How a Forfeited Real Estate Deposit Is Treated for Taxes

The tax treatment of a forfeited real estate deposit turns on which side of the deal you were on and what the property was for. A seller who keeps the earnest money owes tax on it, either as capital gain or as ordinary income depending on how the property is classified. A buyer who loses the deposit can claim a capital loss only if the purchase was for investment or business use; a lost deposit on a would-be personal residence is not deductible at all.

Seller Who Keeps the Deposit

When the buyer walks and the seller retains the earnest money, the seller has income. The character of that income is set by Internal Revenue Code Section 1234A, which treats gain from the cancellation or termination of a right or obligation with respect to property that is (or would be) a capital asset as capital gain.¹ So the question becomes: was the property a capital asset in the seller’s hands?

Capital Gain Treatment

Section 1221 defines a capital asset broadly as any property held by the taxpayer, subject to specific exclusions.² Investment real estate held by an individual, such as a rental or vacant land held for appreciation, generally qualifies. If a buyer defaults on that kind of property and the seller keeps the deposit, Section 1234A gives the retained funds capital gain treatment. Short-term or long-term status depends on how long the contract was held before forfeiture, not how long the seller owned the underlying property.

That result surprises sellers who assume a forfeited deposit is always ordinary income because no sale closed. For a capital asset, that assumption is out of date.

Ordinary Income Treatment

Two exclusions from the capital asset definition matter most for real estate:

Dealer property: real estate held primarily for sale to customers in the ordinary course of business, such as lots or homes being sold by a developer.²
Trade or business property: depreciable property or real property used in a trade or business, such as an owner-operated hotel, office building, or warehouse.²

If the property falls into either category, Section 1234A doesn’t apply and the forfeited deposit is ordinary income. A federal appeals court reached that conclusion in 2018 for a hotel company that kept a forfeited deposit: because the real estate was used in the seller’s business, it was not a capital asset, and Section 1231 did not rescue the outcome where no sale occurred.³

For a dealer, the forfeited funds are business income reported on Schedule C, which means self-employment tax applies on top of regular income tax.⁴ That adds roughly 15.3% to the effective rate, a cost that catches some sellers by surprise.

What Counts as a Dealer

Dealer status applies when someone regularly buys and sells property as a business, treating real estate as inventory. Courts weigh the purpose of acquisition, holding period, volume and frequency of sales, and the extent of marketing or development. No single factor controls. Someone who buys, subdivides, and moves dozens of lots in a year looks nothing like an individual selling a rental held for fifteen years.

When to Recognize the Income

The seller reports the forfeited deposit in the year the forfeiture becomes final, which usually means the year the contract terminates and the escrow agent releases the funds without further dispute. If the buyer contests the forfeiture and the money stays in escrow, recognition waits until the dispute is resolved and the seller has an undisputed right to the funds.

Buyer Who Loses the Deposit

The buyer’s outcome depends entirely on what the property was going to be used for. The tax code draws a hard line between personal use and profit-seeking use.

Personal Residence: No Deduction

A forfeited deposit on a home you planned to live in produces no tax benefit. Section 165 limits individual loss deductions to losses from a trade or business, losses from profit-seeking transactions, and certain casualty or theft losses.⁵ A failed personal-home purchase fits none of them. The IRS lists forfeited deposits, down payments, and earnest money among the nondeductible expenses for homeowners.⁶ Nothing goes on the return.

Investment or Business Property: Capital Loss

When the deposit was tied to property intended as an investment or for business use, the forfeiture produces a capital loss. The purchase contract gave you a right with respect to property that would have been a capital asset (or Section 1231 property), and termination of that right triggers loss recognition under the same Section 1234A framework that governs the seller’s side.¹

The loss is short-term if the contract was held one year or less, long-term if held longer.⁷ Short-term losses offset short-term gains first, and long-term losses offset long-term gains first, before any cross-netting.

Annual Deduction Limit and Carryforward

Capital losses first wipe out capital gains dollar for dollar. If losses exceed gains, you can deduct the excess against ordinary income, but only up to $3,000 a year, or $1,500 if married filing separately.⁸ Anything left over carries forward to the next tax year, keeping its short-term or long-term character.⁹ There’s no expiration on the carryforward. A large forfeited deposit with no offsetting gains can take many years to fully absorb through the $3,000 annual allowance alone. Selling other investments at a gain speeds the process, because losses offset gains without any annual cap.

Reporting on Your Tax Return

Seller

Where the forfeited deposit lands on the return depends on classification. A dealer reports it as business income on Schedule C, and the net profit flows through to Schedule SE for self-employment tax.⁴ A non-dealer whose property was a capital asset reports the amount on Form 8949 and Schedule D, treating it like any other capital gain.¹⁰ A non-dealer whose property was used in a trade or business reports the ordinary income on Schedule 1 (Form 1040).

No Form 1099-S will be issued. That form is triggered by a closing and transfer of a real estate interest, and neither occurred.¹¹ The absence of a 1099-S does not remove the obligation to report the income.

Buyer

A buyer who lost a deposit on a personal residence reports nothing.

A buyer with an investment or business loss reports the forfeiture on Form 8949: the date you entered the contract as the acquisition date, the forfeiture date as the disposition date, the deposit amount as basis, and zero (or any portion returned) as proceeds.¹⁰ The totals move to Schedule D, which nets gains and losses, applies the annual deduction limit, and computes any carryforward.

Keep the purchase agreement, any amendments, escrow instructions, and the written confirmation of forfeiture. If the IRS challenges the deduction, you’ll need proof of both the investment intent and the amount lost. Investment intent is the pivotal document because it’s the line between a deductible loss and a nondeductible personal expense.

State Tax Considerations

Most states with an income tax follow the federal characterization: ordinary income for federal purposes is ordinary income at the state level, and the same for capital losses. States diverge most often on the annual capital loss deduction, which some cap at a different amount than the federal $3,000. A few also apply a separate rate or partial exclusion to capital gains that doesn’t extend to forfeited deposit income. If the property sits in a state where you don’t live, you may need to allocate income or loss between states and file a nonresident return where the property is located. State-by-state rules vary too much for a single answer.

1
Office of the Law Revision Counsel. 26 USC 1234A – Gains or Losses from Certain Terminations
2
Office of the Law Revision Counsel. 26 USC 1221 – Capital Asset Defined
3
Justia Case Law. Cri-Leslie, LLC v. Commissioner of Internal Revenue
4
Internal Revenue Service. 2025 Instructions for Schedule C (Form 1040)
5
Office of the Law Revision Counsel. 26 USC 165 – Losses
6
Internal Revenue Service. Publication 530 (2025), Tax Information for Homeowners
7
Internal Revenue Service. Topic No. 409, Capital Gains and Losses
8
Office of the Law Revision Counsel. 26 USC 1211 – Limitation on Capital Losses
9
Office of the Law Revision Counsel. 26 USC 1212 – Capital Loss Carrybacks and Carryovers
10
Internal Revenue Service. Instructions for Form 8949 (2025)
11
Internal Revenue Service. Instructions for Form 1099-S (Rev. April 2025)