The short version
- A security deposit is the tenant's money that you hold. Record it as a liability, not as income.
- It only becomes income when you apply part of it to rent, fees or damage at move-out.
- Many states require deposits to be held in a separate account or pay interest. Know your state's rules.
- Each month, the deposit account balance should match the total deposits you hold on the balance sheet.
- Last month's rent paid in advance is different from a deposit and is usually treated as prepaid rent.
Security deposits cause more bookkeeping mistakes than almost any other item in rental accounting. The most common one is simple: the deposit lands in the operating account, gets counted as income, and then the landlord is short when it is time to refund it.
Getting it right is not complicated once you see the logic. This guide walks through the full life of a deposit with the entries at each step.
The core idea: it is not your money yet
When a tenant pays a $2,000 security deposit, you have more cash, but you also owe that $2,000 back, minus any lawful deductions, when they move out. In accounting terms, the deposit is a liability. It sits on the balance sheet, not the profit and loss statement.
That one rule drives everything else:
- Deposits do not appear as income when received.
- They do not count toward owner distributions.
- They become income only if and when you keep some of the money at move-out.
The security deposit definition page has the plain language basics, and real estate accounting basics shows where deposits fit in the chart of accounts.
The accounts you need
Set up three accounts before the first deposit comes in:
| Account | Type | Purpose |
|---|---|---|
| Security deposit bank account | Asset (bank) | The actual cash held for deposits |
| Security deposits held | Liability | What you owe tenants |
| Operating bank account | Asset (bank) | Rent, bills and owner money |
If your state requires interest, you may also want a liability account for interest owed to tenants. The chart of accounts setup article covers a full rental chart of accounts.
Step 1: Move-in
The tenant pays a $2,000 deposit at lease signing. You deposit it into the security deposit bank account.
| Account | Debit | Credit |
|---|---|---|
| Security deposit bank account | $2,000 | |
| Security deposits held (liability) | $2,000 |
Nothing hits income. The tenant’s ledger should show the deposit received, separate from rent. Issue a receipt; several states require a written receipt or a notice saying where the deposit is held. Our security deposit receipt template covers the usual details.
Step 2: During the tenancy
Usually nothing happens, with two exceptions.
Interest. If your state or city requires interest on deposits, accrue it as the law requires. Interest owed to the tenant increases the liability. Some laws require annual payment or credit against rent; others pay at move-out.
Applying the deposit early. In most cases you should not apply the deposit to unpaid rent while the tenant still lives there. Many leases forbid it, and doing so leaves you unsecured for the rest of the tenancy. Wait until move-out.
Step 3: Move-out with deductions
The tenant moves out. After your inspection, you document:
- Unpaid rent: $300
- Cleaning beyond normal wear: $250
- Repair to a damaged door: $150
Total deductions: $700. Refund to tenant: $1,300. You send the itemized statement within your state’s deadline.
The entry clears the full $2,000 liability:
| Account | Debit | Credit |
|---|---|---|
| Security deposits held (liability) | $2,000 | |
| Tenant receivable (applies to unpaid rent) | $300 | |
| Cleaning and repairs (or a tenant charges income account) | $400 | |
| Security deposit bank account (refund paid) | $1,300 |
Two notes on this entry:
- The $300 applied to unpaid rent closes the rent balance on the tenant’s ledger. If you are on a cash basis, that rent becomes income now, because this is when you actually received it.
- Practices vary on the $400. Some landlords credit the expense accounts where the cleaning and repair costs were recorded; others use an income account for tenant charges. Pick one approach with your CPA and use it consistently.
Finally, move the $700 you kept from the deposit bank account to the operating account, since it is no longer deposit money. Record it as a transfer between the two bank accounts.
Step 4: Full refund
If there are no deductions, the entry is simple:
| Account | Debit | Credit |
|---|---|---|
| Security deposits held (liability) | $2,000 | |
| Security deposit bank account | $2,000 |
Deposits versus last month’s rent
Many landlords collect first month’s rent, last month’s rent and a deposit at signing. Last month’s rent is not a security deposit. It is rent paid in advance, usually recorded as prepaid rent, a separate liability, until the month it covers. For tax purposes, rent paid in advance is generally income when received, even if your books hold it as prepaid. Ask your CPA how to handle this on your return.
Pet deposits, key deposits and similar refundable amounts follow the same logic as security deposits. Non-refundable fees, such as a pet fee or an application fee, are income when received. The pet deposit page explains the difference.
The monthly check
Every month, compare two numbers:
- The security deposit bank account balance, after reconciliation
- The security deposits held liability balance on the balance sheet
They should match, plus any interest you have accrued but not yet paid. If they do not, look for a deposit put in the operating account by mistake, a refund recorded in the wrong account, or a move-out deduction that was never transferred out. The bank reconciliation walkthrough covers the reconciliation itself.
Rules that vary by state
State law sets most of the rules around deposits. Before you set up your process, check:
- The maximum deposit you can charge
- Whether a separate account or an interest-bearing account is required
- Whether interest must be paid, at what rate and how often
- Receipt and notice requirements at move-in
- The deadline and format for the itemized statement at move-out
- Penalties for missing the deadline
Our security deposit guide covers these topics in general, and our state law pages include deposit rules for each state we publish, such as the California security deposit laws.
How software handles it
The easiest way to avoid deposit mistakes is to use a chart of accounts that treats deposits correctly from day one. In TenantLoop accounting, deposits, prepaid rent and owner money have their own accounts from the start, so a deposit never shows up as income. Deposits held are listed per unit on the rent roll, and the balance sheet shows the liability next to the deposit bank account so the monthly check takes seconds.
Deposit accounting checklist
- Separate bank account for deposits, if required or practical
- Liability account for deposits held, and one for prepaid rent
- Receipt or notice issued at move-in where required
- Interest accrued if your state or city requires it
- Deposit not applied to rent during the tenancy
- Itemized statement sent within the state deadline
- Deductions moved from the deposit account to operating
- Monthly match between deposit bank balance and liability
Note: This is general information, not tax or legal advice. Deposit laws differ by state and city, and tax treatment depends on your situation. Check with your CPA and a local attorney.
What readers ask next.
Is a security deposit taxable income?
Generally not when you receive it, as long as you intend to return it. The IRS treats a deposit as income in the year you keep part of it, for example to cover unpaid rent or damage. A deposit described as last month's rent is usually taxed when received. Confirm the treatment with your CPA.
Do I have to keep security deposits in a separate bank account?
Some states require it, sometimes in an interest-bearing account or at an in-state bank, and some require you to tell the tenant where the deposit is held. Even where it is optional, a separate account makes the bookkeeping much simpler.
How do I record interest on a security deposit?
If your state or city requires interest, the interest generally belongs to the tenant. Record it as an addition to the deposit liability, and pay it out on the schedule the law requires, often annually or at move-out.
What is the difference between a security deposit and prepaid rent?
A deposit secures the tenant's obligations and is refundable. Prepaid rent, including last month's rent collected at signing, is rent paid in advance. It is held as a liability until the month it covers and is usually taxed when received.