Does A Security Deposit Count As Rental Income?

Security deposits stay off your taxable rent ledger as long as you plan to refund them; the IRS treats the money as a security, not income (see IRS Publication 527 on rental property).

When a deposit is forfeited - because of unrepaired damage or unpaid rent - you must record the amount on Schedule E under 'Other income,' which triggers the taxable event discussed in the next section.

The IRS treats a security deposit as a refundable liability, not rental income, until the landlord retains it.

• Treat the deposit as a loan to the tenant - the amount sits on the balance sheet, not on Schedule E, because the landlord must return it if the lease ends without damage (IRS Publication 527 explains this liability treatment).
• If the deposit is applied to unpaid rent or damages, the portion that the landlord keeps becomes taxable in the year it's retained; that amount moves onto Schedule E as ordinary rental income.
• Report any interest earned on the deposit as separate interest income on Form 1040, Schedule B; the principal remains non‑taxable.
• Collect a non‑refundable 'pet fee' or 'cleaning fee' only if it's clearly labeled as a charge for a service; then it counts as income from day one (as we covered above in reporting rules).
• Maintain a detailed ledger tracking each deposit, its purpose, and any deductions for damage; proper documentation shields you from audit adjustments (see IRS Publication 527 for record‑keeping guidelines).

Security deposits turn taxable only when the landlord keeps part or all of them after the tenancy ends, and that retained amount must be reported as rental income on Schedule E according to IRS Publication 527.

1. Identify the kept portion. If you apply the deposit to unpaid rent, damage repairs, or a lease‑break fee, that slice stops being a refundable guarantee and becomes earned rent.
2. Refunded balance stays non‑taxable. Any money sent back to the tenant remains a security deposit, not income, so it never appears on your tax return.
3. Tax year of conversion. The amount you retain is taxed in the year you apply it, not in the year you originally collected the deposit. For example, a $1,200 deposit taken in 2023 but used for damages in 2025 becomes 2025 rental income.
4. Report on Schedule E. List the retained sum under 'rental income' on Schedule E, line 3, just as we covered in the reporting section above.
5. When it stays non‑taxable. A deposit that remains untouched, or that is later returned after the lease, never becomes taxable, regardless of how long you held it.

Security deposits stay non‑taxable when the landlord never keeps any portion for themselves. The IRS points out in Publication 527 that fully refundable deposits are excluded from income.

• Fully refundable at lease end - The landlord returns the exact amount, makes no deductions, and never treats it as rent. Because the tenant gets the money back, the deposit never enters the landlord's taxable income.
• Escrow‑held pet or key deposit - The funds sit in a separate escrow account and are released only when the tenant supplies the pet or returns the key. Since the landlord's control is limited to holding the money, it remains non‑taxable.
• Deposit for future services that are not rendered - A cleaning or move‑out fee held in advance is refunded after inspection shows no damage. The refund negates any claim of income.
• Third‑party custody arrangement - The deposit is transferred to a property‑management company that holds it for the tenant. The landlord never obtains the cash, so the IRS does not treat it as rental income.
• Security deposit used as a performance bond - The tenant provides a bond that is only forfeited if they breach the lease. If no breach occurs, the bond is returned, keeping the deposit outside taxable revenue.

If a tenant forfeits the security deposit before the lease ends, the landlord generally treats the entire amount as taxable rental income the moment it becomes unconditionally yours, per IRS Publication 527. The forfeiture converts a refundable hold into earned cash, so it must appear on Schedule E for that tax year. As we covered above, the deposit stays non‑taxable only while it's still a liability that could be returned.

• Record the forfeited sum as rent received; do not attempt a partial deduction for anticipated repairs.
• Keep the original lease clause that allowed early forfeiture; the IRS may request proof of the contractual right.
• Report the amount on Form 1040, line 3 of Schedule E, and include any related expenses only if you actually incurred them later.
• If the forfeiture triggers a net profit, consider estimated‑tax payments to avoid penalties.

When a tenant damages the unit, the retained portion of the security deposit counts as taxable rental income. Report that amount on Schedule E as ordinary rent; only the refunded portion stays tax‑free.

Accurately handling the claim prevents surprise taxes and protects audit readiness:

• Document the damage with photos, written notice, and a cost estimate before withholding any funds.
• Itemize the withheld amount on the lease ledger, matching the repair estimate.
• Include the withheld sum on Schedule E, treating it like any other rent receipt.
• Pay for repairs using the retained deposit; if actual costs exceed the deposit, deduct the excess on Schedule E as a rental expense (Publication 527 explains the deduction rules).
• Return any surplus to the tenant; the returned cash does not appear on the tax return.

Keeping meticulous records and following the schedule‑E route eliminates unexpected tax hits and streamlines the next section on common landlord mistakes.

The first mistake landlords make is logging the security deposit as rental income right after receipt, which instantly triggers tax liability instead of treating it as a refundable liability.

The second error appears when the deposit gets pooled with regular rent or maintenance funds, blurring the line that lets the IRS see it as earned revenue rather than a separate pledge.

The third slip happens when damage deductions lack a written, itemized statement; without documentation, any retained portion appears as earned rent and raises audit risk, as outlined in IRS Publication 527 (as we covered above).

Advance rent that masquerades as a security deposit is easy to spot. Look for amounts that exceed the typical one‑month rent norm, language that calls the payment 'pre‑paid rent,' or lease clauses that allow the landlord to apply the money toward the first month's rent. An explicit statement such as 'this deposit will be applied to rent if the lease terminates early' is a red flag, as genuine deposits are refundable and not meant to cover tenancy costs (as we covered above).

When the payment qualifies as advance rent, IRS Publication 527 treats it as taxable income in the year it is received, not as a refundable deposit. Record the amount separately from the refundable portion, retain the lease language, and report it on Schedule E. For auditors, a clear paper trail distinguishing the two categories protects against misclassification (see IRS Publication 527 guidelines for rental income).

Tracking security deposits precisely shields you from an IRS audit.

Treat each deposit as a separate transaction in a dedicated ledger; note tenant name, unit number, amount, and date. Keep the signed lease clause that defines refund conditions right next to the entry. Store the bank deposit slip or electronic receipt in the same file.

When the lease ends, reconcile the ledger against the escrow or separate bank account balance, subtract any approved damage charges, and generate a final settlement statement. (IRS Publication 527 outlines these record‑keeping expectations.)

A clean paper trail forces the auditor to see a refundable deposit, not hidden income, and sets up the next look at deposits in lease buyouts.

Security deposits that become part of a lease‑buyout purchase price do not count as rental income; they reduce the seller's amount realized on the sale, while only the non‑refundable portion remains taxable as ordinary income, per IRS Publication 527 and IRS Publication 525.

Consider a tenant who posts a $3,000 security deposit and later exercises a $50,000 buyout option. The landlord applies the full deposit toward the purchase, reports $47,000 as sale proceeds, and registers zero rental income for that year. In a second scenario, a $2,500 deposit includes a $500 non‑refundable damage clause; the landlord treats $2,000 as a reduction of the sale price and records $500 as ordinary income.