When the deal closes
If the sale closes, earnest money is simply part of the purchase price. From the buyer's perspective, earnest money flows into the property's tax basis — it's one of the costs of acquiring the property. From the seller's perspective, the earnest money is included in the total sale proceeds and factors into the capital gain calculation.
No special tax treatment applies. The earnest money is not separately reportable by either party at closing.
When the buyer forfeits the deposit
If the buyer walks away and the seller keeps the earnest money, the tax treatment depends on the circumstances. For the seller, forfeited earnest money is generally treated as ordinary income — not capital gain — because it was not received as consideration for the sale of property. The sale never happened; the deposit is compensation for the buyer's breach.
For the buyer, a forfeited deposit is generally a capital loss, specifically a loss on the disposition of a capital asset (the purchase contract right). If the property would have been a business asset or investment property, it may be a capital loss; if it was intended as a personal residence, the loss is typically not deductible.
When the seller returns the deposit
If the deal falls through and the earnest money is returned to the buyer, there is no taxable event for either party. The buyer simply gets their money back — basis in the contract right returns to zero.
If the return is partial — say the seller keeps a portion as liquidated damages — the buyer's loss is limited to the amount not returned, and the seller recognizes income only on the retained amount. Keep documentation of what was paid, what was returned, and why the deal failed — the IRS may scrutinize large forfeited deposits on audit.
Frequently asked questions
Is forfeited earnest money taxable to the seller?
Generally yes — as ordinary income, not capital gain, because the property was not sold.
Can a buyer deduct a forfeited deposit?
If the property was intended as investment or business use, the forfeited deposit is likely a capital loss. It is generally not deductible if the property was intended as a personal residence.
Does earnest money affect my depreciation basis?
Yes. Earnest money that closes into the purchase is part of the property's tax basis, which affects both depreciation and gain on sale.
Educational information and estimates only. Not tax advice. Tax rules change and vary by situation; consult a qualified tax professional before acting.