When a person or business pays rent in advance, it is prepaid rent to the tenant and unearned rent to the landlord. How these accounts are treated and affect net income depends on whether the rent is being reported for financial reporting or tax purposes. It is a good idea to employ a certified public accountant (CPA) to manage your books and do your taxes, as CPAs are aware of the current accounting rules and tax laws. If you aren't certain about the laws, seek legal advice.
Before determining how to treat prepaid and unearned rent, you need to understand debits and credits. A debit is a bookkeeping notation made on the “left” side of a double book entry accounting system that increases the value of an asset and expense and decreases the value of a liability, revenue, or equity account. A credit is a notation made on the “right” side of an account that is the opposite of a debit. It decreases the value of an asset or expense, but increases the value of liabilities, revenues and equity accounts. All entries must balance; debits must equal credits.
Bookkeeping -- Unearned Rent
Unearned rent is a type of deferred revenue account, because the landlord has received income before providing the service. So, assume that a landlord receives $1,000 in rent for the month of April on April 1. The landlord has not earned the rent yet because the tenant has not used the property for the month. When the landlord receives the rent, he debits his cash for $1,000 because he has to take possession of the money and must increase his cash account to reflect that. To balance the entry, he also credits the liability as account unearned rent revenue. At the end of April, the landlord will have provided the service and the rent would no longer be unearned, so the accounts must be adjusted. Therefore, the landlord will debit unearned rent income by $1,000, zeroing out the liability account, and credit rent revenue. Crediting rent revenue ultimately increases net income.
Bookeeping - Prepaid Rent
Prepaid rent is a type of deferred expense, which is a type of asset. If a tenant pays $1,000 in rent for the month of April on April 1, that amount represents a deferred expense. To reflect this transaction on April 1, he will decrease his cash balance by applying a $1,000 credit to that asset. Then he will increase his prepaid rent asset by debiting it by $1,000. At the end of the month, after the service has been provided, the tenant will zero out the unearned rent by applying a $1,000 credit to the account. To balance the transaction he will debit rent expense by $1,000, which decreases net income.
Rent and Taxes
The treatment of rental income and expenses is different than the reporting requirements for financial statements. Prepaid rent, or any advance rent received before the period the payment is meant to cover, is included in the tax year received regardless of the period covered. This increases total taxable income. If you are a tenant who has prepaid rent, it is important to note that only expenses attributed to business purposes are deductible from taxable income. If you are renting something for business, when you can deduct these expenses depends on your accounting method. If you are a cash-based taxpayer, and most people are, the expense is deductible when you pay the cash. If you are an accrual-based taxpayer, the expense is only deductible when the event that generates the expense has fully occurred, such as the period of time the prepaid rent meant to cover has passed.