Accounting for Security Deposits: Why a Deposit Isn't Income

When a new tenant moves in, a landlord usually collects two kinds of money: the first month’s rent and a security deposit. They often arrive in the same transfer, land in the same account, and look alike on a bank statement. They aren’t alike. Rent is yours. A security deposit is, for now, the tenant’s money that you are holding.

Getting this right keeps your books accurate, keeps your tax return right, and makes the end of a tenancy much less stressful. This guide explains why a deposit isn’t income, how to record it, how to handle deductions and refunds, and the special case of a deposit used as the last month’s rent.

Why a deposit isn’t income

A security deposit protects you against unpaid rent or damage beyond normal wear. If the tenant leaves the home in good shape and owes nothing, you give it back. Because you expect to return it, it’s a debt you owe the tenant, not money you’ve earned.

The IRS treats it the same way. Under Publication 527 (2025 edition), a security deposit isn’t included in income when you receive it if you plan to return it to the tenant at the end of the lease. If you later keep some or all of it, for example because the tenant didn’t live up to the lease, the amount you keep is income in the year you keep it.

Recording a deposit as a liability

In bookkeeping terms, a security deposit is a liability: an amount the business owes. When you receive one, the money in your bank account goes up, and so does what you owe. Nothing touches income.

Worked example: a tenant pays $3,800 at move-in, made up of $1,800 for the first month’s rent and a $2,000 security deposit.

$1,800 is recorded as rent income.
$2,000 is recorded as security deposits held, a liability, for that tenant and that home.

At the end of the year, your rental income shows $1,800 from this move-in, not $3,800.

If you have several homes or tenants, keep a running list of what you hold for each: the tenant, the home, the amount, and the date received. The total of that list should equal your security deposits liability.

Where to keep the money

Many landlords keep deposits in a separate bank account so the money is never spent by accident. Some states and cities go further and require deposits to be held in a particular kind of account, kept separate from the landlord’s own funds, or to earn interest for the tenant. These rules vary a great deal from place to place. Check your state’s and city’s landlord-tenant law, or ask an attorney, before you decide where deposits go.

Deductions at move-out

When a tenancy ends, you compare the home’s condition with the move-in record and check whether any rent is owed. If you keep part of the deposit, two things happen in your books:

The liability goes down by the full deposit.
The part you keep becomes income, and the rest is refunded.

Continuing the example: the tenant moves out owing nothing in rent, but a damaged door costs $350 to repair.

You keep $350 and refund $1,650.
The $2,000 liability is cleared.
$350 is recorded as income (the deposit kept).
$1,650 is recorded as a refund to the tenant.
The $350 repair bill you pay is recorded as a repair expense in the usual way.

Record why each deduction was taken: the damage, the cost, and the invoice or receipt. Many states require landlords to give tenants a written, itemized list of deductions within a set number of days after move-out, and some set penalties for missing the deadline. The details vary, so check your state’s rules.

Normal wear isn’t damage

What you can deduct for, and what counts as normal wear and tear rather than damage, is also a matter of state law and your lease. Faded paint after several years is usually treated differently from a hole in the wall. When in doubt, take advice before deducting.

A deposit used as the last month’s rent

Some leases say that a deposit will be applied to the final month’s rent. Under Publication 527, that’s not a security deposit at all: it’s advance rent, and advance rent is income in the year you receive it, whatever period it covers.

Worked example: a lease signed in November asks for $1,800 first month’s rent, $1,800 last month’s rent and a $1,000 security deposit.

$1,800 first month: rent income when received.
$1,800 last month: also rent income when received, even though it covers a month far in the future.
$1,000 security deposit: a liability until the tenant moves out.

If you’re unsure which kind of deposit your lease creates, look at the wording, and ask your tax preparer or an attorney.

Common mistakes

Counting the whole move-in payment as rent, which overstates income and leaves no record of what you owe the tenant.
Recording the refund as an expense. Returning a deposit isn’t a cost of running the rental; it repays a debt.
Spending the deposit, then struggling to refund it when the tenant leaves.
Losing the paper trail for deductions, which makes disputes harder to resolve.
Forgetting state deadlines for returning deposits or sending an itemized list.

A simple routine

Record each deposit as a liability, by tenant and home, when received.
Keep the money where your state’s rules allow, ideally separate from your own.
Reconcile the deposits you hold with the liability total every month.
At move-out, record deductions with reasons and receipts, the income from what you keep, and the refund.
Keep the records for the whole tenancy and the record-keeping period after.

How Kemback fits

Rental Houses, part of Kemback Business, holds each security deposit as a liability, not income, and records deductions with their reasons and refunds when a tenancy ends. Rent and deposits are recorded, never taken: tenants pay you directly, and Kemback matches each payment to the deposit in your own bank account. A free tenant portal shows each tenant their own tenancy, lease and receipts. See rental property tracking, pricing or create an account.

This post is general information, not tax or legal advice. Security deposit rules vary by state and city and tax rules change over time; check with a qualified tax professional or attorney for your situation.

#security deposits #rental properties #landlord bookkeeping

This article is general information, not financial, tax or legal advice. For decisions about your situation, talk to a qualified professional.