Tax Treatment of Damage or Security Deposits

Accounting is not that difficult, if you do things right!

The IRS is very (well, kind of) clear about the treatment of damage or security deposits.  The agency does not recommend the owner treat receipt of deposits as income, whether you use cash or accrual as your method of accounting.  (See Topic 414 – Rental Income & Expenses, paragraph Rental Income).

Iowa Law requires rental deposits be held in a separate account, which may be a trust account.  It’s not only a good practice it has become the law.  And, if you’re a third-party manager, it must be a trust account as is subject to audit by IREC.   But that is not our question.  The question came up, “How should the receipt of deposits be treated in the chart of accounts?”

IC562A.12(2).   “All rental deposits shall not be commingled with the personal funds of the landlord. Notwithstanding the provisions of chapter 543B, all rental deposits may be held in a trust account, which may be a common trust account and which may be an interest bearing account. Any interest earned on a rental deposit during the first five years of a tenancy shall be the property of the landlord”.

Thus, as the accounting transaction is posted into your accounting system, posting of the first half of the complete transaction should be treated as an increase in cash to a bank account  — it’s a debit to an asset account. But did receipt of this cash or near cash equivalent really increase your assets?  Nope.  And, what about the second half of this transaction? — should this be an increase in a liability or do we simply show it as an increase in income, upon which we must pay taxes in the year of receipt.  Either way, it’s a credit, and our posting entry would balance, but we still have a problem — where should that credit be posted?    And, what about the transactions to be entered when it’s time to issue a refund, or to claim a portion of the deposit to offset actual damages to your rental property?

As they say, “it’s complicated”.

In accounting, when something gets complicated, it’s time to draw out some T-accounts.  That’s what we’ve done in this cheat sheet example.   We’ll step you through an entire cycle of a “security deposit” for clarity on this challenging aspect of being a landlord — How to account for damage/security deposits.