Landlords require security deposits from tenants to help ensure the rent will be paid on time and the other terms and conditions of the lease will be met. But tenants also expect landlords to keep their deposits secure.

As a good business practice and to comply with the law, landlords need to have a security deposit accounting system in place to keep track of the deposit and hold security deposits in trust.  

Key takeaways

• A security deposit is collected from a tenant by a landlord to help ensure that the tenant lives up to the terms of the lease.
• Landlords are responsible for accurately keeping track of security deposits held in trust
• In most cases, security deposits are not treated as rental income.
• State landlord-tenant laws, along with housing laws in some cities, set rules for how a landlord must hold a security deposit, if interest on the deposit needs to be paid, and how soon a landlord must return the deposit after the lease ends.
• A landlord may be able to withhold part of all of a tenant’s security deposit to pay for unpaid rent or damage caused by the tenant, although state laws vary.

Why do landlords collect a security deposit?

A security deposit is money collected from a tenant to protect a landlord from potential financial harm caused by a tenant, such as not paying the rent, damaging the property, or violating other terms of the lease.

While state laws don’t require a tenant to request a security deposit, most landlords do ask for a deposit as part of the up-front money paid before a tenant moves in (along with the first month’s rent and any pro-rated rent). 

Tenant security deposits are normally refundable to the tenant at the end of the lease, unless the lease agreement states otherwise. 

Is a security deposit considered rental income?

Security deposits that are meant to be returned to tenants are not treated as rental income, with a couple of exceptions. 

As the IRS explains in Tips on Rental Real Estate Income, Deductions and Recordkeeping, a security deposit is considered to be rental income:

• If a security deposit is used as a final rent payment, the deposit is considered to be advanced rent and recorded as income when it is received using the cash basis method of accounting.
• If all or part of a security deposit is not returned to the tenant because the tenant does not live up to the terms and conditions of the lease, the amount of the security deposit withheld is recorded as income in that year.

Reasons for keeping a security deposit separate

Some states require a landlord to hold a tenant’s security deposit in a separate account, while others do not. However, even if a state’s landlord-tenant laws do not require it, landlords normally hold a security deposit in a separate account for several reasons:

• Prevents commingling security deposit money with other business or personal funds.
• Avoids accidentally spending the tenant’s security deposit for operating expenses or capital expenditures.
• Easier to keep track of a security deposit when it is held in a separate account.
• Ensures the security deposit funds are immediately available when the tenant eventually moves out.
• Accurately tracks interest accrual that belongs to the tenant if the state requires security deposits to be held in an interest-bearing account.

Security deposit accounting: step-by-step instructions

Keeping track of a security deposit is relatively easy. Here are the general steps landlords follow to accurately account for security deposits:

1. Open a business checking or savings account specifically designated for security deposits and assign the account an “alias” name such as “Security Deposit Trust Account.” 

Be sure that the account is interest bearing if required by state landlord-tenant laws. Also, if the bank charges a monthly maintenance fee for the account, landlords must deposit enough funds in the account to ensure that the bank fees do not reduce the tenant security deposit amount.

2. In the lease agreement with the tenant, identify the exact amount of security deposit, where it is held (such as in the landlord’s security deposit trust account), and whether or not interest is paid to the tenant on the security deposit.

3. Record the security deposit received as a short-term liability on the real estate balance sheet. 

For example, assume the Smith Family pays their landlord a $2,000 security deposit for their single-family rental home in Texas. The landlord records the $2,000 deposit as a cash asset in the bank account used for security deposits, and also records the deposit as a liability that needs to be returned at the end of the lease (assuming the deposit is not withheld).

4. Identify who the security deposit belongs to. 

In this example, the landlord might note that the deposit was paid by the Smith Family in the amount of $2,000 using an ACH (Automated Clearing House transfer) for the property located at 1234 Longhorn Lane. 

Landlords who have multiple properties sometimes use a single security deposit trust account for all deposits. Labeling each individual deposit makes it easier to accurately keep track of each security deposit

All rental accounting software works a little bit differently for security deposit accounting.

For example, real estate investors who use Stessa to manage a rental property portfolio first categorize the security deposit as “Money In” to “Security Deposits.” 

Because the security deposit is not considered rental income it does not appear on the income statement or net cash flow reports. Instead, the deposit is shown on the rental property balance sheet in the security deposit category.

Is there a limit to the security deposit amount?

Each state sets a maximum limit to the amount of security deposit a landlord can require a tenant to pay. 

Some landlords collect the maximum security deposit allowed as a general business practice, while others vary the security deposit amount based on clear-cut criteria such as the tenant’s credit score. However, landlords take care to treat every prospective tenant equally when setting the security deposit amount, to avoid violating state and federal fair housing laws.

Before requiring a tenant to pay a security deposit, landlords may wish to check with their property manager or see if the city the property is located in has its own regulations for security deposit limits, and to also learn what is customary for the local market.

According to the legal resource website Nolo, these are the state security deposit limits as of December 9, 2020. A state with “no statutory limit” means that the state does not specify the amount of security deposit a landlord may charge:

When should a security deposit be returned?

The security deposit statutes of each state set the maximum amount of time a landlord has to return a security deposit to a tenant. Some cities also have rules regarding when and how a security deposit must be returned.

Some states, such as Arizona and Nebraska, require a landlord to return the tenant’s security deposit within 14 days of the termination date of the lease. Others, such as Alabama and West Virginia, allow a landlord to take up to 60 days to return the security deposit once the tenancy has terminated.

Depending on a state’s laws, landlords who don’t return security deposits on time may be subject to penalties or may be sued by the tenant. Both Nolo.com and the Library of Congress provide links to state statutes.

How to account for a returned security deposit

When a security deposit is returned to a tenant, the funds are paid from the bank account used to hold the security deposit. The balance of the security deposit account on the real estate balance sheet is also reduced, to indicate that the short-term liability no longer exists, because the deposit has been returned to the tenant.

If part of the security deposit is withheld from the tenant, the accounting works a little bit differently. 

To illustrate, recall that when the Smith Family moved into their rental home in Texas they paid a security deposit of $2,000. When the Smiths moved out, they accidentally broke a window, and the quote received by the landlord to repair the broken glass was $250.

To account for the partial return of the tenant’s security deposit, the landlord:

• Returns $1,750 of the Smith’s security deposit from the security deposit bank account, and also reduces the short-term liability on the real estate balance sheet by $1,750
• The remaining $250 recorded on the balance sheet as refundable security deposit is reclassified as rental income, which reduces the short-term liability by $250, so that the short-term liability is now $0
• Cash in the amount of $250 is transferred from the security deposit trust account to the landlord’s operating account and used to pay to repair the window that the Smith Family accidentally broke

When (and if) to withhold a security deposit

Every state has different rules regarding whether or not a landlord can use a tenant’s security deposit to pay for damage caused by the tenant. In most cases, a landlord may be able to use a refundable security deposit to pay for unpaid rent or to cover the costs of damage to the property.

However, a security deposit can not be used to pay for normal wear and tear to the property. Generally speaking, wear and tear refers to normal deterioration due to everyday use. On the other hand, damage may be caused by a tenant due to an accident or neglect.

Examples of normal wear and tear include fading paint, doors sticking due to lack of maintenance, worn grout in the bathrooms, and a window cracked due to settling. Some examples of damage caused by a tenant might include the tenant repainting the house without permission, doors with broken handles or hinges, cracked bathroom tiles, and a broken window.