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Security deposits: a cause for concern?

Recent court decisions concerning utility deposits could dramatically affect the tax treatment of security deposits for property managers.

Specifically, managers should be aware of tax distinctions concerning the nature and purpose of deposits. These distinctions determine when a deposit will be viewed as a true deposit-a type of insurance that the terms of a contract will be met--and when it constitutes an advance payment for future services.

Generally speaking, deposits made as a guarantee against the customer's backing out of his or her obligations may be deferred until the taxable year in which they are used. In contrast, deposits made as advance payments must be claimed immediately as gross income. Thus, the purpose of the deposit will determine the timing of its inclusion in a taxpayer's gross income.

However, a recent Supreme Court ruling has added another element to the equation.

In Comm. v. Indianapolis Power & Light Company, 1990, advance payments received by a utility company were analyzed under a new "dominion" test, and the utility won its dispute over the immediate taxability of the payments. Although this and other utility cases concern utility services, not rent, they do share some common elements with rental deposits. Thus, depending on future court interpretation of dominion and other tests, these cases could have broad implications for property managers.

Accounting methods

As with myriad other tax situations, the handling of security deposits does not always fit neatly into a general tax rule. However, the question of when to include a deposit among other income is problematic only for taxpayers who use accrual-type accounting.

Cash-basis taxpayers are required to include in gross income for the taxable year all income that is actually or constructively received (money that is not physically in the taxpayer's possession but has been credited to an account, set apart, or otherwise made available for the taxpayer to draw upon).

Similarly, the accrual-basis taxpayer generally is required to include an item m gross income as soon as the income is earned, due, or received and can be quantified. Therefore, income earned but not yet received would be included in current income, as would income received but not yet earned.

However, this rule has its exceptions. For instance, IRS Revenue Ruling 72-519 states that an accrual-method taxpayer who has received a security deposit that is required under an agreement and is designed to protect the taxpayer's interest in property (not his or her income stream) may defer reporting the receipt of the deposit. We think this ruling may be interpreted to cover the provider of goods or services who has some property in the hands of the customer--such as the landlord who requires a security deposit from a tenant to whom he or she has agreed to rent space.

In the meantime, however, managers can look to existing guidelines covering two different types of deposits.

Advance rentals vs. true deposits

Income tax regulations state that advance rentals must be included in income in the year of receipt, regardless of the period covered or the method of accounting used by the taxpayer.

Citing this regulation, the Internal Revenue Service recently charged that security deposits received by several utility companies should have been counted as income when they were received--not later, when the deposits were applied against utility bills.

In two separate cases, the IRS convinced the courts that the "primary purpose" of the deposits, received when the utility service began, was to cover utilities consumed by the customer at a later date. The courts ruled the deposits were advance payments, not traditional deposits, and so should have been reported immediately.

The dominion test

In Indianapolis Power and Light, however, the IRS lost its case, thanks to a new "dominion" test applied by the Supreme Court. In arguing for the legality of its deferral of deposit receipts, the utility company was able to show that it treated the customer deposits as current liabilities in its financial statements. In addition, each customer had the right to control the ultimate disposition of the deposit. Thus, the utility did not have "dominion" over the deposits.

The Court ruled that the deposits were used as protection against the customer backing out on his or her utility contract, not as advance payments for service, because the customer was not committed to purchase a specific amount of utilities. Thus, the payments constituted true deposits.

The Court concluded: "In determining whether a taxpayer enjoys 'complete dominion' over a given sum, the crucial point is not whether his use of the funds is unconstrained during some interim period. The key is whether the taxpayer has some guarantee that he will be allowed to keep the money. The utility company's receipt of these deposits was accompanied by no such guarantee."

Simply stated: When funds are received and the ultimate disposal of these funds is contingent on events outside of the taxpayer's control, the taxpayer does not have dominion over the funds, the Court said.

Thus, it would appear to follow that if a security deposit is considered an advance payment--both tenant and landlord agree that it is to be applied to future rent and the tenant forfeits any control over the money--it must be counted as gross income upon receipt. But if the renter can, through his or her own action, determine if the deposit is returned, then it does not count as advance rent and its indusion in gross income can be deferred.


The question for property managers is, does the dominion test used by the Court in Indianapolis Power and Light apply to lease deposits? If the case has a narrow application, its impact will be on the utility industry alone. However, the Court did not preclude the inspection of privately structured transactions outside of utility deposits, and thus has left the door open to potential disputes for property managers.

One answer to the problem is the careful wording of lease agreements. It seems logical that a real estate lessor has greater domain and control over a customer's deposit than a utility has. Thus, if managers apply the Court's dominion test to real estate deposits, they may find a need for greater scrutiny in lease agreement language.

For example, in order to prove that the manager does not have dominion over deposits, the lease should outline the provision of payment of a market rate of interest on the deposit. In addition, the lease should not require that the deposit be applied to any particular rental period, but should allow it to cover a breach of contract made at any time during the lease period.

Consider the following lease:

The Lessee or Tenant has deposited with the Lessor and the Lessor acknowledges receipt of the sum of .... which sum is to be considered a security deposit for the strict performance of all of the covenants and conditions of this lease; the said security deposit is to be held, controlled, and disposed of on the following terms and conditions,

If before the expiration of the demised term, the Lessee or Tenant shall abandon or desert the premises, or if during the said term, the Lessee or Tenant shall violate any of the terms, provisions or obligations of this lease, and if said violation shall not cease within... days after receipt of notice sent by ordinary mail to the address of the demised premises as shown herein, the interest of the Lessee or Tenant in the security deposit shall cease and determine and the Lessor shall be entitled, without further action on its part, to retain same as liquidated damages, without prejudice to any of the other rights of the Lessor under this lease.

Interest will be paid to the Lessee at the market rate established under state law on the balance of the security deposit required under this lease agreement for the term stated herein.

These provisions with reference to the security deposit shall continue in effect throughout the term of the lease and shall be binding to any successor to the title of Lessor.

This spells out the standard "dominion" criteria: the landlord will not have access to the deposit during the term of the lease, and the tenant will be able to ensure that the money will be returned.

In many lease agreements, however, the landlord will want to reserve the right to apply a security deposit to the tenant's last month's rent. Such a lease agreement might include a statement like the following:

If the Lessee or Tenant shall not have forfeited the security deposit prior to .... the same sum shall then be credited on the last ... month(s) of the term.

This language includes a so-called "right of set-off," or the right to credit the deposit received to future rent. Because this paragraph follows the earlier passages that provide for return of the deposit and its reservation for the tenant in an account out of the landlord's reach, it would not, in our opinion, fall under the heading of advance rental income under Indianapolis Power and Light.

Jerome S. Horvitz, J.D., LL.M., is an associate professor of taxation at the University of Houston, Texas.

Randall K. Serrett, Ph.D., is an assistant professor of accounting at Fort Lewis College, Durango, Colorado.
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Title Annotation:Tax Issues
Author:Horvitz, Jerome S.; Serrett, Randall K.
Publication:Journal of Property Management
Date:Mar 1, 1992
Previous Article:On-site automation and performance tracking.
Next Article:Guidelines for insurance language for leases.

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