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 be 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 ruling of the United States Supreme Court 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.
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.
A landlord's deductions from a tenant's security deposit must be reasonable. The landlord may make deductions for missing rent payments and for damages beyond ordinary wear and tear, which is the subject matter's depreciation or deterioration in value by reasonable and ordinary use by the tenant. Examples of non-deductible wear and tear include: paint retouching, minor cleaning, small tack holes, and nicks and scratches. Examples of deductible damages include large or excessive holes in the wall, pet urine stains, and broken doors and windows.
If a landlord wrongfully withholds a tenant's security deposit, the tenant may be entitled to additional damages beyond the amount of the security deposit. These may include statutory damages for local consumer collection practices act violations, civil theft damages that may total three times the value of the deposit (depending on the state), consequential (resulting) damages, interest, and in more rare instances punitive damages. For punitive damages to apply, there must be additional non-contract based claims, and the tenant must show that the landlord acted with malice. 
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.
Often car rental and car leasing companies will require deposit to protect itself against possible damage to the car. Once the car is returned it is checked for any possible damage and if needed funds are deducted from deposit to cover the loss of value and repairs.
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)
- "How to Get Your Security Deposit Back in Florida". www.avvo.com. Retrieved 2016-04-17.
- A Quick Guide to Recovering your Security Deposit in Florida
- 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.