Taxpayer signs a purchase and sale agreement to sell real estate to an unrelated buyer for $2,500,000. Buyer deposits 10% of the purchase price, or $250,000, as an earnest money deposit and as liquidated damages in the event the buyer fails to complete the purchase. The buyer subsequently fails to complete the acquisition, and the deposit is forfeited to the Taxpayer. The real estate in question was held as long-term capital property and not as inventory.

Question: How should this forfeited deposit be treated for federal income tax purposes?

Answer: A seller who retains both the earnest money deposit and the property must treat the forfeited deposit as ordinary income.

Some taxpayers have tried to argue that the forfeited deposit should either be treated as capital gain (assuming the underlying property is a capital asset) or possibly as a tax-free return of tax basis. However, courts have generally rejected these arguments.

In the case of Josephine Binns, for example, the controversy arose out of a sales agreement entered into by the Taxpayer, who agreed to sell 26,000 shares of stock of the Phillips and Buttorff Company at $43 per share, of which $75,000 was paid as down payment, and the balance was to be payable a week later. The stock was delivered to the Commerce Union Bank and placed in escrow. Before the end of the week the purchasers of the stock learned they were unable to complete the transaction and agreed to forfeit their down payment of $75,000, as consideration for their being released from further liability under the contract. The Taxpayer agreed to release the purchasers from further liability under the contract and accepted the down payment. Josephine Binns v. U.S., 385 F.2d 159 (6th Cir. 1967).

The sole question in the case was whether or not the gain is to be treated as a sale or exchange of a capital asset. The Taxpayer contended that the sale was completed when the stock was placed in escrow. The Commissioner determined that the $75,000 which was forfeited, was ordinary income since the sale had not been completed.

The Sixth Circuit Court of Appeals, in a strikingly economical use of words, stated: “We agree [with the Commissioner].” Id.

The theory underlying these cases is that there is no sale or exchange transaction and hence no recognition of capital gain. Rather, the forfeited deposits and/or related settlement payments made by the buyer for failure to perform the purchase and sale contract are in the nature of liquidated damages, and hence ordinary income. See Handleman for a discussion of these issues. Philip Handelman v. Commissioner of Internal Revenue. 509 F.2d 1067 (2nd Cir. 1975), revg (1973) TC Memo 1973-57, 32 CCH TCM 249; Milton Ailes, (1983) TC Memo 1983-388, 46 CCH TCM.