Security deposit

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 property owner against default by the tenant and for 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.

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Wikipedia