Is Lost Earnest Money Tax Deductible on Your Tax Return?

Losing earnest money in a real estate transaction can be frustrating, especially if the deal falls through. Many wonder whether this loss can be deducted on their tax return. The answer depends on how the property was intended to be used and whether the loss qualifies under IRS rules.

Classifying Earnest Money in Real Estate

Earnest money is a deposit made by a buyer to show commitment to purchasing a property. It is typically held in escrow and applied toward the down payment or closing costs if the sale proceeds. If the deal falls apart, the fate of the deposit depends on the purchase agreement.

For tax purposes, classification depends on the type of property. If the purchase was for a primary residence, the deposit is considered a personal expense and is not deductible. However, if the transaction involved an investment property, the deposit may be treated as a capital expenditure or a business-related cost.

For real estate investors, earnest money becomes part of the acquisition cost if the purchase is completed. If the deal is abandoned, the lost deposit may be classified as a capital loss or a business expense, depending on the circumstances. This distinction is crucial, as it determines whether the loss can be deducted or if it becomes a sunk cost.

Determining Deductibility

The ability to deduct forfeited earnest money depends on whether the property was for personal use or an investment. Personal losses, such as those from backing out of a home purchase, are not deductible. The IRS treats these as nondeductible personal expenses, similar to losing a security deposit on a rental.

For investment properties, the tax treatment differs. If the property was being acquired for rental income or resale, the lost deposit may be classified as a capital loss or a business expense.

– Capital losses apply when the property was an investment, such as buying a property to hold and sell later. In this case, forfeited earnest money is treated as a capital loss. However, capital losses are subject to limitations—only $3,000 per year can be deducted against ordinary income ($1,500 for married taxpayers filing separately), with any excess carried forward to future years.

– Business expenses apply if the property was for business use, such as a real estate development project or part of a rental business. In this case, the lost deposit may be deductible as an ordinary expense under Section 162 of the Internal Revenue Code. Unlike capital losses, business losses can be deducted in full in the year they occur, reducing taxable income without the annual limitations imposed on capital losses.

The distinction between capital and business losses affects how quickly the deduction can be used. A capital loss may take years to fully deduct, while a business loss can be deducted immediately.

Documenting the Transaction

Thorough records are necessary when dealing with lost earnest money. The purchase contract and escrow instructions should be retained, as they outline the terms of the deposit and its forfeiture.

Bank statements and escrow records should be preserved to confirm the deposit and its release. If the earnest money was paid via wire transfer or check, copies of these transactions should be kept. If the seller retained the deposit due to a breach of contract, correspondence explaining the forfeiture—such as emails or formal notices—should be included in the records.

If the IRS requests verification, additional documentation may be needed, such as a written statement from the escrow company confirming the forfeiture or an accountant’s memo explaining how the loss was classified for tax purposes. Organized records help prevent complications if an audit occurs.

Reporting the Loss on Tax Returns

How a forfeited earnest money loss is reported depends on whether it is classified as a capital loss or a business expense.

– Capital losses must be reported on Form 8949, Sales and Other Dispositions of Capital Assets, which is then included in Schedule D of Form 1040. The transaction should be categorized as a lost investment rather than a sale, with the earnest money recorded as the cost basis and a proceeds value of zero. Capital losses offset capital gains first, and any remaining amount can be deducted against ordinary income, up to the $3,000 annual limit ($1,500 for married taxpayers filing separately). Excess losses can be carried forward to future years under Section 1211(b) of the Internal Revenue Code.

– Business losses are reported on Schedule C (Profit or Loss from Business) for sole proprietors or Form 1120 for corporations. Unlike capital losses, business losses are immediately deductible against ordinary income, reducing taxable earnings without annual limitations. Proper classification is important, as misreporting a business loss as a capital loss could delay full utilization of the deduction.