Security deposit

In the field of taxation, a deposit is not included as gross income to the receiving party until the depositing party chooses to apply the funds to purchase services. A 1990 ruling ["Commissioner v. Indianapolis Power & Light Co.", 493 U.S. 203 (1990)] provides that a deposit differs from an advance payment because the depositing party has dominion over the funds and retains the right to insist upon repayment in cash. On the other hand, the party making an advance payment retains no right to insist upon the return of the funds as long as the recipient fulfills the contractual agreement.

The rationale behind the court’s decision is that the recipient of the deposit does not enjoy “complete dominion” over the funds and is subject to an express obligation to repay so long as the customer fulfills his or her legal obligations. Additionally, both the timing and the method of refund are largely within the control of the depositing party, as he or she can choose to insist upon repayment in cash or apply the deposit to purchase services. The recipient’s right to retain the funds of the deposit is contingent upon events that are outside of his or her control.

An important note is that although the recipient may receive an economic benefit from the deposits – i.e. interest – the prospect that income will be generated provides no ground for taxing the principal. However, any income that the recipient may earn through the use of the deposit money is, of course, taxable.

Security deposits are required most often by lessors of automobiles, apartments, and commercial real estate.

The security deposits required by many residential landlords of their tenants are the source of much dispute and litigation. Many states and municipalities have enacted laws that specifically regulate the landlord's ability to withhold tenant security deposits after a tenant moves out. Some states and cities require that interest be paid to the tenant as it is earned on the security deposit. Washington DC, Alaska, Illinois, and Wisconsin have notably more tenant-friendly legislation in place than states like Indiana or Michigan, for example. Within Illinois and Wisconsin, the cities of Madison, Wisconsin and Chicago, Illinois have in place substantially greater protection of tenants' security deposit rights than the surrounding areas. [Madison's General Ordinance Chapter 32 and Chicago's Residential Landlord Tenant Ordinance.]

References

* Donaldson, Samuel A. "Federal Income Taxation Of Individuals: Cases, Problems and Materials" (2nd ed.). St. Paul: Thomson West, 2007. pg. 145.