It is not uncommon in property transactions, particularly those involving commercial property, for a potential buyer to pay the vendor a deposit in respect of the property. The terms of agreement between the parties might provide that the deposit is non-refundable if the contract is rescinded and the property purchase does not proceed.
For example, the purchaser may have sufficient cash to pay the deposit, but subsequently be forced to pull out of the deal after discovering that they are unable to obtain the necessary borrowings to meet the purchase price for the property. If the deposit is forfeited because the purchaser cannot complete the deal, how should the deposit be treated by the recipient and payer for tax purposes?
This article looks at whether the forfeited deposit is a taxable receipt for the property owner, and whether it is an allowable or non-allowable deduction for the payer (nb any VAT and stamp duty land tax issues etc. are beyond its scope). It is assumed for the purposes of this article that the prospective property buyer and seller are both individuals; the position where one or both of them are companies (e.g. an investment company) is subject to different considerations, which are not addressed here.
Treatment of the receipt
The tax treatment of the forfeited deposit for the recipient generally depends on whether or not the individual is a property trader.
If the recipient is a property trader, HMRC is likely to regard the forfeited deposit as a trading receipt, on the basis that it is received in the course of the individual’s trade (Elson v Prices Tailors Ltd  1 WLR 287). HMRC’s guidance indicates that they expect the forfeited deposit to be recognised for tax and accounting purposes when it is reasonably certain that the property transaction will not be completed and the deposit will be forfeited (BIM31110).
If the recipient is not a property trader (e.g. an investor, or possibly an owner-occupier), the forfeited deposit may be a capital receipt instead (although first it should be considered whether the receipt is chargeable as income, as an income tax or corporation tax charge generally takes precedence over capital treatment (TCGA 1992, s 37(1)).
For capital gains tax purposes, a forfeited deposit on a prospective sale that is abandoned falls to be treated in the same way as the consideration for an option that binds the vendor to sell the property, where the option is not exercised (TCGA 1992, s 144(7)). It is therefore necessary to consider how an option to acquire the property would be treated.
The grant of an option to acquire (for example) a property is generally treated as the disposal of a separate asset (i.e. the option) by the individual selling the property (TCGA 1992, s 144(1)). This treatment as a separate asset broadly applies unless the option is exercised, and the whole proceeds are chargeable as a gain (Strange v Openshaw  STC 416). If the option is exercised, its grant or acquisition and the subject matter of the option are treated as one transaction, taking place on the date of exercise (s 144(2)).
However, if the option is not exercised, there has been a deemed disposal of the option, and the property seller is chargeable on the proceeds from granting the option. Thus as a forfeited deposit is treated as the abandonment (by the payer) of an option, the property owner, being the recipient of the deposit, is chargeable on the proceeds. The forfeited deposit is treated as consideration received by the recipient for the deemed option. A chargeable gain arises when the contract is rescinded and the property seller receives the forfeited deposit (subject to any allowable expenditure).
Example: unexpected windfall
Mary decided to sell her investment property. James offered to pay £500,000 for the property, which Mary accepted. It was agreed that James would pay Mary a non-refundable deposit of £25,000.
Unfortunately, James subsequently suffered sudden and unforeseen financial problems. Consequently, the contract fell through, and his deposit was forfeited.
Mary’s capital receipt of £25,000 is chargeable to capital gains tax.
In the case of a forfeited deposit to purchase an individual’s only or main residence, HMRC will not allow private residence relief for capital gains tax purposes in respect of the receipt, on the basis that there has been no disposal of the property itself (CG64609).
How is the payment treated?
If the individual suffering the forfeited deposit is a property trader, the expenditure might be an allowable deduction from profits on the basis that it was ‘wholly and exclusively’ incurred for trade purposes (ITTOIA 2005, s 34), if the property would have been a trading asset had it been acquired.
Otherwise, as indicated above, a forfeited deposit generally falls to be treated as an option binding the grantor to sell that is not exercised. The abandonment of the property acquisition does not constitute the disposal of an asset by the individual paying the deposit (TCGA 1992, s 144(4)). The individual who paid the forfeited deposit will therefore generally incur a non-allowable capital loss.
In the recent case Hardy v Revenue & Customs  UKFTT 250 (TC), the taxpayer funded 10% deposits on the prospective purchase of two properties. Both of the deposits were paid on exchange of contracts with the sellers. However, funds were not subsequently available to complete the purchases. The sellers refused to wait while the buyers raised the necessary funds to complete, and rescinded both contracts and retained the deposits. The taxpayer, who had realised capital gains on other properties, sought to offset the loss of the forfeited deposits against capital gains in respect of other properties. HMRC disallowed the loss relief claim, and the taxpayer appealed.
The First-tier Tribunal decided that neither the exchange of contracts, nor the satisfaction of a condition in the contracts as to the construction of houses, marked the acquisition of assets by the appellant, because the intended transactions never took place. The tribunal therefore held that the rescission of the contracts did not mark a disposal of assets on which a loss (or a gain) could be realised. The loss of the deposits was not capable of being allowed against chargeable gains. The taxpayer’s appeal was dismissed.
Property sellers should consider requiring the prospective buyer to pay a non-returnable deposit. A forfeited deposit may at least provide some consolation if the contract for the property is rescinded through no fault of the seller, notwithstanding that there may potentially be some tax to pay on the receipt.
The above article was first published by Tax Insider (August 2015) (www.taxinsider.co.uk).