Security deposits are considered property of the bankruptcy estate, and as such, are generally required to be returned to the debtor.  Even so,  landlords are permitted in certain instances to setoff their rejection damage claim against the security deposit.  This benefits a landlord for two reasons.  First, instead of returning the deposit to the debtor-tenant, a landlord can setoff its claim against the deposit, and thus reduce the amount of the deposit that must be returned.  Second,  the landlord’s rejection damage claim is a general unsecured claim, meaning it gets paid after all other types of claims under the Bankruptcy Code.  However,  the landlord’s rejection claim can be setoff against the security deposit “dollar for dollar,” which in essence raises the status of the rejection claim to secured status, up to the amount of the security deposit.

Landlords should not setoff any claims they have against the debtor-tenant’s deposit without first receiving an order from the bankruptcy court granting the landlord relief from the automatic stay.  If the parties reach an agreement as to the amount of the claim to be applied to the deposit, the debtor-tenant may consent to relief from the automatic stay.