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Security Deposits in Residential Rentals: Accounting for Lease Income After COVID-19

May 15, 2020

As the COVID-19 pandemic continues and stresses our economy across the board, many individuals are struggling to make their rent payments. In an effort to keep units occupied, landlords of residential dwellings are working to renegotiate lease terms and offer some rental concessions to assist their tenants during these difficult times. One agreement landlords and tenants may strike is to apply the tenant’s security deposits against rents in arrears. Naturally, this will lead to many questions from landlords on how to recognize these renegotiated changes for income tax purposes.

A security deposit is a sum deposited by a tenant with a landlord to secure the tenant's performance of their obligations under the lease, such as rent payments, the restoration of the leased property, or any of the tenant's other lease obligations. Generally, the tax treatment of a security deposit is similar to that of a loan from the tenant to the landlord. The landlord may be obligated to pay it back assuming the tenant has met all obligations upon termination of the lease. Therefore, it is generally not considered income when received by the landlord.

However, when the deposit is used to offset a tenant’s obligation under the lease terms, it would be considered income to a cash basis landlord and, for an accrual basis landlord, it would offset the tenant’s accounts receivable ledger. During this current economic situation, the benefit to this arrangement for accrual basis landlords who have already reported the income is providing current access to an otherwise restricted cash account. However, as there no longer is a deposit, the tenant may not have the incentive to maintain the leased property with care, and if the tenant were to severely damage the property, the landlord may have little recourse at this time to cover the damages.

It should be noted that due to recent legislation by various states, landlords may have their hands tied as far as renegotiating goes. Here in the tri-state area, each of New York, New Jersey and Connecticut have given tenants the option to use their existing security deposits account plus any accrued interest earnings to offset rent due. Below is a table summarizing the details of recent legislation for the tri-state area.

Date Effective into Law 4/10/2020 5/7/2020 4/24/2020
Who must originate security deposit request to offset rent? Tenant Tenant Tenant
Tenant request must be writing  (email is acceptable) Yes Yes Yes
Emergency law period 3/10 - Through duration of state emergency declaration 3/7/20 - 6/7/20 3/9/20 thru 60 days after end of state emergency declaration
Can tenant use deposit to offset rent in arrears? Only can be used for rents due for April, May, June 2020, and only a tenant's deposit exceeding one month's rent can be applied as rent. Yes Only for rents originally due during state emergency period plus an additional 60 days
Can tenant use deposit to apply against upcoming rent due? Only can be used for rents due for April, May, June 2020, and only a tenant's deposit exceeding one month's rent can be applied as rent. Yes Only for rents originally due during state emergency period plus an additional 60 days
Are all tenants eligible to use their deposits? Tenant must express in writing they have experienced financial hardship due to covid-19 Only those eligible for unemployment insurance or other benefits under Fed or state law due to Financial hardship due to Covid-19 Pandemic. Yes
Is tenant required to replenish deposit? Yes Yes No, unless a new lease is renewed or extended
When does replenishment period start? Landlord may demand full replenishment at end of emergency declaration No less than 90 days from the date the security deposit was applied against rent due. Upon exection of new  or extension of lease, at which point the deposit mush be replenished by the later of six months after emergency period ends or date lease was extended/revised
How is deposit replenished? In full upon demand 1/12th of deposit used for rent is due back from tenant in monthly installments In full upon demand

Landlords will look to include new lease terms for the tenant to eventually restore the deposit either through installments starting over the remaining lease life, or in one lump sum payment at an agreed- upon date during the lease life. The receipt of these future payments, whether in lump sum or installment to replenish a tenant’s deposit obligation, would not be considered income to the landlord.

As the impact of this crisis continues to develop, landlords and property management companies will continue to look for innovative solutions such as utilizing security deposit funds. Every solution has a potential effect on financial reporting and should be considered carefully during implementation.

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Artur Kilerciyan

Artur Kilerciyan is a Tax Senior Manager in the Real Estate Services Group with over 15 years of public accounting experience.

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