When my tenant's 1 year lease expires, I gave that tenant the option to re-new it with another 1 year lease at a higher rent.

But, the tenant wants to use part of their security deposit to pay for that rent increase. 

When the tenant applied, there was some issues with their credit history but their income seemed good. So, I agreed to rent to this tenant if the tenant paid a higher security deposit than I originally asked for.

After I gave the tenant their notice, the tenant says that their income has dropped since last year and wants to explore the option of using part of the higher security deposit to pay for the rent increase.

It might be easier if I use some numbers- I was asking $2750 per month and a security deposit of $2100. With the tenat's credit history, tenant needed to put down $4200 for the security deposit and pay $2750 a month. I wanted to increase rent to $2850 for new lease, but the tenant is asking to use part of the security deposit to pay for that rent increase. So, the security deposit would go from $4200 down to $2100, the amount I originally wanted, and use the rest of that security deposit, $2100, to pay for the rent increase. 

What do you think? What are the potential pitfalls to do this?

Answer - NO! If the tenant has said their income has dropped, then you should recommend that they look for another place. They are giving you all the warning signs that things are about to go south.

No. When I raise the rent, I raise the security deposit to match. This tenant has already admitted their income is lower this year so that means your risk is higher. I think you should tell the tenant to move on so you can get a tenant that can easily afford the rent.

Do you have good-long lasting history with this tenant? Any major issues or problems during the initial 1 year lease period? Have they missed any payments or have they made any late payments? Do you have to contact them every month to get the rent? Can they provide sufficient reasoning behind the claim that their income has dropped? I think these are all questions that should be taken into consideration when making your final decision. Sounds to me like they will have no issues paying the current rent, but with the $100 bump they don't want to have to pay out of pocket. Just a thought

What did the tenant's credit history show to require such a high security deposit in the first place? Is the tenant still at such a high risk level?

I would look at how the tenant has performed this past year and if his current income is enough to continue to afford to rent the place. Are they abiding by the terms of the lease? Are they taking good care of your property? Do you charge for damages when you find them so you don't need to depend heavily on the security deposit? Is the tenant congenial and cooperative?

Sounds to me the tenant is trying to figure out a way to have less of his money tied up in a security deposit, so he can put it to better use. More likely his request came from a bargaining position than from a real need. I would approach this as two separate issues..... 

1. Considering his new income level, can he still afford to rent the place? (Without factoring in any refund.)

2. Is such a high security deposit still justified? What has he been doing to improve his credit history and is it better now than it was? 

I'd rather see tenants use their funds to pay back bad debt and become more responsible in managing their money, thereby reducing their risk, than have their money tied up in a security deposit. But I would still require enough to cover my real need.

I would reassess the risk-benefit and consider reducing the security deposit. Perhaps it still needs to be so high. But if the tenant is abiding by the terms of your rental agreement and is overall a good tenant, you may be able to reduce his security deposit. Everything's negotiable. Could you reduce the security deposit a bit and still cover your risk?  

The tenant probably felt the security deposit was too high from the start, but was willing to pay it to secure a place to live. When raising rents, it's easier for a tenant to accept a rent raise if they perceive it's a fair deal and they are getting value for their money.... make it a win-win. Perhaps reduce the security deposit from $4200 to $3000 based on his good performance as a tenant.

I would not lower the security deposit.