" I will pay the tenant his earned interest and keep the principal as rent." you have a tax issue.
if a security deposit is intended to be used as a final rent payment, the amount of the deposit is included as rental income by a landlord when it is received, even if a lease does not end until a following year. report the interest on 1099-INT and then use the nominee adjustment line to zero it out so you don't pay taxes on it. however, this is only if state law requires you to pay or return interest earned on the deposit. if it's not then it's your income. you get a deduction in the year you return it to the tenant which may not happen if damage is dome to the property and the law allows yo to keep the interest as part of the damages.
