Security Deposits in Rental Books: Liability or Income?

Is a tenant's security deposit income when I receive it?

A security deposit is not rental income when you receive it if you plan to return it, or may be required to return it, to the tenant at the end of the lease. It becomes income in the year you keep it. If the lease says the money will be the final month's rent, it is advance rent and counts when you receive it (Publication 527; Tax Topic 414). In the books, record a refundable deposit as a liability: debit Bank, credit Tenant deposits held, not rent.

The IRS says when a deposit counts as income. It does not say which account to use. Booking the deposit as a liability, as shown below, is bookkeeping practice that keeps the books in line with that rule. A deposit booked as rent overstates income when it arrives, and the refund later shows as a false expense. A deposit mixed into your own account can break a state holding rule and leave the books unable to show what you owe each tenant.

A deposit case is not simple if:

• the lease calls the money "last month's rent" or says it may be applied to the final rent;
• a tenant left owing rent or damage and you kept part of the deposit;
• deposits went into your own account, or were booked as rent in earlier years, and several leases or years need re-sorting before a return is filed;
• a deposit was paid in cash or by transfer and there is no lease or receipt;
• a property manager holds the deposits, or you sold a rental with tenants in place;
• an entity owns the rental. A single-member LLC that has not elected corporate treatment is generally reported on its owner's return, Schedule E for a rental (IRS), so this page applies. Publication 527 and Tax Topic 414 are written for individual landlords, so for a partnership (including a two-owner LLC) or a corporation, confirm with the preparer how each case is reported. See books for an LLC per rental and rental property in an LLC.

Gather each lease (deposit amount, refundable or applied to the last month), proof of what each tenant paid and when (including any receipt, text or transfer record showing a deposit amount and date), the bank statement showing where the money sits, move-out inspections with repair invoices, and any manager statements.

What is the journal entry and account when a rental deposit comes in?

Record each refundable deposit in an other current liability account such as "Tenant deposits held", tagged to the property and the tenant. A deposit is not an asset to you: the cash is yours to hold, but you owe it back, so it reaches rental income only if you keep it. Chart of accounts for rental property shows where this account sits beside the Schedule E accounts.

The entries below assume the cash method, which most individuals use: rent counts when you receive it and expenses when you pay them (Tax Topic 414).

If the deposits sit in their own bank account, debit that account instead. Moving cash between your accounts is a transfer, not income or expense. The "Tenant deposits held" balance should equal the unreturned deposits on your leases on any date.

Under the accrual method, rent counts when earned, not when paid (Publication 527). Unpaid rent already booked as income is then cleared against the deposit, not booked twice.

What if the "deposit" is really last month's rent?

An amount the lease says will pay the tenant's final month's rent is advance rent. You include it in income when you receive it, not when you apply it to the last month (Tax Topic 414). Advance rent is any amount received before the period it covers, and it counts in the year received whatever your accounting method (Publication 527).

Read the lease, not the label. Money held against damage and unpaid rent is a deposit. Money the lease assigns to the final month is rent paid early. Book it in the rent account when you receive it and note the month it covers on the list of what each tenant owes and pays.

State law can still treat this money as the tenant's. Massachusetts requires a receipt and interest on rent paid in advance for the last month (section 15B(2)). Florida's deposit statute covers advance rent for other than the next immediate rental period (section 83.49(1)). Tax and state law answer different questions, so settle an unclear lease before you book it.

The tenant left owing rent or damage: when does the deposit become income, and what do I deduct?

A deposit becomes income in the year you keep it. Publication 527 says to include what you keep when the tenant does not live up to the lease. Tax Topic 414 gives two examples: the tenant breaks the lease by leaving early, or damages the property and you must repair it.

• Unpaid rent or an early move-out. Include the amount you keep in income in that year. A cash-method landlord cannot deduct uncollected rent (Publication 527), so applying the deposit is when that rent first reaches income.
• Damage. If your practice is to deduct repair costs as expenses, include the amount you keep in income that year. Only if your practice is not to deduct them is the part of the deposit that reimburses those costs left out (Tax Topic 414).

On Schedule E, a deposit you keep goes in with your other rental income on line 3 (Instructions for Schedule E). Then deduct the repair as an expense at what the work cost you, which can differ from the amount of deposit you kept. Whether the work is a repair or an improvement is covered in repair or improvement for a rental. Any amount the tenant still owes above the deposit is not income on the cash method until you collect it.

The IRS says to include the amount in income in the year you keep it, and neither source defines the moment. State rules set the claim process. For most dwelling units, New York requires an itemized statement and the balance back within 14 days after the tenant leaves, or the landlord forfeits any right to keep part of the deposit (General Obligations Law 7-108). Massachusetts requires the deposit, less lawful deductions, back within 30 days after the tenancy ends. A damage deduction needs an itemized list sworn under penalty of perjury, with estimates, bills or receipts, inside that period, or the lessor forfeits the right to keep any of the deposit (section 15B(4) and (6)). Florida requires the deposit back within 15 days if the landlord makes no claim. To claim, the landlord must send notice within 30 days by certified mail or qualifying e-mail, and the tenant has 15 days to object. Missing the notice forfeits the right to deduct from the deposit, though the landlord may sue for damages after returning it. A tenant who leaves early or has a periodic tenancy must give 7 days' written notice with an address unless the lease says otherwise, and without it the landlord need not send the claim notice (section 83.49(3) and (5)). Money you must give back is not income. If the move-out and the claim fall in different years, ask your preparer which year applies.

What is the entry when I return the deposit in full?

Debit "Tenant deposits held" and credit the bank for the full amount. Rental income and expenses do not change, because the deposit was never income (Publication 527).

Do not book the refund as an expense or a rent reduction. A deposit booked as rent when it arrived and refunded as an expense later overstates rent in the first year and expenses in the second, and Schedule E shows both lines too high.

Does the deposit need its own bank account, and what do state laws say about holding it?

Neither Publication 527 nor Tax Topic 414 says where a deposit must be held. State law does, and it varies. Three examples show the range:

Your state may differ from all three. Search your state legislature's website for its landlord-tenant or security deposit statute, and read where the deposit must be held, whether interest is owed, the deadline to return it and the notice for deductions. Skipping the holding step has a cost: in Massachusetts the tenant may demand the deposit back at once, the lessor forfeits the right to keep any of it, and the tenant can be awarded three times the deposit plus interest (section 15B(3), (6) and (7)).

If deposits are already mixed into your own account, the liability still exists, and the books should show what you owe each tenant. For whether to open an account for each property, see a bank account for each rental.

Whose is the interest a deposit earns, and how is a Form 1099-INT handled?

If the interest on a deposit belongs to the tenant, the full Form 1099-INT amount still goes on your return and the tenant's share comes off as a nominee distribution (interest paid to you that belongs to someone else). If state law lets you keep all the interest, there is nothing to split. A small amount can still be the tenant's: state law decides who owns it, and the reporting level below decides only whether a form is needed.

State law decides whose interest it is. Under the table above, New York interest is the tenant's less the holder's fee, Massachusetts interest is the tenant's up to the statutory rate (or what the bank paid, if less), and Florida depends on the method the landlord chose. Publication 550 describes nominee interest in general and does not mention tenant deposits. Applying it to a tenant's share is the usual reading, so confirm it with your preparer.

A bank usually issues the Form 1099-INT in the name and number on the account, so it shows the whole amount to you. On an individual return, Publication 550's nominee steps are to:

1. Report the full 1099-INT amount on Schedule B, Part I, line 1 (interest income).
2. Under a subtotal, enter "Nominee Distribution" and the amount that belongs to someone else, and subtract it.
3. Prepare a Form 1099-INT as the payer for each other owner and give that owner a copy by January 31 after the interest year. File with the IRS by February 28, or March 31 if filed electronically; a weekend or holiday date moves to the next business day. Ten or more information returns in all generally must be e-filed, and Form 1096 goes only with paper filing (General Instructions for Certain Information Returns). No form is needed for your spouse. You need each tenant's name and taxpayer ID for that form.

The nominee amount is limited to interest the account actually earned for the tenant. If state law makes you pay the tenant more than the account earned, the extra comes from your own funds and is not nominee interest; ask your preparer how to treat it.

The Form 1099-INT instructions set the reporting level at $10 per person. The share you keep, such as New York's fee, stays with you. The IRS publications do not say how it is characterized, so ask your preparer where to report it.

Publication 550 is written for individual returns. A partnership or corporation reports its interest on its own return, so the preparer confirms where the nominee amount comes off.

How do I record pet deposits, cleaning fees and non-refundable fees?

Ask whether any part of the money can go back to the tenant. If it can, it is a deposit and follows the sections above, whatever the lease calls it, until you apply it to a cost. If it can never come back, it is not a deposit.

Rental income is any payment you receive for the use or occupation of property (Publication 527). The IRS publications do not name pet or cleaning fees, so the non-refundable row applies that general rule.

State law may limit these charges. Massachusetts lists what a lessor may require at or before the start of a tenancy: first and last month's rent, a security deposit of no more than the first month's rent, and the cost of a key and lock. The statute lets state regulations allow a fee in place of the deposit (section 15B(1)). A separate pet or cleaning charge there needs a state-law check first.

What happens to the deposits when I sell the property or a manager holds them?

When you sell a rental with tenants in place, state law sets how the tenants' deposits pass to the buyer, and your liability for that property comes off the books only when your state's transfer steps are done, as in these three examples:

• New York. The holder turns the deposit over at the deed or within five days after and notifies the tenant by registered or certified mail. The seller is then released from liability to the tenant (General Obligations Law 7-105).
• Massachusetts. The lessor transfers the deposit with accrued interest. The buyer is liable from the transfer and notifies the tenant within 45 days. If the seller does not transfer the deposit, the buyer still assumes liability to the tenant, so check each tenant's deposit at closing. The seller stays liable until the transfer and notice are done or the deposit is returned (section 15B(5)).
• Florida. Deposits and advance rents transfer with earned interest and an accounting. Once the funds and records are transferred and a written receipt is sent, the seller is free of the holding duty (section 83.49(7)).

The closing statement shows how the transfer is paid. See the rental closing statement in the books.

A property manager who holds deposits holds the tenants' money, not your income. Only an amount applied to rent or damage on your behalf is income. Who answers to the tenant depends on the lease, the management agreement and state law. See the manager's owner statement in the books.

Example

Amounts are illustrative and in US dollars.

A deposit paid and returned

A tenant pays a US$2,000 deposit at move-in. You debit Bank US$2,000 and credit Tenant deposits held US$2,000. Rental income does not change. At move-out you return all of it: debit Tenant deposits held and credit Bank, both US$2,000. The liability is back to zero, and Schedule E shows no income or expense for the deposit.

A tenant leaves early

A tenant breaks the lease and owes US$1,500 in rent, and the unit has US$500 of damage. You keep the whole US$2,000. Debit Tenant deposits held US$2,000 and credit Other rental income US$2,000, in the year you keep it. You pay a contractor US$500 that year to repair the damage and record it as Repairs, if the work is a repair and not an improvement and your practice is to deduct repair costs. The year shows US$2,000 of income and US$500 of expense. Had the repair cost US$650, the deduction would be US$650: it follows what the work cost, not the amount you kept.

A New York building with eight units

You own an eight-unit building in New York and keep a tenant's US$1,200 deposit in an interest-bearing account that earns US$24 for the year. The statute lets you keep 1% a year of the deposit, US$12, and the other US$12 is the tenant's. The bank sends a Form 1099-INT for US$24 in your name. On your individual return, you report US$24 on Schedule B and subtract US$12 as a nominee distribution, following Publication 550's nominee steps. Those steps point to a Form 1099-INT as payer showing US$12 for the tenant, which is above the US$10 reporting level and needs the tenant's taxpayer ID.

Different for you?

• Deposits were booked as income, mixed into your own account, or several leases and years need re-sorting before a return is filed: the right entry depends on each lease and on whether a state holding rule applies, and earlier years may need correcting. Get bookkeeping help before you file, or if earlier returns already counted deposits as rent.
• A partnership or corporation owns the rental: the books can use the same liability account, but the accounting method and the return treatment depend on the entity, so confirm them first. Start with bookkeeping help.
• Your rental books are years behind: see catching up on rental property books.
• You are deciding where deposits should sit: see a bank account for each rental.
• You need to know what records to keep for deposits and repairs: see rental property records and receipts.
• You or the owner live outside the US: a deposit you keep is still rent, and the filing and withholding rules differ; see nonresident landlords.
• You rent through a short-term platform that holds damage deposits: see short-term rental payouts in the books.