By Jason Watson (Google+)
This answer is straight from the IRS (Topic 414)– Most individuals operate on a cash basis, which means they count their rental income as income when it is actually or constructively received, and deduct their expenses as they are paid. Some specific types of income are:
Amounts paid to cancel a lease– If a tenant pays you to cancel a lease, this money is also rental income and is reported in the year you receive it.
Advance rent– Generally you include any advance rent paid in income in the year you receive it regardless of the period covered or the method of accounting you use. So, first and last month’s rent are reported as rental income in the current year.
Expenses paid by a tenant– If your tenant pays any of your expenses, those payments are rental income. You in turn can deduct these expenses. For example, your tenant pays a utility invoice for $100 and deducts it from his rent of $1,500. You would still record the rent of $1,500 even though you received $1,400 as a payment, but you would also deduct the $100 utility invoice. Your net rental income would be $1,400, which is the same whether your tenant paid the invoice directly or not.
Security deposits– Do not include a security deposit in your income if you may be required to return it to the tenant at the end of the lease. But if you keep part or all of the security deposit during any year because the tenant damaged the property or did not live up to the terms of the lease, this money is taxable income in the year this determination is made (but you get to wash that income by deducting the expense of the repair). If the security deposit is to be used as the tenant’s final month’s rent, you include the money as income when you receive it, rather than when you apply it to the last month’s rent.
Uncollected rents– If you are a cash basis taxpayer, you cannot deduct uncollected rents as an expense because you have not included those rents in income. Most property owners are cash based (versus accrual).
In addition, if your tenant performs work on your property in exchange for paying rent, then the fair market value of the work performed (typically the rental amount) is considered rental income and must be reported. If the work performed would have qualified as an expense, you may also expense it. This make sense since if you collected rent from your tenant yet paid a contractor to perform the repair, the net result would be the same. As a paper trail side note, we encourage you to pay your tenant, get a receipt for the work, and then have that tenant pay you.