This is kind of a converse rule relative to the accounts receivable rule discussed above.
This rule states that if you receive an amount in the course of your business for services to be rendered or goods to be provided after the year of receipt, you must include the amount in income. So, you include it in income, even though you haven’t yet earned it in the year of receipt. The rule also applies if you are in the business of renting properties and have received a payment on account of a future year’s rent.
Fortunately, there is an optional deduction that allows you to deduct the amount. Since the deduction is a reserve, if you claim it in one year, you then add back the amount in income for the next year. Then, if there are services or goods or the use of the rental property that are provided after the next year you can claim another deduction, and the cycle can continue until all services and goods have been delivered or the rent has been used up.
I am in the business of renting property.
At the beginning of Year 1, I rent property to Joe under a three-year lease. The rent is $30,000 per year.
For whatever reason, we agree that Joe will pay me the entire $90,000 ($30,000 x 3) in year 1.
I must include $90,000 in my income in Year 1. However, I can claim a $60,000 reserve of the rent covering Years 2 and 3, so that my net inclusion in Year 1 is $30,000. Again, the reserve is optional so I can claim all of it, some of it, or none of it, depending on my tax situation.
Assuming I claimed the full reserve, I include the $60,000 in income in Year 2. But since $30,000 of that amount covers the rent in Year 3, I can claim a reserve, meaning that I include the net amount of $30,000 in Year 2.
In Year 3, there are no future years of prepaid rent to me. So, I include the remaining $30,000 in income and pay tax on it.