Rental Income rules for security deposits
Each state has slightly different rules regarding deposits collected when a new tenant moves in. Deposit can be collected for utilities, cleaning, damages, last month rent and some other purposes. Deposits can be refundable or nonrefundable in some cases. The rules will vary from state to state.
A deposit is a liability. In other words this is money that you may have to return at some future date. Because of this many states have enacted rules regarding what can and cannot be done with these funds. In Washington State, these funds must be deposited in a separate bank account and that information disclosed to your tenant. These funds must be held in trust.
Federal Income tax rules applying to deposits
For tax purposes it is important to know the purpose of any deposit. Money that is being held in trust to pay for any future damages or refundable cleaning must be returned within a certain number of days unless written notice is provided as to why any amount has been withheld. This money is not considered income at the time it is received for tax purposes.
When the tenant moves out any portion of the damage deposit not returned to the tenant is considered rental income. Of course generally this is offset by rental expenses that were listed on the written notice provided to the tenant at move out.
If a landlord collects a nonrefundable cleaning deposit or advance rent payment this is considered rental income in the year received.
State income rules generally are similar to the federal rules, but you should consult with your tax preparer.