Security deposits are not income when you receive them
The single rule that saves new landlords from themselves: a security deposit is not income when you receive it. It's money you're holding in trust—like a coat check ticket. The coat still belongs to someone else until they leave scuff marks on the wall.
Treat it as a liability on your books. Spend it like it's yours and you may owe it back with interest, penalties, or a very unhappy tenant lawyer—depending on your state's mood.
When you receive a security deposit: - Record it as a liability (you owe this money back to the tenant) - Do not count it as rental income - Hold it separately from operating funds (required by law in many states)
State-specific requirements for holding deposits
Most states require security deposits to be held in a separate, dedicated account—either a regular savings account or a dedicated security deposit account. Some states require the account to be interest-bearing, and require you to pay accrued interest to the tenant at the end of the tenancy (minus a small administrative fee in some states).
Check your state's landlord-tenant law for: - Whether deposits must be held in a separate account - Whether the account must be interest-bearing - What interest rate applies (if required) - How soon you must return the deposit after move-out - What documentation you must provide when making deductions
Penalties for violating security deposit laws can be severe—some states allow tenants to recover 2–3 times the deposit amount if the landlord fails to comply with return and documentation requirements.
How to track deposits
Use a simple ledger or spreadsheet with columns for: - Tenant name - Unit address - Deposit amount - Date received - Date returned or deducted - Amount returned - Amount withheld (with reason)
At any given time, the total of all active security deposit liabilities should match the balance in your security deposit account.
If you commingle deposits with your operating account (where allowed), you must still track each deposit as a separate liability. The balance in your operating account should always be sufficient to cover all outstanding deposit obligations.
When the deposit becomes income
A security deposit becomes income only when you have a legitimate claim against it and you retain the funds. This happens when:
- Tenant damages the unit — You withhold funds to cover repairs beyond normal wear and tear
- Tenant fails to pay rent — You apply the deposit to unpaid rent
- Tenant breaks the lease early — You withhold funds for early termination penalties (if allowed by your lease and state law)
- Cleaning costs — You withhold funds for cleaning beyond normal move-out cleaning (if allowed)
When you make a valid deduction, the amount withheld becomes income in the year you keep it, and the corresponding repair or cleaning expense is deductible.
Example:
Tenant moves out. You inspect and find: - Carpet cleaning: $150 - Repair hole in wall: $200 - Rekey locks: $75
Total deductions: $425
You held a $1,200 deposit. You return $775 to the tenant and keep $425.
Accounting: - The $425 you kept becomes income - The $425 in repairs/cleaning is deductible as an expense - Net effect on taxable income: $0 (the income and expense offset)
Normal wear and tear cannot be deducted
Security deposits can only be used for damage beyond normal wear and tear. What qualifies as normal wear depends on how long the tenant lived there, the condition when they moved in, and local standards.
Normal wear and tear (not deductible from deposit): - Faded paint or minor scuff marks after several years - Carpet wear in high-traffic areas - Minor scratches on floors - Loose cabinet hinges or handles after years of use - Worn caulking or grout
Damage beyond normal wear (deductible from deposit): - Large holes in walls - Stains or burns in carpet - Broken windows or doors - Pet damage (if pets were not allowed or damage exceeds agreed-upon limits) - Missing or broken fixtures - Extreme uncleanliness requiring professional cleaning
If you make deductions, document them with photos, receipts, and written explanations. Most states require you to provide an itemized list of deductions within a specific timeframe (often 14–30 days).
What if the damage exceeds the deposit?
If repair costs exceed the deposit, you can pursue the tenant for the additional amount. Whether you succeed depends on: - Your lease terms - State law - Whether you can locate the tenant - Whether the tenant has assets to collect against - Whether it's worth the cost and effort to pursue (small claims court, collections)
Many landlords write off losses that exceed the deposit by a small amount (under $500–$1,000) because the cost of collection exceeds the potential recovery. For larger amounts, small claims court or a collections agency may be worth pursuing.
Interest on deposits
If your state requires security deposits to be held in an interest-bearing account and interest paid to the tenant: - Track the interest accrued for each tenant separately - Pay the interest to the tenant when you return the deposit (or at annual intervals, depending on state law) - The interest you pay is a deductible expense - The interest the account earns is taxable income to you (you'll receive a 1099-INT if the account is in your name or your business name)
Some states allow you to retain a small administrative fee (e.g. 1%) when paying interest to tenants. Check your state's rules.
Last month's rent vs. security deposit
Some landlords collect last month's rent in addition to a security deposit. These are not the same and must be tracked separately.
- Last month's rent is income when received. You're being paid in advance for a future month of occupancy. This is taxable in the year you receive it.
- Security deposit is not income when received. It's a refundable deposit unless you have a claim against it.
Make sure your lease clearly states which funds are a security deposit and which are advance rent.
Move-out checklist for proper deposit accounting
When a tenant moves out:
- Inspect the unit within 24–48 hours (before cleaning or repairs, to document condition accurately)
- Photograph or video every room, appliances, fixtures, and any damage
- Compare to move-in inspection (you should have a move-in inspection report and photos for every tenancy)
- Itemize deductions with photos, receipts, and descriptions
- Return deposit or send itemized statement within your state's required timeframe
- Record the transaction in your books:
- Amount returned to tenant (reduces security deposit liability to $0)
- Amount withheld (becomes income)
- Repair/cleaning expenses (deductible)
Holding deposits vs. security deposits
A holding deposit (sometimes called an application deposit) is paid when a prospective tenant applies to hold the unit while their application is processed. This is different from a security deposit.
If the applicant is approved and signs the lease, the holding deposit typically converts to part of the security deposit or first month's rent. If the applicant withdraws or is denied, you may or may not return the holding deposit, depending on your lease terms and state law.
Check your state's rules on holding deposits—some states regulate them separately from security deposits.
You might also like:
- Security Deposits & Move-Out topic hub — Full guide to deposit accounting, deductions, and turnover procedures
- Tenant moved out early and stopped responding: what landlords should do next
- Rental property bookkeeping basics for small landlords
- What to do when a tenant gives notice: a turnover checklist for self-managing landlords
ManorKeeper tracks security deposits by unit and tenant
ManorKeeper automatically tracks security deposits as liabilities, logs deductions with documentation, and generates move-out reconciliation reports. See how security deposit tracking works.