If you have a rental property and use the cash basis for tax purposes, you would report your rental income on your tax return for the year you receive the rent payments. And you can deduct your expenses for the rental property in the year you pay them. You can also deduct depreciation. But if your tenant does not pay the rent, according to the IRS you cannot claim a deduction for uncollected rent because you have not included the rent in your income.
If you receive a security deposit that you intend to return to the tenant at the end of the lease, you would not report the deposit as taxable rental income. But according to the IRS, if you keep the security deposit because your tenant does not live up to the terms of the lease, such as not paying the rent, you would report the security deposit as rental income that year.
If you use the accrual basis for tax purposes, you would report your rent income as it is earned, regardless of when it is received. If you are unable to collect the rent you may be able to deduct it as a business bad debt. The IRS indicates that you must be able to show that you have taken all reasonable steps to collect the rent. You do not have to go to court in order to claim the deduction if you can show that a judgment from the court would be that the debt is uncollectible.
Depending on the actions you take to collect the rent, you may have tax deductible expenses, such as travel expenses to collect the rent, and legal and other costs of collection actions. You may also have to do cleaning and repair work in your rental property after a tenant leaves. You could claim these as deductible expenses.
If your rental expenses are more than your rental income because of uncollected rent, you could run the risk of being subject to the passive activity limit. According to the IRS this limit normally applies to rental real estate activities. You could only deduct a loss against income from other passive activities and not against non-passive income such as salaries and wages or income from a business you actively operate. But there is an exception. If you, or your spouse if you are married, actively participate in the rental activity you can deduct up to $25,000 of loss from your non-passive income.
Sources:
Publication 527, Residential Rental Property
Publication 535, Business Expenses, IRS
Topic 414 – Rental Income and Expenses, IRS
Topic 453 – Bad Debt Deduction, IRS