Is Security Deposit Considered Rental Income? Tax Tips for Property Owners

Ever wondered what really counts as rental income when it comes to taxes? Well, buckle up because we're about to dive into all the nitty-gritty details every rental property investor needs to know! From security deposits to regular monthly rent and tenant-paid expenses, we'll break down exactly what the IRS considers rental income.

Plus, we'll explore when security deposits count towards your rental income and how they affect your taxes. Stick around to find out how to report rental income and expenses on your tax return and discover some handy tips for reducing your taxable income. 

And, if you're looking for an easy way to manage your rental finances, we've got you covered with a sneak peek at how Azibo can automate income and expense tracking. Let's get started on this rental income adventure together!

What is considered rental income?

Generally, any payment tenants make to rental property owners to use or live in their property is considered rental income by the IRS. These payments are typically made in one of the following ways:

Regular monthly rent

Naturally, you should report all monthly rent payments, whether that's to rent an apartment, a home, a garage or a commercial property, as income.

Advance rent

If you collect last month's rent or if tenants pay several months' rent in advance during move-in, this must be counted as rental income. It should be reported in the year you receive it, not in the year it is intended to cover.

For example, let's say you charge $1,200 per month for a rental unit. A tenant pays you the first month's rent and last month's rent upon move-in in December 2024. Although the last month's rent will apply in 2025, you'll need to report it, as well as the first month's rent, towards your rental income in 2024, for a total of $2,400 in monthly rent payments.

Late rent

In the same vein as advance rent, late rent should be reported as rental income on your taxes in the year the tenant pays it. If a tenant misses their rent payment in November 2023 and only manages to pay it in February 2024, it will count towards your 2024 income.

Tenant-paid expenses

When tenants pay for repairs or utilities for their rental that, according to the lease agreement, are outside their realm of financial responsibilities, you must report the repair costs as rental income. Let's look at some examples at how this would work:

Repair-and-deduct: 

Your tenant discovers a mice infestation in their apartment. Horrified, they want to get this resolved as soon as possible. They seek out and hire an exterminator on their own dime to expedite the extermination process, and it costs $200. They deduct the cost of the exterminator from their monthly rent of $700.
You'll have to report the cost of the exterminator ($200) as well as the net amount of the rent payment after the repair deduction ($500) as your rental income for the tenant for that month.

Utility bills:

Let's say a tenant rents an apartment in a building where the landlord is responsible for providing and paying for water and sewage services according to the terms of the lease agreement. However, due to an oversight, the water bill for the building is not paid by the landlord, resulting in a temporary interruption of water service to the entire building.

The tenant decides to pay the water bill out-of-pocket to avoid the inconvenience of having no water service. While the tenant technically shouldn't be responsible for paying this utility bill, they may choose to do so temporarily to ensure they have access to water until the landlord resolves the issue.

As a landlord, you would be required to maintain documentation of the payments the tenant made and report them as rental income to the IRS.

In both cases, the cost of repairs or utilities must be reported separately from the net rental income for that month. Luckily, these costs can often be considered deductible rental expenses.

Paying rent via services

If a tenant has experience as an electrician, plumber, or another trade valuable to you as a property manager, you may elect to receive rent payments from the tenant in the form of services received in lieu of money.

Per the IRS, you should value any services provided in lieu of cash payments of rent at their fair market value. When the tenant provides services at a price the landlord has agreed to in advance, that price will serve as the fair market value.

Fees

Any fees that go towards the tenants' use of the rental property count towards a property owner's rental income. Common fees include those for:

• Parking spaces
• Pets living on the premises
• Early lease cancellation
• Rental applications
• Late payments

Forfeited security deposits

Partial or total security deposits withheld due to damage or missed rent payments will be considered taxable income. For instance, if a tenant paid a security deposit of $750 at the beginning of their lease term but damaged the plumbing, leading you to withhold $500 of their deposit to cover the cost of repairs, you would report the withheld $500 as rental income.

We'll go into this in more detail below.

Should I report security deposits as rental income?

Security deposits function as a financial cushion against any damages a landlord might incur to their property. As such, they're paid by the tenant at the beginning of their lease term with the intent of being returned at the end of the lease. 

Due to their refundable nature, they're only considered rental income when kept, either partially or in full, by the landlord.

If, for any reason, you need to tap into a tenant's security deposit to cover the cost of unfulfilled rental obligations, such as unpaid rent or significant damages beyond normal wear and tear, you'll need to report the amount of the security deposit that you've kept as rental income in the year that you kept it.

However, if you receive a security deposit with the intent to use it towards the last month's rent, you should report the security deposit as rental income at the time of receipt, as the IRS considers this advance rent.

How is rental income taxed?

The IRS taxes rental income like regular income. Your tax rate will vary from state to state, depending on factors such as where your rental property is located, your filing status, and your tax bracket as an investor. 

You can expect to be taxed anywhere from 10% to 37% on your rental property income. However, as a real estate investor, you can deduct many of your operating expenses when filing taxes, ultimately lowering your taxable income.

Reporting rental income and expenses on your tax return

Reporting rental income and expenses on your tax return as a rental property investor involves several steps.

1. You'll need to gather all relevant financial documentation pertaining to your rental properties, including records of rental income received and expenses incurred throughout the tax year.
2. Next, you'll complete a tax form called Schedule E, which is specifically designed for reporting rental income and expenses. On this tax form, you'll itemize your rental income, detailing the amounts received from tenants. Additionally, you'll list your deductible expenses, such as mortgage interest, property taxes, repairs and maintenance, utilities, and property management fees.
3. After tallying up your total rental income and deductible expenses, you'll calculate your net rental income by subtracting the total expenses from the total income. This net rental income figure represents the amount subject to taxation.
4. Finally, you'll transfer the relevant information from Schedule E to your main tax return form. Maintain organized records of your rental activity to support the figures reported on your tax return and to be prepared in case of any inquiries from tax authorities.

Should you encounter any uncertainties or complexities in this process, seeking guidance from a tax professional or accountant is highly advisable to ensure accurate reporting and compliance with tax regulations. In addition, the IRS's Publication 527 serves as a great resource on deductible expenses.

How to reduce taxable income

Looking for deductions wherever you can in your business operations will help soften the blow of paying taxes come April. Real estate investors have a number of potential deductions at their disposal to lower the taxes they owe.

Deductible expenses

• Utilities paid by the landlord
• Property taxes
• Property maintenance costs
• Property managers
• Advertising (when costs are documented over time)
• Traveling to and from a rental property (be careful with this one — your trip has to be exclusively for business purposes to count as a deductible expense)

As always, consider consulting a tax professional to assess your specific situation and maximize the deductions for all your properties.

Bonus depreciation

Bonus depreciation offers rental property investors the opportunity to deduct a portion of the property's value each year as an expense on their tax return, which helps offset rental income and reduce taxable income.

Depreciation generally occurs over a period of 27.5 years for residential real estate and 39 years for commercial property, as the IRS considers this time period the useful life of a property.

Bonus depreciation is like getting a special boost when you're spreading out the cost of your rental property over time. It lets you deduct more of the property's cost in the first year you start renting it out, which is super helpful for lowering your taxes.

While bonus depreciation can save you money on taxes now, keep in mind that it might affect your taxes down the road. Taking a big deduction now means you might have smaller deductions later on, which could mean more taxes in the future. 

Also, the laws surrounding taxes can change over time, so stay updated and chat with a tax professional to make sure you're making the most of bonus depreciation without facing any unpleasant surprises down the road.

How to automate income and expense tracking with Azibo

Azibo is a handy tool for real estate investors to keep track of finances, making tax season less painful. Here's how it helps:

1. Easy tracking: Azibo makes it simple to track all of the incoming and outgoing payments for your rental properties.
2. Custom reports: You can create reports that show you exactly what you need, whether it's how much money you're making or what you're spending the most on.
3. Help with taxes: Speaking of taxes, Azibo can help you get all your ducks in a row come tax season. It keeps your financial records neat and tidy, so you're ready to go when it's time to file.

With Azibo, you can spend less time worrying about your finances and more time growing your real estate empire!

Tax insights on security deposits

So, we’ve untangled the web of what counts as rental income for property owners come tax time. While we've covered the basics like monthly rent and advance payments, let's not forget about those sneaky security deposits. 

Usually, they're not considered rental income since they're meant to be returned to tenants. But, if you end up holding onto some or all of a deposit because of missed rent or damages, that chunk does need to be reported. 

Don't stress, though! By keeping your records tidy and seeking advice when needed, you'll breeze through tax season like a pro. And for those looking to simplify their financial game, tools like Azibo can be a lifesaver, letting you focus on growing your real estate empire hassle-free.

Does security deposit count as rental income? FAQs

What are the tax rules associated with vacation home rentals?

If you rent out your vacation home for less than 14 days a year, you don't need to report that rental income to the IRS. However, if you exceed 14 rental days, all rental income must be reported on your tax return.

What should I do if I rent a former main home?

If you're now renting out a home that previously served as your primary residence, you must report any rent payments received from tenants living in that home as rental income.

However, if the property served as your primary residence for at least two out of the last five years before renting it out, you may qualify for the primary residence exclusion, meaning that you can exclude up to $250,000 of capital gains ($500,000 for married couples filing jointly) when you sell the property, as long as you meet certain ownership and use requirements.

Can you deduct rental expenses on your taxes?

Yes, you can deduct many of the expenses related to operating a rental property. These include utilities that you pay for, property taxes, property maintenance costs, property managers, advertising, and traveling to and from a rental property.