Security Deposit Accounting: An Overview for Landlords

Security deposits are a common part of rental property ownership, helping to protect your investment from any potential damage caused by tenants. Properly accounting for security deposits is essential to ensuring tax compliance and understanding your rental property business performance. In this article, we’ll share security deposit accounting tips for real estate investors, as well as how to account for security deposit returns. 

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

While security deposits may seem straightforward, improper accounting practices can lead to messy bookkeeping, unhappy tenants, or even tax audits and lawsuits. Before accepting a security deposit for your rental property, review your accounting process and follow these tips to ensure compliance and avoid costly mistakes.