As a landlord, you're concerned about losing money on your rental property. After all, it's how you make money, right? Advance rent payments and security deposits help you here. They help make sure you get paid what the tenant agreed to pay and protect you against damages to the property.

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

Advance Rent

Advance rent is the full or partial payment of rent by a tenant for a future period of time. You may require it as protection against a tenant's moving out before the end of a lease without paying the rent, for example.

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?

As a general rule, 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 in December 2010 your tenant pays the first six months of 2011's rent, you must report the advance payment as income on your 2010 return.

Security Deposits

Practically every lease agreement calls for a security deposit from a tenant. Usually, it's meant to make sure the tenant honors the terms of the lease - payment of rent by the specified due date, for example. Also, it's typically used to keep your out-of-pocket expenses down if you need to repair damages to the rental property caused by the tenant.

Unlike an advance rental payment, you generally must refund the security deposit if the tenant lives up to the terms of the lease. Of course, the refund may be in full or partial. For example, if the cost to repair some damage is less than the security deposit, you must refund the excess.

Taxable?

A security deposit isn't included in your gross income when received. Instead, it's included only if and when you're no longer obligated to return it. 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 money paid by a tenant is labeled "advance rent," but it's meant to be and actually treated as a security deposit, it isn't includable in gross income even though you may have temporary use of it.

Treatment of Security Deposits

It's important for you to document security deposits properly, making sure not to include them as income when received. 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.

Telling the Difference

Whether a payment is a nontaxable security deposit or a taxable advance rental depends on the lease's language. 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.

The keys are if, how and when:

  • You can use the money
  • You must return the money

For tax purposes - and for your bottom line - it's important to make sure your lease agreement specifies how any advance payments are treated. 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?
  • 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, how should that payment be treated for tax purposes?
  • 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?

Tagged as: Taxation, Property Tax, rental income, security deposits