Failed purchase of rental property

[appelman]

A client got well into the process of purchasing a rental property, then backed out when it appeared not to be as represented. He has a 25K deposit locked in escrow that the would-be seller won't release. He has also incurred legal and appraisal fees and other expenses in connection with the aborted purchase. My thought would be that the expenses should be capitalized into the basis of a property he does successfully purchase. I wouldn't think anything could be done regarding the deposit until escrow is closed one way or the other. But if the 25K is truly lost, would it also be capitalized? I would think so. Anyone have another opinion?

[Burke]

You are correct that nothing can be done until escrow is closed one way or another. However, the disposition of the deposit should be specified in the contract between the two parties, so he should know whether it will be returned or not. In general, it is kept by the seller if the deal does not go through, but again, the contract controls this. I know it is treated as ordinary income to the seller. See IRC Sect 1234 regarding the cancellation or termination of a contract for property purchased after 9/4/97 (TRA 1997). Your TP's deposit is considered the disposition of a capital asset, and it is usually short-term, Sche D.