Security Deposit Accounting: An Overview for Landlords

Have you ever found yourself questioning if you're handling your rental security deposits in the best way possible?

Security deposits are more than just a safety net against tenant damages. They play an important role in rental property management, especially when it comes to tax compliance and evaluating the profitability of your real estate investments.

Imagine the confidence of knowing you're not only protecting your property but also optimizing your financial practices for long-term success. The power of understanding security deposit accounting can set you apart in the competitive world of real estate.

Dive into our comprehensive guide to discover essential strategies for managing security deposits. Learn not only how to account for them but also the best practices for ensuring smooth and compliant security deposit returns.

What is security deposit accounting?

Security deposit accounting is an integral aspect of managing a rental unit, providing clarity for both property owners and tenants on the financial intricacies of the leasing process.

• Essence of the security deposit: A security deposit is a financial safeguard, typically equivalent to one month's rent. This deposit acts as a protective measure for landlords, ensuring that potential damages or breaches in the lease agreement can be financially covered. However, unlike monthly rents or other property-associated fees, a security deposit holds specific stipulations on its collection, maintenance, and return.
• Dedicated management: Beyond just holding funds, the holistic approach to security deposit accounting involves systematic record-keeping. Landlords might need to navigate requirements such as holding deposits in an escrow account or understanding stipulations surrounding interest accrual if the deposit is held in an interest-bearing account.
• Geographic variations: Rental properties situated in different states or municipalities, like Rhode Island or South Dakota, might have unique requirements. These can encompass regulations about maximum allowable security deposit amounts, directives on interest-bearing accounts, or mandates on the timely return of these deposits post a tenant's relocation.
• Advanced considerations: Navigating the nuances of security deposit accounting might also mean diving into areas like pet deposits, guidelines on furnished units, and understanding if, when, and how a security deposit transitions from being a refundable amount to considered rental income.
• The bigger picture: At its core, security deposit accounting isn't just about money; it's about trust. Properly managing and accounting for these funds plays a crucial role in building a transparent landlord-tenant relationship, ensuring that both parties feel secure and respected throughout the leasing journey.

3 tips for security deposit accounting

Successful landlords must have a system in place to accurately account for their security deposits. Following are best practices to help you manage your security deposits and maintain compliance. 

1. Know your local security deposit laws

Real estate investors are aware that real estate laws vary by state and municipality — including regulations around security deposits. Depending on where you own rental property, there are regulations for various aspects of security deposits — including the amount landlords can collect, where they keep the deposit during the lease term, in which scenarios the funds can be used, and how quickly the deposits must be returned after move-out. 

In terms of security deposit accounting, rental property owners should also be aware of the local laws on whether you need to keep security deposits in escrow or a separate bank account from your operating account, whether the account must earn interest, and whether you need to return the interest earnings to tenants. Learn which states require separate and/or interest-bearing security deposit accounts.

2. Keep security deposits in a separate bank account

Even if your local real estate laws don’t require it, it’s a good idea to have a separate bank account to manage security deposits. This account should be separate from the operating account you use for collecting rent and paying rental property expenses. You can choose an interest-bearing security deposit bank account — but you may be required to pay the interest earnings to tenants. When returning your security deposit, transfer the money from your security deposit account directly to your tenant. 

Having a separate security deposit account has many benefits. First off, it’s cleaner accounting and gives you a clear view of when and from which tenants you received deposits. It also avoids commingling security deposits with other business or personal funds, so you maintain tax compliance. Importantly, it also prevents you from spending the security deposit on other expenses, ensuring that the funds are readily available when it comes time to return them to the tenant. Finally, you’ll be able to more accurately track security deposit interest earnings with a separate account. 

3. Don’t report security deposits as income (with some exceptions)

A common question about security deposit accounting is whether a security deposit is considered rental income. In most cases, the answer is no. 

According to the IRS, a security deposit should not be reported as income if you’re planning to return it at the end of the lease. However, there are a few exceptions: 

• When a security deposit is used as the final rent payment, it is considered advance rent and can be reported as income when you receive it. Of course, be sure not to double count the rent in your tenant’s final month. 
• If you keep part or all of the security deposit funds at the end of the lease to cover damage caused by the tenant, the amount withheld should be reported as rental income at that time.

Because security deposits are generally not considered rental income, they should not appear on your income statement or cash flow statement. Instead, include it as a liability on your balance sheet on the date you received it, since it’s an amount you’re planning to eventually return. 

When you report security deposits in your books, be sure to include key information such as date received, name of tenant, and rental property address. Your accounting software may also have the ability to categorize the transaction as a security deposit, and tag it by tenant, lease, property, and rental unit. 

How to account for security deposit returns

Once it’s time to return the security deposit, there are a few additional accounting factors to be aware of. 

In rental property accounting, returning a security deposit is not considered an expense, and should not be included in a Schedule E. Instead, you simply reduce the liability on your balance sheet by the amount you return. 

If you keep part or all of the security deposit, that amount should be reported as rental income on the date it was withheld. The amount withheld, once used to pay for the repairs or other damage caused by the tenant, should then be reported as an expense in your Schedule E under the appropriate category. 

As an example, say your tenant gives you a security deposit of $3,000 at the start of the lease. When the tenant moves out, you withhold $275 to cover the cost of repairing a cabinet the tenant broke. Here’s how the security deposit accounting should work in this scenario: 

• Report the $3,000 deposit as a liability on the date it was received on your balance sheet.
• At the end of the lease, report the $275 as rental income on the date it was withheld and reduce the original $3,000 liability to $2,725. 
• Transfer the withheld $275 from your security deposit account to your operating account so that you can use the funds to pay for the repair. 
• Return the remaining $2,725 to the tenant and reduce your liability to $0). 

Accurate and compliant security deposit accounting

Navigating the complex world of real estate can be daunting, but as we've explored, understanding the intricacies of security deposit accounting is essential for landlords. This isn't just about safeguarding funds; it's a testament to building trust, transparency, and compliance in landlord-tenant relationships.

With varying regulations across states and municipalities, rental property owners must stay vigilant, ensuring they not only adhere to local laws but also implement best practices that optimize their financial success.

By keeping security deposits separate, understanding their non-revenue nature, and meticulously tracking every transaction related to them, landlords can confidently say they are making the best decisions for their property, their tenants, and their business.

As you continue in your real estate endeavours, we hope the strategies and insights shared here serve as an valuable guide towards successful and compliant security deposit management.

Security deposit accounting FAQs

Is security deposit an asset in accounting?

In accounting, a security deposit is not typically considered an immediate asset for the landlord. Instead, it represents a financial obligation since the landlord might need to return the security deposit money at the end of the lease. However, if the landlord has the right to keep the deposit due to specific conditions met (like damages or breach in the lease agreement), it can then be recognized as an asset or rental income.

How is security deposit shown in balance sheet?

On the balance sheet, a tenant's security deposit amount is generally shown as a liability. This is because it's an amount that the landlord may owe back to the tenant at the end of the leasing journey. It's categorized this way to reflect the potential obligation to return the funds. If the security deposit is expected to be returned within a year, it would typically be listed under "current liabilities." If it's expected to be held for more than a year, it could be listed under "long-term liabilities.

Are security deposits considered a liability?

Yes, security deposits are usually considered a liability in accounting for rental property owners. This is due to the nature of the deposit: it's a sum that landlords might need to return to tenants, thus representing a future financial obligation. Properly managing and accounting for these funds ensures transparency and compliance in the landlord-tenant relationship, especially when it comes to the potential return of these deposits.