The tax treatment of forfeited earnest money splits along two lines: the seller who keeps the deposit almost always reports it as ordinary income at their marginal rate, and the buyer who loses it gets no deduction on a personal home purchase but can claim a capital loss if the property was for investment or business use. Because deposits typically run one to five percent of the purchase price, a collapsed deal can shift thousands of dollars in tax consequences onto both sides.
One threshold point before the tax rules. A buyer who exits under a valid financing, inspection, or appraisal contingency gets the deposit back, and no one has a taxable event to report. Forfeiture, and the tax consequences below, apply only when the buyer walks after contingencies have expired or been waived and the seller keeps the money as liquidated damages.
How the Seller Is Taxed
When a seller retains a forfeited deposit, the IRS treats it as ordinary income taxed at the seller’s marginal rate. The reasoning is straightforward: no property changed hands, so there was no sale or exchange, and without a sale or exchange the long-term capital gains rates of 0%, 15%, or 20% don’t apply.1Internal Revenue Service. Topic No. 409, Capital Gains and Losses The seller received money, and the IRS taxes it like other miscellaneous income.
This holds even if the seller later resells the property to a different buyer at the same or a higher price. The forfeited deposit and the eventual sale are separate taxable events. The ordinary-income treatment can sting: marginal rates in 2026 reach 37% for high earners, well above the 20% ceiling on long-term capital gains.
The Narrow Section 1234A Exception
Section 1234A of the Internal Revenue Code says that gains or losses from the termination of a right or obligation related to a capital asset are treated as capital gains or losses.2Office of the Law Revision Counsel. 26 USC 1234A – Gains or Losses From Certain Terminations On its face, this seems to open a path to capital gains treatment on forfeited deposits. In practice, it rarely does.
The obstacle is the definition of “capital asset.” Section 1221 specifically excludes depreciable property used in a trade or business and real property used in a trade or business.3Office of the Law Revision Counsel. 26 USC 1221 – Capital Asset Defined That exclusion covers rental buildings, hotels, warehouses, and most commercial real estate. If you were selling a rental property or a building used in your business, the property isn’t a capital asset in your hands, and Section 1234A doesn’t apply. The U.S. Tax Court confirmed this in its 2016 CRI-Leslie, LLC decision, holding that forfeited deposits from a terminated hotel sale were ordinary income because the hotel was business property excluded from the capital asset definition.
Section 1234A can reach a seller holding property purely for investment and not used in a trade or business, such as vacant land held for appreciation. That’s a narrow category. Most sellers of commercial or rental real estate will owe tax on forfeited deposits at ordinary rates.
Reporting It, and Why You Should
No Form 1099 typically arrives for a forfeited deposit. The instructions for Form 1099-S cover sales and exchanges of real estate, not forfeited deposits.4Internal Revenue Service. Instructions for Form 1099-S Some sellers take that as cover to skip the income. It’s a bad bet. Escrow files, contract cancellation records, and state disclosures can surface during an audit, and an omission exposes the seller to the 20% accuracy-related penalty on the underpayment.5Office of the Law Revision Counsel. 26 USC 6662 – Imposition of Accuracy-Related Penalty on Underpayments
Sellers report the amount on Schedule 1 (Form 1040), on the “Other income” line (Line 8z on the current form), with a description such as “forfeited earnest money deposit.” It flows to Form 1040 and is taxed at the marginal rate.
How the Buyer Is Taxed
For the buyer, everything turns on what the property was going to be used for.
A Personal Home: No Deduction
If you were buying a place to live in, the lost deposit is a personal loss. Federal tax law flatly prohibits deductions for personal, living, or family expenses.6Office of the Law Revision Counsel. 26 USC 262 – Personal, Living, and Family Expenses The reason you walked away doesn’t matter. Job relocation, divorce, cold feet, all produce the same answer: no tax benefit, and you can’t add the forfeited amount to the basis of a different home you buy later. The money is gone for tax purposes.
Investment or Business Property: Capital Loss
Buyers purchasing property for investment or business use have better options. Section 165 allows individuals to deduct losses from transactions entered into for profit, even when the transaction never closes.7Office of the Law Revision Counsel. 26 USC 165 – Losses The loss is deductible in the tax year the contract terminates and you know the deposit won’t be returned.
The character of the loss usually lands on the capital side. Under Section 1234A, when a buyer’s right to acquire property that would have been a capital asset is terminated, the resulting loss is a capital loss.2Office of the Law Revision Counsel. 26 USC 1234A – Gains or Losses From Certain Terminations For most investment purchases, the property would have been a capital asset in the buyer’s hands, since the buyer isn’t a dealer holding it for resale, so the forfeited deposit produces a capital loss.
Capital losses first offset any capital gains you realized during the same tax year. If losses exceed gains, you can deduct up to $3,000 of the excess against ordinary income, or $1,500 if married filing separately.1Internal Revenue Service. Topic No. 409, Capital Gains and Losses Any remaining loss carries forward indefinitely, so a large forfeited deposit may take several years to fully absorb.
You report the loss on Schedule D (Form 1040), listing the property description, the date the contract was entered, the date it terminated, and the amount forfeited. Your basis is the deposit; your proceeds are zero.
Real Estate Dealers
If you buy and sell properties as a regular business, the properties you hold for resale to customers are inventory, not capital assets.3Office of the Law Revision Counsel. 26 USC 1221 – Capital Asset Defined A forfeited deposit on inventory property produces an ordinary loss rather than a capital loss. That works in the dealer’s favor: ordinary losses aren’t capped at $3,000 and can offset other business income in the year the deal dies.
Legal Fees From the Dispute
Fights over earnest money sometimes pull in attorneys, mediators, or a small claims court. Whether you can deduct those legal fees follows the same personal-versus-business line.
If the property was a rental or other business asset, legal fees to collect or defend the deposit are deductible as a business expense. Rental owners report them on Schedule E; other business owners use Schedule C. These above-the-line deductions survived the Tax Cuts and Jobs Act.8Internal Revenue Service. Publication 538, Accounting Periods and Methods
For a personal home purchase, the answer is worse. Legal fees on personal matters used to fall under the miscellaneous itemized deduction subject to a 2% floor. The TCJA suspended that deduction starting in 2018, and the One Big Beautiful Bill Act of 2025 made the elimination permanent. Legal fees you pay fighting over earnest money on a personal home are not deductible.
Which Tax Year, and What to Keep
The taxable event lands in the year the contract terminates and the deposit is officially forfeited, not the year the contract was signed or the deposit paid into escrow. A deposit paid in November 2025 on a contract cancelled in February 2026 shows up on the 2026 return.
Because no 1099 will typically arrive, you build your own paper trail. Keep the purchase agreement and any amendments, the written cancellation or termination notice, and escrow records showing when and how the funds were disbursed. If the forfeiture was disputed and resolved by settlement or litigation, keep the settlement agreement, court filings, disbursement schedules, and records of legal fees paid.9Internal Revenue Service. Tax Implications of Settlements and Judgments Those records carry the return if it’s examined, since you’ll need to prove both the amount and whether the transaction was personal or profit-motivated.