The general rule: include prepaid rent in income when received
Under the claim of right doctrine, you must include in gross income any amount you receive without restriction, even if you might have to repay it later. When a tenant pays first and last month's rent at lease signing, the last month's rent is prepaid rent — it covers a future period, but you receive it now without any obligation to return it (you will apply it to the last month of the lease).
The IRS requires cash-basis landlords to include prepaid rent in income in the year received, not in the year it covers. A landlord who collects last month's rent in December for a lease that starts in January must report it as December income. There is no option to defer it to the following year.
The critical distinction: security deposit vs. prepaid rent
A security deposit is fundamentally different. It is a payment held in trust, subject to return to the tenant if they leave the property in good condition. Because you have an obligation to return it, it is not income when received. Include it in income only when you apply it (to unpaid rent or repair costs) or when you determine you will not return it.
The distinction matters enormously: last month's rent (called "prepaid rent" even if you call it a deposit) is income now; a true security deposit is not. How you characterize the payment in your lease affects the treatment. If your lease says the payment is "nonrefundable last month's rent," that is income in the year received. If it says "refundable deposit," it is not income until applied.
Practical implications: how to handle it at tax time
In December or January, landlords who collected large advance payments at the start of the lease year need to carefully categorize each payment. Pull the lease agreement and the description of each payment received.
Keep a simple log: for each tenant, document the date received, the amount, and whether each payment is (1) current rent, (2) prepaid rent, or (3) security deposit. This log is your Schedule E support. Prepaid rent and current rent go into your rental income total; security deposits do not until applied.
If you have multiple properties with prepaid rent received at year end, this categorization directly affects your taxable income for the year. Getting it right — in both directions — is worth the effort.
Frequently asked questions
Is last month's rent taxable in the year I collect it?
Yes. Last month's rent is prepaid rent and is income in the year received, even if it covers a future period.
Is a security deposit taxable when I receive it?
No. A security deposit held with an obligation to return it is not income when received. It becomes income when you apply it or keep it after the tenant leaves.
What if I label last month's rent as a 'deposit'?
The label matters less than the economic reality. If the payment is nonrefundable or contractually applied to the last month regardless of the tenant's behavior, the IRS treats it as prepaid rent — taxable when received.
Sources
Educational information and estimates only. Not tax advice. Tax rules change and vary by situation; consult a qualified tax professional before acting.