How Is a Forfeited Real Estate Deposit Taxed?

A real estate deposit, often called earnest money, is a sum a buyer provides to a seller to demonstrate serious intent to purchase a property. This deposit is usually held in escrow and becomes part of the purchase price if the transaction closes. If a real estate deal fails, perhaps due to a buyer’s breach of contract, the deposit may be forfeited to the seller. This situation raises questions about the tax implications for both sellers and buyers.

Tax Treatment for the Deposit Recipient

For a seller, a forfeited real estate deposit is generally treated as ordinary income. The Internal Revenue Service (IRS) typically views such forfeited deposits as compensation for the buyer’s failure to fulfill the contract, rather than proceeds from the sale of property. This characterization as ordinary income applies because no actual sale or exchange of the property occurred.

The timing of income recognition for the seller typically occurs when the forfeiture becomes final, meaning the seller has a clear right to the funds. This usually happens when the purchase agreement is formally terminated and the deposit is released from escrow to the seller. This treatment aligns with the concept of “liquidated damages,” where parties agree in advance to a specific sum of money to be paid in the event of a contract breach. Such damages are generally considered taxable income to the recipient.

A common misconception is that a forfeited deposit might be treated as a capital gain. However, this is generally not the case, especially if the property was used in a trade or business. For example, in CRI-Leslie, LLC v. Commissioner, a hotel owner who retained a forfeited deposit argued it should be treated as capital gain. The Tax Court and Eleventh Circuit affirmed that because the hotel was used in the seller’s trade or business, the forfeited deposit constituted ordinary income. Internal Revenue Code Section 1234A applies to capital assets, and real property used in a trade or business is typically not classified as a capital asset.

There are narrow exceptions. If the property was an investment property (a capital asset) and not used in a trade or business, the forfeited deposit could be treated as capital gain for the seller. For real estate dealers holding property as inventory for sale to customers, a forfeited deposit would be considered ordinary income, consistent with their business operations.

Tax Treatment for the Deposit Payer

For a buyer who forfeits a real estate deposit, tax treatment largely depends on the property’s intended use. If the property was intended as a personal residence, the forfeited deposit is generally considered a non-deductible personal loss. Personal losses are not deductible against taxable income.

This type of loss does not qualify as a deductible casualty or theft loss. Casualty losses typically arise from sudden, unexpected, or unusual events like natural disasters, and theft losses involve the illegal taking of property. Forfeiting a deposit does not meet these criteria, as it results from a contractual agreement.

The situation differs if the forfeited deposit was for investment or business property. In such cases, the buyer may deduct the lost deposit. If the property would have been a capital asset in the buyer’s hands (e.g., raw land held for investment or a rental property), the forfeited deposit may be treated as a capital loss. Capital losses are deductible, but their use is subject to limitations. Taxpayers can use capital losses to offset capital gains. If capital losses exceed capital gains, individuals can deduct up to $3,000 of the excess against ordinary income per year, or $1,500 if married filing separately. Any remaining capital loss can be carried forward indefinitely to offset future capital gains or ordinary income, subject to the annual limit.

If the property was intended for use in a trade or business, the forfeited deposit might qualify as an ordinary loss. This could apply, for example, if a developer forfeits a deposit on land intended for a building project. Ordinary losses are generally more favorable than capital losses because they are fully deductible against ordinary income without the $3,000 annual limitation. The timing of the loss recognition for the buyer typically occurs in the tax year the deposit is definitively forfeited, and the buyer’s right to recover the funds is extinguished.

Required Tax Reporting

The deposit recipient must report the forfeited amount as income on their tax return. For individuals, this income is typically reported on Schedule 1 (Form 1040), Part I, Line 8, as “Other income.” For businesses, the income would generally be reported on Schedule C (Form 1040), Profit or Loss from Business, or other appropriate business income forms, depending on the business structure. In certain circumstances, a Form 1099-MISC (Miscellaneous Income) might be issued by the escrow agent or buyer if the forfeited amount exceeds a certain threshold, typically $600.

For the deposit payer, if the forfeited deposit is for a personal residence and therefore non-deductible, no specific tax reporting is required on their return. However, if the loss is deductible, such as for investment or business property, the reporting process depends on the character of the loss. A capital loss is reported on Form 8949, Sales and Other Dispositions of Capital Assets, and then summarized on Schedule D (Form 1040), Capital Gains and Losses. For an ordinary loss related to a trade or business, it would be reported on the relevant business income form, such as Schedule C (Form 1040) or other appropriate forms.

Maintaining accurate records, including the purchase agreement, proof of deposit, and documentation of the forfeiture, is important for both parties. This documentation helps substantiate the income or loss reported on their tax returns and can be crucial in the event of an IRS inquiry.