forfeited deposit on purchase of rental property

[jgcpa]

My client retained the deposit that the prospective buyer forfeited because the purchaser changed his mind. Would the forfeited deposit that my client kept be reported in Schedule  1 or with Rental income Schedule E. The rental activity is a passive activity, no active participation.  The IRS says that forfeited deposits are ordinary income. Does that mean it is not passive income?

[TaxGuyBill]

"Ordinary" income doesn't necessarily mean it is nonpassive.  However, in this case, in my opinion it is nonpassive.  I'm not sure if I would enter it as a short-term gain or enter it on line 8 of Schedule 1.

[BobKamman]

I am confused by Section 1234A, the root of this uncertainty.  The most recent Tax Court opinion says, "Forfeited deposits from the termination of a contract to sell a hotel are taxed at capital gain rates if the hotel is held as a passive investment. The same forfeited deposits are taxed as ordinary income if the hotel is used in a trade or business."  So, is this rental a passive activity, and does that make a difference?  They could have avoided this problem by calling it an option, not a deposit.  So sue the lawyers who wrote the contract, for malpractice. Or more likely, the real estate agents.  

[jgcpa]

Thanks for your replies. The forfeited earnest money is Ordinary income. The question then becomes is it Passive income and report on Sch E as rental income. There is no Other Income labeled line in Sch E. Or report in Sch 1. If I report as rental income, then there are enough expenses that no deposit will be taxed. If I report as Other Income, sch 1, no rental losses can negate the forfeited deposit since the owner does not actively participate. Thoughts? I have looked at AI and I get varied results.

[jgcpa]

In most cases, the forfeited deposit from a failed sale of rental property is considered ordinary income to you, the seller. This is because the deposit is essentially compensation for the buyer's failure to fulfill the purchase agreement, and it's not directly tied to the sale of a capital asset (which rental property used in a trade or business typically isn't).

Schedule E (Form 1040), Supplemental Income and Loss: This is the form used to report income and expenses from rental real estate. You would include the forfeited deposit as part of your rental income on this schedule.

• You would likely list it under "Other income" on Schedule E, as it's not rent. Be sure to clearly describe it as "Forfeited deposit from sale."

I found this in in AI. Sch E has no Other Income line. The above says to include forfeited deposit as part of the rental income.  There is no consistency.