As a landlord, some of your biggest concerns are getting the rent paid on time and being reimbursed for any damages tenants do to your rental property. Many landlords address these concerns by collecting advance rent payments and security deposits.
If you collect either of these deposits but don’t end up using the full amount you received, you’ll have to return what’s left to your tenants. This refund might impact your taxes and affect your bottom line.
Advance Rent
As the name implies, advance rent is the full or partial payment of rent by a tenant for a future period of time. Landlords often require tenants to prepay the last month’s rent as a protection against being shorted if tenants move out at the end of the lease without making their final payment. Collecting advance rent can also be a hedge against renting to high-risk tenants: For example, you might rent to tenants with bad credit on the condition that they pay you the first six months of rent up front.
You may use the advance rent payment in whatever way you’ve designated it in your lease or rental agreement. If you’ve called it “last month’s rent,” you may use it to cover only rent owed for the final month of the tenancy. If you simply referred to it as “advance rent,” you may use it to cover any rent owing at any point during the tenancy.
Typically, landlords don’t refund advance rent. Rather, they apply the funds toward rent for the timeframe specified in the lease or rental agreement. If you decide to refund advance rent to a tenant for some reason (perhaps because you agree to terminate the lease early), consider consulting with a tax professional to discuss how to best classify the refund for tax purposes.
Is Advance Rent Taxable?
Advance rent is considered taxable income to you in the year you receive it from tenants. This is true even if the advance payment isn't mentioned in the lease or rental agreement.
For example, if your tenant pays you in December for the first six months of rent starting in January, you must report the advance payment as income for the year in which you received the payment (December) and not for the year the tenants were in the property.
Security Deposits
Leases and rental agreements almost always require tenants to provide a security deposit. (Landlords also sometimes collect other deposits, like pet deposits—as long as it’s a refundable deposit, the rules discussed here apply). The amount of the security deposit is usually equal to one month's rent, and its purpose is to cover damage to the premises beyond normal wear and tear. It also can cushion the financial blow if a tenant skips out early before the end of a lease without paying. If you don’t have to apply all or some of the security deposit to cover missing rent or your costs to repair damage caused by the tenants, you must refund the security deposit.
Most states (and some cities) have landlord-tenant laws that regulate security deposits. For example, in California a landlord may require no more than two months’ rent as a security deposit for an unfurnished rental, and three months’ rent for furnished rentals. California landlords must return their tenants’ security deposits within 21 days after they move out along with an itemized statement of any deductions. (Cal. Civ. Code §§ 1950.5, 1940.5(g) (2019).)
Is a Security Deposit Taxable?
Unlike advance rent, a security deposit isn't taxable when you receive it. Instead, it's taxable income only if and when you're no longer obligated to return it to the tenant. For instance, if a tenant agrees to forfeit the security in exchange for an early lease cancellation, the money is included your gross income at that time.
If a departing tenant damaged a rental unit and you deduct the cost of repairs from the security deposit, the amount is also taxable income. However, you get to deduct the cost of the repairs as a landlord expense, which effectively cancels out the income from the security deposit.
Example. Aiden owns a three-unit apartment building. After one of his tenants moves out, he discovers a broken window in the unit. He hires a repairperson to fix the window at a cost of $100 and deducts the amount from the tenant’s $1,000 security deposit. He refunds the remaining $900 to the tenant. The $100 Aiden kept is rental income he must report on his Schedule E for the year. But the $100 he spent to fix the window is an expense he can deduct that year. This offsets the $100 he kept, so he ends up paying no tax on the amount of the security deposit he kept.
If you deduct money from a tenant’s deposit for damage and don’t fix it, you’ll have no expense deduction to offset the increased rental income. Of course, no decent landlord would do this. This is one situation where the tax law encourages landlords to act honestly.
Treatment of Security Deposits
Landlords must always keep in mind that a security deposit is essentially a loan: It’s the tenant’s money until the tenancy ends. Your job is to keep the money safe until it is time to return it to the tenant or use all or part of it to offset damages or unpaid rent. Some state and city laws require that landlords deposit this money in a separate account.
Also, landlord-tenant laws where your rental is located might require you to take certain steps when you receive or use a security deposit. For example, many laws require landlords to pay interest on security deposits, return (or account for) security deposits within a certain amount of time after tenants move out, and give tenants a detailed accounting of any deductions from the security deposit.
Is the Payment Advance Rent or a Security Deposit?
Whether taxing authorities will consider a payment as a nontaxable security deposit or as a taxable advance rental payment depends on the language in your lease or rental agreement. Simply labeling the payment as one or the other isn’t determinative; rather, it’s the description of how the funds will be used that matters. If an advance payment is labeled a "security deposit" in a lease, but there's no obligation to pay it back to a tenant and it may be used to cover future rental payments, the payment is actually an advance payment of rent and is taxable when received. Similarly, if money labeled “advance rent” can be used by the landlord to make repairs, the amount is actually a security deposit, and isn’t taxable when received.
Talk to a Lawyer
If you have questions about the proper language of a lease agreement, or how to treat advance payments on a tax return, a local attorney can help you understand the applicable laws and make sure your best interests are protected.