A security deposit is a sum of money held in trust either as an initial part-payment in a purchasing process (often used to prevent the seller selling an item to someone else during an agreed period of time while the buyer verifies the suitability of the item, or arranges finance) - also known as an earnest payment, or else, in the course of a rental agreement to ensure the cost of repair in relation to any damage explicitly specified in the lease and that did in fact occur.
In certain taxation regimes a deposit need not declared as part of the gross income of the receiving party (person or corporation) until either the depositing party or an arbitrator agrees the funds may be used for the intended purpose.
A 1990 United States of America ruling 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.
In some legal regimes the deposit has to be placed with an independent escrow agent or licensed deposit taker such as a bank so that the risk of fraud is reduced and the funds earn interest at a fair market rate.
In the United States of America, Washington DC, Alaska, Illinois, and Wisconsin have notably more tenant-friendly legislation in place than states like Indiana or Michigan, for example. The cities of Madison, Wisconsin and Chicago, Illinois have in place substantially greater protection of tenants' security deposit rights than the surrounding areas.
- Commissioner v. Indianapolis Power & Light Co., 493 U.S. 203 (1990)
- Madison's General Ordinance Chapter 32 and Chicago's Residential Landlord Tenant Ordinance.
- Donaldson, Samuel A. Federal Income Taxation Of Individuals: Cases, Problems and Materials (2nd ed.). St. Paul: Thomson West, 2007. pg. 145.