Tax Treatment of Non-Refundable Deposits and Forfeitures

The tax treatment of non-refundable deposits usually surprises both sides of the deal: the recipient owes tax on the money almost immediately, while the payer generally can’t deduct it until the goods or services are actually delivered or the deposit is formally forfeited. The label on the contract doesn’t decide this. What matters is whether the recipient has any legal obligation to give the money back, and once that obligation is gone, the IRS treats the payment as income rather than as a deposit being held.

Why the IRS Calls It Income, Not a Deposit

The controlling question is control. In Commissioner v. Indianapolis Power & Light Co., the Supreme Court held that a payment is not income when the person who paid it keeps the right to demand it back. The recipient has to have “complete dominion” over the funds before the money counts as income.¹

A true security deposit fails that test. It sits on the recipient’s books as a liability, sometimes in escrow, always subject to return under defined conditions. A non-refundable deposit is the opposite. The recipient can spend it, doesn’t have to segregate it, and owes nothing back if the deal collapses. That’s dominion, and that’s income.

Calling a payment a “deposit” in the contract does not protect either party from this. If the economic reality is that the recipient keeps the money no matter what, the IRS treats it as an advance payment.

When the Recipient Has to Report It

Once the payment is classified as an advance payment rather than a refundable deposit, the timing turns on the recipient’s accounting method.

Cash Basis

Cash-method taxpayers report income in the year they receive it. A non-refundable deposit collected in December is taxable that year even if the work won’t start until March. The IRS is direct about this: advance commissions and amounts received for future services are included in income in the year of receipt.²

The rule extends to constructive receipt. Money credited to your account or made available without substantial limits counts as received even if you haven’t touched it.³ A non-refundable payment sitting in the business checking account clears that bar easily.

The practical problem is a mismatch. Tax is due this year on money received for work you’ll perform, and pay for, next year. Businesses that take large non-refundable deposits in the fourth quarter should plan for the bump.

Accrual Basis

Accrual-method taxpayers recognize income when the right to receive it is fixed and the amount is reasonably determinable. For a non-refundable advance payment, that right is fixed at receipt, so the default is full inclusion in the year of receipt.⁴

IRC 451(c) offers a limited escape. If you receive an advance payment this year but haven’t recognized part of it as revenue on your financial statements yet, you can elect to defer the unrecognized portion for one additional tax year. The key parameters:

The payment must be for goods, services, or certain other items the IRS specifies. Rent, insurance premiums, and payments tied to financial instruments are excluded from this deferral.⁵
Maximum deferral is one year. Whatever wasn’t included in Year 1 must be included in Year 2, whether or not you’ve finished the work.
Any portion recognized as revenue on your financial statements in the year of receipt must also be recognized for tax that same year.
Once elected for a category of advance payments, the method applies to future years unless the IRS consents to a change.⁵

Treasury Regulation 1.451-8 fills in the mechanics and defines what counts as an “applicable financial statement” for this purpose.⁶

When the Payer Gets a Deduction

Writing the check doesn’t produce a deduction. The economic performance rule of IRC 461 requires the underlying activity to actually occur before the expense is deductible. If you’ve prepaid for services, the deduction accrues as the services are performed. If you’ve prepaid for property, it accrues on delivery.⁷

Until then, the deposit is a prepaid asset on your books, not a current expense.

The result is an uncomfortable asymmetry. A cash-basis recipient may report the income immediately, while the payer sits on a non-deductible prepayment until performance. Both sides are following the rules; the tax hits just land in different years.

Forfeited Deposits

When the deal falls through and the recipient keeps the money, the tax picture splits by side.

Recipient Keeps the Money

A cash-basis recipient who already reported the deposit as income has nothing more to do; the income was recognized on receipt. An accrual-basis recipient who deferred under IRC 451(c) has to include the forfeited amount no later than the year of forfeiture, because performance is now off the table.

Payer Loses the Money

A forfeited deposit tied to a trade or business is deductible in the year of forfeiture as an ordinary and necessary business expense under IRC 162.⁸ Cancellation and restocking fees work the same way when the underlying purchase was for the business.

For individuals, purpose controls the outcome. IRC 165 limits individual loss deductions to trade or business losses, losses from transactions entered into for profit, and certain casualty or theft losses.⁹ A forfeited deposit on an investment fits the profit-motive category. A forfeited deposit on something personal, like a wedding venue or a vacation rental, is a non-deductible personal loss.

Real Estate Earnest Money

Earnest money is a partial exception because a third-party escrow agent almost always holds the funds. The seller has no control over the money until closing or termination, so the payment isn’t income to the seller when it’s paid into escrow.

If the sale closes, the earnest money simply becomes part of the purchase price and is reported as part of the sales proceeds, subject to whatever gain or loss rules apply to the property.

If the buyer defaults and the seller keeps the earnest money, no property has changed hands, so the forfeited amount isn’t sale proceeds. The seller typically reports it as ordinary income representing compensation for the buyer’s failure to perform. IRC 1234A treats gain or loss from the termination of a right or obligation with respect to property as capital only if the underlying property is a capital asset, and property used in a trade or business is not a capital asset.¹⁰ Forfeited deposits on commercial real estate land as ordinary income to the seller; residential investment property that qualifies as a capital asset can be treated differently, which is worth confirming with a tax professional when the amount is large.

The Buyer Who Walks Away

A buyer who forfeits earnest money on a personal residence gets nothing. The IRS lists forfeited deposits, down payments, and earnest money among the items homeowners cannot deduct.¹¹

A buyer forfeiting earnest money on investment property does better. Under IRC 1234, the loss from a failed option to purchase property takes the character of the underlying property.¹⁰ Investment real estate is a capital asset, so the forfeiture generates a capital loss reported on Form 8949 and Schedule D.¹² Capital losses exceeding capital gains for the year can offset up to $3,000 of ordinary income ($1,500 if married filing separately), with any remainder carried forward.¹³

Rental Deposits and the Last-Month’s-Rent Trap

Landlords face this classification question on every new lease. The IRS rule for a rental security deposit is straightforward: don’t include it in income if you may be required to return it at the end of the lease.¹⁴ If the tenant later breaks the lease or damages the unit and you keep some or all of the deposit, that amount goes into income for the year you keep it.

“Last month’s rent” is different, and this catches landlords off guard. A payment designated as the tenant’s final month’s rent is advance rent, and it goes into income in the year received, not in the future month it covers.¹⁴ Two checks collected on the same day from the same tenant can have completely different tax timing: the security deposit stays off the return until forfeiture, while the last-month’s-rent check hits income immediately.

Returning a Non-Refundable Deposit in the Same Year

Sometimes parties unwind a deal and return money that was contractually non-refundable, through mutual agreement or court order. If the unwinding happens in the same tax year as the original payment, the rescission doctrine under Revenue Ruling 80-58 can eliminate the tax consequences altogether. The IRS treats the transaction as though it never happened.¹⁵

Two conditions have to be met:

Both parties must be restored to the positions they would have occupied if no contract had been made.
The restoration must happen within the same taxable year as the original transaction.

Cross a year boundary and the doctrine is unavailable. The recipient will already have reported the income, and the later return of funds runs through different mechanics. Publication 525 notes that repayments made in a later year may be deductible as an itemized deduction or may support a tax credit for cash-method recipients who reported the income earlier.² The year-end pressure is real. If a deal collapses in November and the parties are negotiating a return, closing that out before December 31 versus January 2 can be the difference between neutrality and a multi-year problem.

Records That Back Up the Treatment

The burden of proving how a deposit should be treated falls on the taxpayer. Records must be kept long enough to substantiate the entries on the return.¹⁶

For deposit transactions specifically, contract language does more work than usual. Keep the signed agreement showing whether the deposit is refundable, any correspondence about forfeiture or return, bank statements documenting the flow of funds, and evidence of whether the money went to escrow or directly into the operating account. If you’re claiming a loss for a forfeited deposit, you’ll also need documentation of the forfeiture event and the business or investment purpose of the underlying transaction.

In an audit, the deposit-versus-advance-payment question comes down to documentary evidence of who controlled the money and under what conditions it could be returned. Businesses that regularly collect non-refundable deposits are better off building that documentation into the intake process than reconstructing it at tax time.

1
FindLaw. Commissioner v. Indianapolis Power and Light Co.
2
Internal Revenue Service. Publication 525, Taxable and Nontaxable Income
3
Internal Revenue Service. Publication 538, Accounting Periods and Methods
4
Office of the Law Revision Counsel. 26 USC 451 – General Rule for Taxable Year of Inclusion
5
Office of the Law Revision Counsel. 26 U.S. Code 451 – General Rule for Taxable Year of Inclusion
6
eCFR. 26 CFR 1.451-8 – Advance Payments for Goods, Services, and Certain Other Items
7
Office of the Law Revision Counsel. 26 U.S. Code 461 – General Rule for Taxable Year of Deduction
8
Office of the Law Revision Counsel. 26 U.S. Code 162 – Trade or Business Expenses
9
Office of the Law Revision Counsel. 26 U.S. Code 165 – Losses
10
Office of the Law Revision Counsel. 26 USC 1234 – Options to Buy or Sell
11
Internal Revenue Service. Tax Benefits for Homeowners
12
Internal Revenue Service. Instructions for Schedule D (Form 1040)
13
Office of the Law Revision Counsel. 26 U.S. Code 1211 – Limitation on Capital Losses
14
Internal Revenue Service. Topic No. 414, Rental Income and Expenses
15
Internal Revenue Service. IRS Chief Counsel Memorandum 200843001
16
Internal Revenue Service. Recordkeeping