Renting out your property to a new tenant comes with risks for potential damages and unpaid rent. To protect your real estate investment, collect a rental security deposit — a one-time payment that you hold throughout the lease term.
You can use the refundable deposit as a financial cushion in case anything goes wrong.
Keep reading to learn more about security deposit accounting, including limits on security deposit amounts, security deposit deductions, how to account for returns, and more.
3 Tips for Accounting for Security Deposits
If you want to be a successful landlord, you have to keep track of your security deposits. Here are some best practices for managing security deposits.
1. Understand Local Security Deposit Laws
Security deposit laws vary by state. As a landlord, you must follow local laws regarding the security deposit amount, the type of account where it should be held, and the conditions for deductions. Make sure you know how long you have to return the deposit after a tenant leaves.
You also need to know if the deposits should be kept in an escrow bank account or a separate bank account from your operational funds. Some states also require a deposit account to accrue interest paid to the tenant. Learn which states have these requirements so you can comply.
2. Use a Separate Bank Account for Security Deposits
Using a separate security deposit account can help simplify your rental property accounting, even if the law doesn’t require it. It’s a good way to track deposits from different tenants and prevent deposits from getting mixed up with other financial transactions or payments.
Keeping security deposit money in a separate bank account ensures these funds aren’t used for operating expenses, so they’ll be available when it’s time to return the deposit. This is especially important for accounts accruing interest that must be paid to tenants.
3. Avoid Recording Security Deposits as Income, Except in Certain Circumstances
According to the IRS, you don’t have to report security deposits as rental income if you plan to refund them. There are a few exceptions, though:
- Deposits used for last month’s rent payments should be recorded as advance rent and reported as income.
- Keeping all or a portion of a deposit is considered income for your rental business.
Put security deposits on your balance sheet as a liability when you receive them, reflecting your obligation to return them. Keep detailed financial records of the reception date, tenant’s name, and property address.
What Can You Fix with a Security Deposit?
Security deposits shouldn’t be used for normal wear and tear, like minor dents on door handles, faded paint, and small marks or carpet stains. These funds are meant to cover the cost of repairs and the cost of cleaning, including:
- Broken fixtures and tiles in bathrooms
- Removing wallpaper or paint applied by the tenant
- Excessive mildew and mold in the bathroom
- Large holes in the walls
- Pest control, including fleas and ants
- Damaged or broken appliances
You can also use a security deposit for unpaid utility bills and unpaid rent. All deductions must be recorded in a written notice provided to tenants within the time allowed by each state.
Security Deposit Accounting: Step-by-Step Instructions
The general steps to account for security deposits are:
1. Open a business account for security deposits and give it an alternative name like “Security Deposit Account for Unit 1.”
Check to see if your state’s landlord-tenant laws require interest-bearing accounts. If the bank charges monthly maintenance fees, deposit enough to avoid deducting from the security deposit amount.
2. Outline details of the security deposit process in the lease agreement.
Make sure to include how much the security deposit is, where it’s held (in escrow or a separate account), and if interest is paid to the tenant.
3. Record the security deposit on the real estate balance sheet as a short-term liability.
Say the Simpson Family pays their landlord a $3,000 security deposit for their Texas single-family rental. The landlord records the $3,000 deposit as a cash asset in the bank account used for security deposits and a liability that needs to be returned after the lease ends.
4. Identify who owns the security deposit.
Labeling security deposits makes them easier to track, especially if you manage multiple properties. For example, the landlord might note that the Simpson Family paid $3,000 for the rental property located at XYZ NY Lane using ACH (Automated Clearing House).
How to Account for Security Deposit Returns
When it’s time to return the security deposit, there are a few things to keep in mind.
Step 1: Receiving the security deposit:
- Record the full amount (e.g., $2,000) of security deposits on the balance sheet as a liability.
- This amount is not considered an expense; it is a liability you intend to return.
Step 2: Withholding a deposit:
- Specify the amount to be withheld (e.g., $275 for cabinet repairs).
- Report the deducted amount as rental income on the date it was withheld.
Step 3: Returning the deposit:
- Adjust your liability on the balance sheet to the new value after withholding (e.g., from $2,000 to $1,725).
- The withheld amount should now be moved to your operating account for repairs.
Step 4: Using security deposit deductions:
- Use the withheld amount (e.g., $275) for the intended repairs or payments owed for rent or utility bills.
- Report this as an expense in your Schedule E under the correct expense category.
Step 5: Returning the deposit:
- Return any remaining security deposit amount (e.g., $1,725) to the tenant.
- Your balance sheet should now show the security deposit liability as $0.
Accurate Security Deposit Accounting With Baselane
Security deposit accounting errors can lead to paying for repairs out of your pocket or facing legal action from tenants. Using property management tools to collect and track security deposits will help avoid potential problems that arise with manual bookkeeping and accounting.
Baselane’s property management software puts everything you need to manage security deposits and rental finances all in one place. You can open multiple security deposit accounts, collect and return deposits online, automatically record and track deposits, and more.
Learn more about how you can collect and manage rent and security deposits online.
Click here to register for the FREE Baselane Demo.
Some FAQs on Security Deposit Accounting
Is a security deposit a current asset?
Security deposits are typically listed under current assets if they’re expected to be returned within a year. If they will be held for more than a year, they might be listed under long-term assets.
How is the security deposit shown on a balance sheet?
Security deposits are usually shown as liabilities on the security deposit balance sheet. It’s recorded this way because funds might need to be returned to the tenant at the end of the lease.
Are security deposits an expense?
Security deposits aren’t an expense. They are recorded on balance sheets as a liability. Only deductions used for repairs or unpaid bills are recorded as expenses in a Schedule E.