When Are Forfeited Security Deposits Rental Income?

You recognize a forfeited security deposit as income in the tax year you obtain a legally enforceable right to keep it. The right typically crystallizes when the lease ends or when a tenant breaches a lease provision that triggers forfeiture. Once that right is fixed, the amount shifts from a liability to taxable rental income under IRS guidelines (IRS guidance on security deposits).

1. Confirm the forfeiture event. Identify a lease violation - unpaid rent, property damage exceeding normal wear, or early termination that the lease expressly penalizes. As we covered in '3 reasons deposits turn into your income,' such events convert the deposit from a refundable guarantee to a potential revenue source.
2. Establish a legal entitlement. Verify that the lease language authorizes retention and that you have provided any required written notice to the tenant. The moment the notice is delivered and the tenant has no realistic opportunity to contest, the entitlement becomes enforceable.
3. Record the income in the appropriate year. When the entitlement is enforceable - usually at lease expiration or immediately after the breach - you must include the forfeited amount on your Schedule E for that calendar year. If a subsequent settlement returns part of the deposit, adjust the prior year's figures with a deduction for the returned portion.

Spotting the trigger early (next section) helps avoid delayed reporting and potential IRS flags.

• When a tenant leaves owing rent, the landlord retains the forfeited security deposit to offset that balance; IRS Publication 527 treats the unrecovered portion as rental income in the year it is applied (as discussed in the preceding section).
• When damages exceed normal wear, the landlord deducts repair costs from the forfeited security deposit; any remaining amount counts as income under the same IRS guidelines.
• When a lease ends early and a forfeiture fee applies, the landlord applies the deposit toward that fee; the amount applied becomes taxable rental income at the point of forfeiture (see the upcoming 'report forfeited income' section).

Spotting likely forfeiture early saves you a tax surprise and a courtroom drama. Look for concrete actions, not mere rumors, that let you retain the deposit as compensation.

• Written notice of overdue rent followed by a landlord's election to apply the deposit to the balance; the IRS treats the retained amount as income only when it actually lands in your account.
• Documented lease violation such as an unauthorized pet, structural alteration, or illegal activity, coupled with a proper breach notice; the deposit becomes taxable if you keep it to cover repair costs.
• A settled judgment or settlement that authorizes you to keep the deposit as payment for the tenant's debt; tax liability triggers upon receipt, not merely on the court order.
• Tenant abandonment confirmed by a final walkthrough and utility shut‑off; the deposit may be applied to outstanding damages, making it rental income once you cash it.
• Repeated failure to cure a violation after a formal cure period; each ignored notice strengthens your right to retain the security deposit.

These indicators line up with the 'reasons deposits turn into income' section above and set the stage for the 'claim damages to justify keeping deposits' step that follows.

A landlord can justify keeping a forfeited security deposit only by proving the tenant caused actual damage beyond normal wear and tear. Proof must be compiled, presented, and sent within the repair‑claim window imposed by state law (state security‑deposit laws summary).

• Photograph every dent, stain, or broken fixture.
• Obtain written repair estimates from licensed contractors.
• Itemize each charge on a clear statement, referencing the lease clause.
• Send the itemized notice to the tenant via certified mail before the deadline.
• Retain invoices, receipts, and the mailed proof for at least three years.

When the claim stands, the retained amount shifts from a disputed deposit to recognized income, triggering the reporting steps outlined later.

Forfeited security deposits become taxable the moment the landlord's right to retain them is established. Enter the full amount on Schedule E, line 3, as part of rental income; no extra attachment accompanies the return. Maintain the lease, breach notice, and a concise internal memo for each case - those records satisfy any audit request under IRS guidelines.

Avoiding a red flag means timing the entry with the lease termination, matching the reported figure to the actual deposit, and documenting the reason for forfeiture. A clean paper trail - digital copies of the lease, dated notice, and a brief note - demonstrates legitimate income recognition and keeps the IRS at bay. The next step explores how deductible expenses can offset this newly reported income.

Forfeited security deposits become taxable income at lease termination, as we covered above. The IRS allows landlords to deduct any expense that directly restores the unit to rent‑ready condition. Cleaning fees, ordinary repairs, advertising to locate a new tenant, and legal costs tied to lease enforcement all count as ordinary and necessary business expenses, reducing the amount reported as income.

Only capital improvements - such as installing new flooring or repairing structural damage caused by the tenant - are depreciated over the property's recovery period (see IRS guidance on rental property depreciation), while routine repairs are expensed in the current year. Maintain detailed receipts and a clear link between each expense and the forfeited deposit to satisfy IRS documentation requirements, then proceed to tax the partial forfeiture properly in the next section.

A partial forfeiture makes only the retained portion taxable  -  the landlord must include that amount in rental income for the year the lease ends, while the returned portion remains non‑taxable. IRS guidelines require reporting the forfeited share on Schedule E, treating it as ordinary rental revenue, and keeping supporting documentation such as itemized statements and repair receipts.

Example: A $1,500 security deposit yields $400 for unrepaired damage and $1,100 returned. The $400 appears on Schedule E as rental income; the $1,100 does not. If $250 of the $400 covers actual repair costs, the landlord can deduct that expense on Schedule E, leaving $150 net taxable gain.

Another case: a $2,000 deposit applied $800 toward unpaid rent, $1,200 refunded. The $800 is reported as income, with any related collection fees deductible. In both scenarios, retain the lease, damage report, and receipt copies for at least three years per IRS Publication 527.

When an eviction judgment awards the landlord the tenant's security deposit, IRS guidelines require the forfeited security deposit to be recognized as rental income in the tax year it becomes the landlord's property. No state‑prescribed claim period or waiting window postpones that inclusion.

In practice, record the eviction date, attach an itemized damage worksheet, and deduct verified repair costs before reporting the net forfeited amount; this avoids any premature 'shift' of income and aligns with the earlier 'spot tenant forfeiture triggers' section while paving the way for the short‑term‑rental discussion that follows. IRS guidance on security deposits

Forfeited security deposits in short‑term rentals become taxable the moment the rental period ends and the host retains the funds under the lease terms. The IRS treats that amount as ordinary rental income, regardless of the reason for forfeiture.

1. Confirm the rental‑type classification - Verify that the property qualifies as a short‑term rental under IRS Publication 527; this determines the reporting form and allowable deductions.
2. Document the forfeiture trigger - Keep a detailed log of the guest's breach (e.g., damage, early checkout) and the date the deposit was retained. Photographs, inspection reports, and written notices satisfy IRS audit standards.
3. Calculate the taxable portion - Subtract any documented repair costs that you will later expense. The remaining balance is the amount you must include on Schedule E.
4. Report on the correct line - Enter the net forfeited amount as 'rental income' on Schedule E, line 3, and attach a brief statement linking the entry to the guest's reservation record.
5. Maintain receipts for repairs - Store invoices and vendor invoices for at least three years; these will support the expense deduction that offsets the forfeited income.
6. Apply state‑level rules if applicable - Some jurisdictions treat short‑term rental deposits differently; consult the local tax authority to avoid double reporting.
7. Prepare for the next cycle - Update your rental agreement template to include a clear forfeiture clause, reducing future disputes and simplifying income recognition.

The moment a tenant walks out early and the lease stipulates loss of the security deposit, the forfeited security deposit becomes taxable rental income for that calendar year. In a recent case, a renter terminated a 12‑month lease after four months, left the apartment spotless, but the lease clause forced the landlord to retain the $1,200 deposit. The landlord reported that $1,200 as income on the same year the lease broke.

IRS guidelines consider the forfeiture a realized gain the instant the landlord takes possession of the money, regardless of whether any repair costs are later incurred. As we covered in the 'income recognition' section, the landlord may deduct any documented damages or cleaning expenses against the forfeited amount, potentially reducing the net taxable figure to zero.

In the example, $400 of unpaid rent and $200 of cleaning fees offset the $1,200 deposit, leaving $600 to report.

To file, the landlord lists the $1,200 on Schedule E, then subtracts the $600 of qualified expenses on the same line item, mirroring the treatment described in the 'offset forfeited income with deductible costs' paragraph. The IRS Publication 527 page on security deposits explains this process in detail (IRS publication on rental property).