audit follows the office rule set out in Chapter 1: you produce the records, without a subpoena and without client consent. Calling counsel when a matter turns serious is sensible; withholding records until he arrives is not.

Part D — Disputed money

A deal collapses and both parties demand the deposit. Your position is fixed: you never decide the dispute and you never pick a side. The funds stay in trust until the parties sign a written release, a court orders release, or another lawful route resolves it.

Interpleader is that route where it is available: you deposit the disputed funds with a court, name the competing claimants, and step out of the fight, leaving the parties to litigate their own contract. Availability and procedure are set by your state.

Know why each alternative fails, because the exam offers all of them. Returning the money to whoever paid it decides the dispute for the buyer; splitting it evenly decides it on terms neither party agreed to; handing it to the party the listing agent believes is right substitutes your firm's judgment for the parties' written contract; and moving it to the operating account adds commingling to the pile.

Tested trap: In an ordinary closing the purchase contract controls how the deposit is applied — typically credited to the buyer — and it governs disposition if the deal fails. Not the seller, not the listing broker, not local custom. Commission is paid under the listing agreement out of the seller's proceeds; the listing broker has no claim on the deposit.

Part E — Property-management trust money

Rents and security deposits are trust funds held for others, so a firm with a management department runs a property-management trust account separate from the firm's own funds, with a ledger per owner. Whether those funds may share one trust account with sales deposits or must sit in an account of their own is set by your state. You remit according to the management agreement rather than taking your fee off the top of incoming rent.

The hardest instruction comes from a client. An owner short of cash tells you to wire the tenants' security deposits to his personal account. You refuse. Those deposits are neither his working capital nor yours, and sending them would be conversion. An indemnity agreement does not authorize it: your duty runs to the parties beneficially entitled to the money and to your state's trust-fund rules, not to a client's promise to make you whole. Sending part of each deposit is the same violation in smaller pieces.

Deposit caps, interest, holding location, and deduction and refund deadlines are all set by state law, which you follow rather than the client's instruction.

On-site managers who handle money — unlicensed where your state exempts them from licensure — must be trained, supervised, and in many places bonded, with every dollar routed into the firm's trust account rather than a personal or building account. An owner's own accountant auditing the books once a year does not discharge your recordkeeping duty.

Key rules to memorize

Set by your state, not by this chapter: deposit deadlines, reconciliation frequency, the permitted amount of broker funds in trust, who may sign, record-retention periods, interpleader availability and procedure, security-deposit caps, interest, holding location, deduction and refund deadlines, and bonding requirements for unlicensed staff.

Chapter recap

Trust status follows ownership of the money, not the label on the check. Commingling mixes; conversion spends. The three-way reconciliation proves both the account and the ownership of what is in it, and a ledger per beneficiary makes the third leg possible. When money is disputed, hold it; do not judge it. When an employee errs, the shortage is still yours to restore. Learn the principle in full and let your state-law chapter supply every number.