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only the part of it that was for rent and not the part for the security deposit would be considered income, correct?

I'd treat it as you would have treated the funds if you got them directly from the property manager. So yes, rent income for the rents and non-taxable for the security deposit.

Also have a question about the timing of the income -- the check from the State was cut in 2012 but wasn't received until 2013 -- can we choose when to recognize the income?

Assuming you are on the cash basis of accounting (and you almost certainly are unless you KNOW that you're not), you recognize income when received or constructively received.

Why was the manager holding six months of rent? More specifically, had you asked sooner, would you have been able to get that rent from them? Could you have asked for that rent at any time?

I'd say that as long as you had the ability to demand the rent money from the manager at any time, you constructively received the rent when the manager received it. So you'd recognize the income in whatever year the manager received it.

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