A taxpayer who rents out property is required to report rental income to the extent of the cash or the fair market value of any property received. Most individuals report their operations to the Internal Revenue Service using the cash basis method of accounting. Therefore, they must include rental income when it is actually received. An amount paid by a tenant to cancel a lease is rental income that is taxable in the year received.

Whether or not a security deposit is taxable rental income depends on the nature of the deposit. If the taxpayer intends to return it to the tenant at the end of the lease period, it should not be included as rental income. At that time, if some or all of the deposit is retained due to damage to the property, the taxpayer has taxable income. However, if the taxpayer plans to use the security deposit as the tenant's last month's rent, then he or she should include it in taxable income in the year that it was received rather than the year it is applied to the rent.

Rental Expenses

The fact that most taxpayers operate on the cash basis requires the reporting of expenses in the year in which they are actually paid. Typical rental expenses include repair, maintenance, advertising, fire and liability insurance, taxes, interest, and commissions paid for the collection of rent. The taxpayer who is handy and personally makes repairs on rental property is not entitled to a deduction for the value of his or her labor. Only the cost of out-of-pocket expenditures such as materials is deductible.

In addition to out-of-pocket expenses, the Internal Revenue Code authorizes the recovery of some or all of the original investment in rental property, including furnishings, and the cost of later improvements through depreciation. Depreciation allocates these costs over the expected lifetime of the property and results in a yearly deduction.

Taxpayers who rent property are often surprised to learn that they are not allowed to deduct any uncollected rents. However, as cash basis taxpayers, they have never included those rents in income and thus are not entitled to a deduction.

Copyright 2009 LexisNexis, a division of Reed Elsevier Inc.