Specialized Returns and Taxpayers · Rental property

Rental income (e.g., deposits, pre-paid rent, not rented for profit)

Most rental income questions are timing questions. The rent itself is plainly income; what is contested is the year it lands in, and the rules pull against the taxpayer’s accounting method more often than they follow it. Deposits, prepayments, lease cancellations and improvements left behind by a tenant each have their own answer, and none of them is intuitive.

The rule

The base rule (Reg. § 1.61-8(a)). gross income includes rentals received or accrued for the occupancy of real estate or the use of personal property (Treas. Reg. § 1.61-8(a))^TY2026

Advance rent overrides the method. advance rentals are included in income for the year of receipt regardless of the period covered and regardless of the taxpayer’s method of accounting, except as IRC § 467 or published guidance provides otherwise — so an accrual-method landlord reports prepaid rent when it arrives (Treas. Reg. § 1.61-8(b))^TY2026 This is the exception that surprises accrual taxpayers: prepaid rent is taxed on receipt whatever period it covers, and the ordinary deferral available for advance payments for services does not extend to it.

Deposits. a security deposit the landlord is obliged to return is not income on receipt, because it is held subject to an obligation to repay; it becomes income in the year and to the extent the landlord becomes entitled to keep it — whereas an amount labelled a deposit but applied as final-period rent is advance rent taxed on receipt^TY2026 The distinction is legal rather than linguistic. Money the landlord must return on stated conditions is not income; money the landlord may keep, or which is designated as the final month’s rent, is.

Lease cancellation. an amount received by a lessor from a lessee for cancelling a lease is gross income for the year received, being essentially a substitute for rental payments; amounts received by a *lessee* for cancelling a lease are governed by IRC § 1241 instead (Treas. Reg. § 1.61-8(b))^TY2026

What the tenant pays for you. as a general rule, where a lessee pays any of the lessor’s expenses those payments are additional rental income of the lessor; and where a lessee places improvements on real estate which constitute in whole or in part a substitute for rent, the improvements are rental income to that extent (Treas. Reg. § 1.61-8(c))^TY2026

What the tenant leaves behind. gross income does not include income other than rent derived by a lessor of real property on the termination of a lease, representing the value of the property attributable to buildings erected or other improvements made by the lessee (IRC § 109)^TY2026 neither the basis nor the adjusted basis of any portion of the real property is increased or diminished on account of income excludable under IRC § 109 — so the lessor takes the improvement free of tax and with no basis in it (IRC § 1019)^TY2026 Read the two together: the landlord excludes the improvement’s value on termination and takes no basis for it. The benefit is a deferral of the whole amount into the eventual sale, not a permanent exemption, and it fails if the improvement was a substitute for rent in the first place.

Uneven rents. a section 467 rental agreement is any rental agreement for the use of tangible property under which at least one amount allocable to a calendar year’s use is payable after the close of the following calendar year, or under which the rent increases; the section does not apply where the aggregate payments and other consideration for the use do not exceed $250,000 (IRC § 467(d))^TY2026 the lessor and lessee under a section 467 rental agreement take into account the rent accruing for the year, allocated in accordance with the agreement, plus interest for the year on amounts taken into account in prior years and still unpaid — an accrual on a present value basis regardless of the parties’ own methods (IRC § 467(a), (b))^TY2026

Not rented for profit. where an activity of an individual or S corporation is not engaged in for profit, deductions are limited to those allowable without regard to profit motive, plus the deductions that would be allowable only if it were engaged in for profit, and those only to the extent gross income from the activity exceeds the first category (IRC § 183(a), (b))^TY2026 where gross income from an activity exceeds the deductions attributable to it, computed without regard to profit motive, in 3 or more of the 5 consecutive taxable years ending with the year in question, the activity is presumed engaged in for profit unless the Secretary establishes otherwise; for an activity consisting in major part of breeding, training, showing or racing horses the test is 2 of 7 (IRC § 183(d))^TY2026 A property let below market to a relative, or a holiday let with no realistic prospect of a return, can fall outside the profit requirement, and then deductions are capped at gross income with no loss and no carryforward. notwithstanding any other provision of IRC § 280A or IRC § 183, where a dwelling unit is used by the taxpayer as a residence and is actually rented for fewer than 15 days in the year, no deduction on account of the rental use is allowed and the rental income is excluded from gross income under IRC § 61 entirely (IRC § 280A(g))^TY2026

Current figures

How it works in practice

Read the lease on deposits rather than the ledger. The label the parties used decides nothing. What matters is whether the landlord holds the money subject to an obligation to return it — in which case it is not income on receipt, on the ordinary claim of right analysis — or holds it free of any such obligation, in which case it is. A “last month’s rent” payment taken at the start of a tenancy is almost always advance rent, taxed on receipt, because the landlord is entitled to keep it against a period of occupancy rather than obliged to return it.

Then track a deposit across its life. A refundable deposit becomes income in the year the landlord becomes entitled to retain it — typically the year the tenancy ends and damage is quantified — and to the extent retained. The corresponding repair expense is deductible in the year incurred, so the two usually offset, but they are separate entries and can land in different years.

For lessee improvements, ask why they were made before applying IRC § 109. The exclusion covers value the landlord receives on termination of the lease from buildings or improvements the tenant made. It does not cover improvements that were a substitute for rent — Treas. Reg. § 1.61-8(c) makes those rental income when made, to that extent — and it does not cover a payment in cash instead of the improvement. Where the exclusion applies, IRC § 1019 denies any basis, so the landlord’s eventual gain on sale is larger by the excluded amount.

Check whether a long or escalating lease is a section 467 rental agreement before accepting the parties’ allocation. Rent that increases, or rent for one year payable more than a year after the close of the year of use, brings the agreement within IRC § 467 unless the total consideration is at or below the threshold. Where it applies, both parties accrue rent on a present value basis according to the agreement’s allocation, with interest on unpaid amounts — regardless of whether either party is otherwise on the cash method.

How this has changed

The core of Treas. Reg. § 1.61-8 dates from 1957 and has been amended once in substance, to carve out IRC § 467 agreements and to allow the Commissioner to provide otherwise in published guidance. That second carve-out matters: the deferral method for advance payments now in Treas. Reg. § 1.451-8 expressly does not apply to rent, so the regulation’s “regardless of the method of accounting” survives the 2017 changes to IRC § 451 intact.

IRC § 467 was added by the Deficit Reduction Act of 1984 to stop mismatches between cash-method lessors and accrual-method lessees on stepped or deferred rents. The final regulations issued in 1999 and the proposed regulations issued in 2023 have narrowed the field of play, but the statutory threshold has never been indexed, so far more agreements fall inside it now than in 1984.

IRC § 109 has not been amended since 1954. Its companion at IRC § 1019 was tidied in 2014 by Pub. L. 113-295 § 221(a)(76), removing an obsolete cross-reference and nothing else. The pairing is one of the oldest deferral mechanisms in the Code and is entirely stable.

The practical importance of the IRC § 183 analysis has grown with short-term letting. A property let through a platform for a handful of weeks a year, at rates that never cover its costs, invites both the IRC § 280A analysis and the not-for-profit analysis, and the two produce similar outcomes by different routes — which is why an examiner will often plead both.

Exam focus

Know that advance rent is income on receipt regardless of accounting method, and be ready to distinguish it from a refundable security deposit. Expect a fact pattern with all three payments made at signing.

Know that a lease cancellation payment to the landlord is ordinary income and that lessee-paid expenses are additional rent. Know the IRC § 109 and IRC § 1019 pairing and the exception where the improvement substitutes for rent.

Know that IRC § 183 caps deductions at gross income with no carryforward, in contrast to the IRC § 280A(c)(5) cap which carries forward, and know the 3-of-5 presumption and its 2-of-7 variant for horses.

Check yourself

1. A cash-method landlord receives $18,000 in December 2026 covering all of 2027. When is it income?

Answer: 2026. On the cash method it would be 2026 anyway, and Treas. Reg. § 1.61-8(b) confirms that advance rentals are income in the year of receipt regardless of the period covered. The same answer holds for an accrual-method landlord, which is the point of the rule.

2. A tenant pays the landlord’s property tax of $6,000 directly to the municipality under the lease. Does the landlord have income?

Answer: Yes, $6,000 of additional rental income. Treas. Reg. § 1.61-8(c) provides that where a lessee pays any of the lessor’s expenses, those payments are additional rental income of the lessor. The landlord also deducts the $6,000 of property tax, so the net effect is usually nil — but both entries must appear.

3. A tenant surrenders a lease early and pays the landlord $50,000 to be released. How is it taxed?

Answer: As ordinary income in the year received. Treas. Reg. § 1.61-8(b) treats an amount received by a lessor from a lessee for cancelling a lease as gross income for the year of receipt, being essentially a substitute for rental payments. Had the payment gone the other way — the landlord paying the tenant to leave — IRC § 1241 would treat the tenant’s receipt as an amount received in exchange for the lease.

4. A landlord excludes $120,000 under IRC § 109 when a tenant’s improvements pass to her on termination. She sells the building three years later. What is the basis effect?

Answer: None. IRC § 1019 provides that neither the basis nor the adjusted basis of the property is increased on account of income excludable under IRC § 109. Her gain on sale is therefore $120,000 larger than it would be had the improvement been taxed and added to basis. The exclusion is a deferral into the sale, not a permanent exemption.

5. A rental has produced a loss in each of the last six years and the owner lets it to friends below market. Which limit applies?

Answer: Potentially both IRC § 183 and IRC § 280A, and the examiner will usually plead both. IRC § 183(d) gives no presumption of profit here — the activity has not had gross income exceeding deductions in 3 of the last 5 years — so the burden is on the owner. If IRC § 183 applies, deductions are limited to gross income under IRC § 183(b) and there is no carryforward, which is harsher than the IRC § 280A(c)(5) cap.