When Is a Forfeited Security Deposit Considered Rental Income?

A security deposit is a sum of money a tenant provides to a landlord at the start of a rental agreement. Its primary purpose is to safeguard the landlord against potential financial losses and act as an assurance throughout the tenancy. These losses can arise from tenant-caused damages to the property beyond normal wear and tear or from the tenant’s failure to fulfill lease obligations, such as unpaid rent.

Initial Treatment of Security Deposits

A refundable security deposit is not considered rental income when a landlord first receives it. Instead, it is treated as a liability on the landlord’s balance sheet, reflecting the landlord’s obligation to potentially return the funds to the tenant at the end of the lease term. The money legally remains the tenant’s funds, held in trust by the landlord.

This means the deposit does not impact the landlord’s income statement at the time of receipt. For tax purposes, the Internal Revenue Service (IRS) states that a security deposit is not included in income if the landlord plans to return it.

When Forfeited Deposits Become Income

A previously refundable security deposit becomes taxable rental income for the landlord in the tax year it is no longer refundable. This occurs when the landlord gains an absolute right to the funds. For instance, if a tenant breaches the lease agreement, such as through early termination, the landlord may be entitled to retain the deposit.

The deposit also becomes income if it is used to cover unpaid rent or to repair damages to the property that exceed normal wear and tear. Additionally, if the deposit is applied to other tenant obligations specified in the lease, that portion becomes income. The income is recognized in the tax year the landlord makes the decision to keep the funds or applies them to the tenant’s obligations. For example, if a landlord decides to keep a deposit in December for damages, it is income in that tax year.

Distinguishing Other Tenant Payments

Refundable security deposits differ from other payments that are always considered rental income upon receipt. Advance rent, for example, is any amount a landlord receives for future rent periods. Unlike a security deposit, advance rent is immediately included in the landlord’s gross income in the year it is received. This is because there is no obligation to refund advance rent.

Non-refundable fees, such as cleaning fees, pet fees, or application fees, are also treated differently. These fees are considered income when received because the landlord has no obligation to return them. With non-refundable payments, the landlord keeps the money without conditions, whereas a security deposit carries an obligation of return.

Reporting Forfeited Security Deposits

When a security deposit or a portion of it is forfeited and becomes income, landlords must report it on their tax returns. This income is reported on Schedule E, Supplemental Income and Loss, which is used for reporting rental property income and expenses. The amount retained from the security deposit should be entered on the “Rental Income” line of Schedule E for the tax year in which the forfeiture occurs.

The timing of this reporting is important; it must be included in income in the year the landlord keeps the amount, not necessarily the year the deposit was initially received. While the initial receipt of a refundable security deposit is not reported on Schedule E, any amount converted to income due to forfeiture is.