Many landlords require tenants to pay advance rent when signing a lease, with the most common situation being the prepayment of the last month's rent. With that in mind, here's a rundown of what exactly advance rent is, how it differs from a security deposit, and what landlords should keep in mind before requiring advance rent payments from their tenants.
What is advance rent?
As the phrase implies, advance rent refers to rental payments made for the future use of a property. However, this does not include rent that is paid for the month immediately following the payment -- by that definition, virtually all rent would be considered advance rent.
The most common definition of advance rent is any rent that has been prepaid more than 30 days in advance. For example, if you signed a lease in January and prepaid the first three months' rent, the first month would be considered your standard payment of the monthly rent due in January, while February and March would be considered advance rent payments.
Although it's possible for a tenant to pay any agreed-upon amount of rent in advance, the most common use of advance rent in practice is to require tenants to pay first and last months' rent, or two months' rent altogether, when signing a lease. In this case, the last month's rent would be considered advance rent.
How is advance rent different from a security deposit?
One major difference between advance rent and a security deposit is the tax treatment. Advance rent is required to be treated as income in the year it is received. Meanwhile, security deposits aren't included in income reporting at all, unless you end up keeping some or all of it to cover damages.
Speaking of damages, another key difference is how landlords are allowed to use each type of payment. In most states, advance rent can only be used to cover rent. If a tenant prepays their final month's rent, it can't be used to pay for repairing damage to the unit caused by the tenant. On the other hand, security deposits are more flexible. They can be used to pay for damage caused by the tenant or can be applied to unpaid rent.
Advance rent vs. security deposit
|Advance Rent||Security Deposit|
|• Must be treated as income in the year it is received.
• Can usually only be used to cover rent, not any damages.
|• Not reported as income unless you keeping some or all to cover damages.
• Can be applied to either damages or unpaid rent.
It's not uncommon for landlords to require advance rent and security deposits, depending on the market. Just to name one example, in South Florida it's quite common for landlords to request "first, last, and security," which amounts to three months' rent, prior to moving in.
Should you ask your tenants for last month's rent in advance?
There are arguments to be made for and against asking tenants to pay last month's rent upfront when signing a lease. The obvious advantage is that you're virtually guaranteed to get paid for the last month a tenant occupies your unit, as it's not unheard of for tenants to simply not pay the last month's rent when they know they'll be moving out.
However, there are a few things to consider before deciding to charge last month's rent when your tenants sign a lease agreement.
Tax complications: According to theIRS's guidance, you are generally expected to include advance rent as income in the year it was received. So, the advance rent you receive could make your taxable rental income artificially high one year and artificially low in the year the tenants move out.
It's not a security deposit: I already mentioned the key differences between advance rent and security deposits, so be sure to take into account that advance rent can generally not be used to cover damages and repairs. If you charge first and last months' rent (without an additional security deposit), you could find yourself on the hook for any damages that need to be repaired before the unit can be re-rented.
Accounting complications: In some states, you're required to pay your tenants interest on any advance rent you collect. This can be a pain to keep track of and may add an unwanted complication to your accounting procedures.
The Millionacres bottom line
Advance rent can seem like a no-brainer, but there are certain things you might want to consider. Depending on how complicated you want your real estate investments and how flexible you want the money to be, it could be a better idea to require a substantial security deposit instead.
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