Security deposits are not taxable income for landlords at the time you receive them, as long as you plan to return the money to the tenant at the end of the lease. The tax picture only changes when you gain the right to keep some or all of the funds, when the lease treats the deposit as a final rent payment, or when the charge is non-refundable from the start. At that point, the amount becomes rental income for the year you keep it and gets reported on Schedule E.
When the Deposit Stays Off Your Return
The IRS position is direct: do not include a security deposit in your income when you receive it if you plan to return it to your tenant at the end of the lease.1Internal Revenue Service. Publication 527, Residential Rental Property Because you owe the money back, it isn’t yours yet. You don’t report receiving it, and you don’t owe tax on it while the lease is running and the tenant is meeting its terms.
The operative word is “plan.” Your intent to return the money is what preserves the non-taxable status. That intent evaporates the moment something in the tenancy gives you a legal right to keep the funds.
When a Retained Deposit Becomes Income
If you keep part or all of a security deposit during any year because the tenant didn’t live up to the lease terms, include the amount you keep in your income for that year.1Internal Revenue Service. Publication 527, Residential Rental Property The usual triggers are unpaid rent, early lease termination, and property damage beyond normal wear and tear.
Timing follows retention, not receipt. If a tenant moves out in March 2026 owing back rent and you apply the deposit to that balance, the retained amount is 2026 income, no matter when the tenant first paid it.
Damage Repairs and the Deduction Pairing
When you withhold part of a deposit to cover repairs, the tax treatment depends on whether you deduct the repair costs. If you deduct the repair expenses, include the retained deposit in your income for that year.2Internal Revenue Service. Topic No. 414, Rental Income and Expenses The two often wash: keep $1,200 to replace a carpet, deduct $1,200 as a repair, and the net effect on your taxes is zero.
If your practice is not to deduct repair costs as expenses, you don’t include the retained deposit in your income to the extent it reimburses those costs.2Internal Revenue Service. Topic No. 414, Rental Income and Expenses What you can’t do is skip the income side and still deduct the repairs. Pick one approach and be consistent.
When the Money Funds an Improvement Instead of a Repair
Ordinary repairs that keep the property in working condition are deductible in the year you incur them. Improvements that add value, extend the property’s life, or adapt it to a new use must be capitalized and depreciated over time.1Internal Revenue Service. Publication 527, Residential Rental Property Patching drywall, fixing a broken window, or repainting after a move-out is usually a repair. Replacing a roof or an entire HVAC system is an improvement.
If you retain a deposit to fund an improvement, you still report the retained amount as rental income in the year you keep it, but you can’t offset it with a full deduction that same year. You recover the improvement cost gradually through depreciation. That means the deposit income hits your return now while the write-off drags out over future years.
Deposits That Function as Last Month’s Rent
If the lease says the deposit will be applied to the final month’s rent, the IRS doesn’t treat it as a security deposit at all. It’s advance rent, and advance rent is taxable the moment you receive it, regardless of your accounting method or when the rent period it covers begins.1Internal Revenue Service. Publication 527, Residential Rental Property
The lease label controls. A payment called a “security deposit” that your lease designates as the final rent payment is advance rent.1Internal Revenue Service. Publication 527, Residential Rental Property So if a tenant hands you $2,000 in January labeled as last month’s rent for a lease ending the following December, that $2,000 goes on your current year’s return even though the rent period is almost a year away. If you collect both a refundable deposit and a last-month’s-rent payment, keep them clearly separated in the lease so the tax treatment is obvious for each.
Non-Refundable Fees
Pet fees, cleaning fees, move-in fees, and similar charges don’t qualify for the “plan to return it” exception because the money is never coming back to the tenant. A non-refundable payment is rental income in the year you receive it, whatever you call it in the lease. Labeling a charge as a “non-refundable deposit” doesn’t change the analysis. If the tenant can’t get it back, it’s a fee, and it’s taxable when received.3Internal Revenue Service. Rental Income and Expenses – Real Estate Tax Tips
Interest Earned on the Deposit
Several states require landlords to hold security deposits in interest-bearing accounts and pay the interest to the tenant. When state law requires you to pay that interest over, the tenant generally owes the income tax on it. Your obligation is reporting: if you pay $10 or more in interest to a tenant in a tax year, you must file Form 1099-INT for that payment. If you pay interest of $600 or more in the course of your rental business, the reporting requirement applies regardless of the $10 threshold.4Internal Revenue Service. Instructions for Forms 1099-INT and 1099-OID Keep per-tenant records of interest accrued and paid so year-end filing is clean.
In states that don’t require an interest-bearing account, any interest the deposit earns while it sits in your bank account is your income, because you’re the account holder. Report it like any other interest income.
Where It Goes on Your Return
Taxable security deposit amounts go on Schedule E (Supplemental Income and Loss) of Form 1040, on the “rents received” line for the property. If you own multiple properties, Schedule E gives each one its own column.5Internal Revenue Service. Instructions for Schedule E (Form 1040) Repair expenses you’re pairing with a retained deposit go on the expenses side of the same schedule, so both the income and the deduction appear on one form.
Recordkeeping is what backs all of this up. Keep the lease, move-in and move-out inspection reports, photos of damage, repair invoices, and correspondence about deductions from the deposit. If the IRS questions the return, those documents are what show the retention was justified and the repair costs were real.
What Underreporting Costs
Leaving retained deposits off your return exposes you to the accuracy-related penalty of 20 percent of the underpaid tax, which applies when the IRS finds a substantial understatement of income or negligent disregard of the rules.6Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments In cases involving intentional concealment, the civil fraud penalty is 75 percent of the underpayment attributable to fraud.7Office of the Law Revision Counsel. 26 USC 6663 – Imposition of Fraud Penalty Interest on the unpaid tax accrues on top of either penalty from the original due date. A single deposit is usually a modest amount, but the numbers add up quickly if the IRS finds a pattern across multiple properties or years.