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From IRS Topic 414 re Rental Income:
Security deposits – Do not include a security deposit in your income if you may be required to return it to the tenant at the end of the lease. If you keep part or all of the security deposit because the tenant breaks the lease by vacating the property early, include the amount you keep in your income in that year. If you keep part or all of the security deposit because the tenant damaged the property and you must make repairs, include the amount you keep in that year if your practice is to deduct the cost of repairs as expenses. To the extent the security deposit reimburses those expenses, do not include the amount in income if your practice is not to deduct the cost of repairs as expenses. If a security deposit amount is to be used as the tenant's final month's rent, it is advance rent that you include as income when you receive it, rather than when you apply it to the last month's rent.
This is a part where the tax code differs from the law and in which neither of the aforementioned agree with GAAP.
I believe a best practice to apease all the government and professional association acronyms, is to treat the deposit as income in the year received and expense in the year returned.
If you do intend to hold the deposit in unearned income per your landlording books and carry that treatment to the tax return, make sure the deposit is held in a separate interest bearing account that is set up with an escrow. The interest earned should be credited to the tenants account ledger annually at a minimum. When the tenancy terminates, send the reconciliation of their deposit, their refund check (or likely bill), and a timely form 1099INT for the amount of interest that their account accrued over their tenancy (if the tenant stays for multiple years, the 1099INT filing should align with entries to the tenants account ledger i.e. if crediting tenant account annually, send a timely form 1099INT for the interest earned each tax year.)
Additionally all of this should be double checked against some seriously stringent local statutes that vary widely at the city to city level, which landlords would be wise to head avoiding trouble with fair housing authorities and the like.
The above scenario has worked well in my experience in several California Counties, the state of Nevada, Texas, and various international outreaches.
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