Taxation

Advance Rental Income, Security Deposits, and Taxes

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As a landlord, you're two biggest concerns are getting the rent paid on time, and being reimbursed for any damages tenants do to your rental property. There are two highly effective tools to help you accomplish these goals: advance rent payments and security deposits. They help make sure you get paid what the tenant agreed to pay and they protect you against damage to the property.

You need to know, however, that these payments may impact your taxes and affect your bottom line if you have to return them.

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. For example, you might agree to rent to a tenant with bad credit if he or she agrees to pay you the first six months of rent up front. Landlords often require prepayment of the last month’s rent as a protection against a tenant moving out at the end of the lease term without paying for the final month.

You may use the advance rent payment to cover rent for the last month of the lease, or it may be used to cover rent over the entire term of the lease. It all depends on how much advance payment is made, how much rent you charge, and when rent payments are due.

Taxable?

Advance rent is considered taxable income to you in the year you receive it from the tenant. This is true even if the advance payment isn't mentioned in the lease 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

Practically every lease agreement calls for a security deposit from a tenant. This is a dollar amount, usually one month's rent, that's intended to cover damage to the premises beyond normal wear and tear. It also can cushion the financial blow if a tenant skips out early on the lease without paying. Unlike an advance rental payment, you generally must refund the security deposit if the tenant lives up to the terms of the lease.

Most states 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 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.

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: Ed owns a three-unit apartment building. After one of his tenants moves out, he discovers a broken window in the unit. He hires a repairman 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 Ed 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.

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 case where the tax law encourages landlords to act honestly.

Treatment of Security Deposits

Remember a security deposit does not belong to you, the landlord. It is money you are holding on loan from the tenant 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. Most states require that landlords deposit this money in a separate account. Also, landlord-tenant laws in your state may require you to carefully account for security deposits by giving tenants detailed information on how much money was deducted from a deposit and why. Some states and cities even require that tenants be paid interest on their security deposits.

Telling the Difference

Whether a payment is a nontaxable security deposit or a taxable advance rental payment depends on the language of the lease. The labels used for the payments aren't as important as the actual terms and conditions in the lease as to what the funds are meant for. 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 is not taxable when received.

If you have questions about the proper language of a lease agreement, or how to treat advance payments on a tax return, talk to an attorney to make sure your best interests are protected.

Questions for Your Attorney

  • If a payment of advance rent covers the last rental payment in the lease term, which falls in a future year, when should I include it in my income? The year of receipt or the year the lease ends?
  • I want to be sure on how payments from tenants will be treated, as security deposits or advance payments of rent. Can you review the lease I use for my rentals?
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