Cross References

  • VanDemark, 6th Circuit Court of Appeals, June 30, 2022

A security deposit on the rental of property is not taxable when received. It becomes taxable when the recipient is no longer obligated to return it to the tenant.

This case had to do with a taxpayer convicted of tax evasion for concealing cash down payments received from his car dealership which leased and sold cars to customers. The taxpayer appealed the conviction to the court of appeals, in part, because a criminal conviction means the taxpayer was guilty beyond a reasonable doubt of trying to conceal income from the IRS.

The taxpayer argued that the receipt of a deposit isn’t taxable income unless the taxpayer has some guarantee that he or she will be allowed to keep the money. He claimed that his lease agreements tied up the deposit until the very end when the customer decided to turn in the leased car or purchase it. Thus, the reporting of a deposit as income should have been considered a timing issue rather than willfully trying to conceal taxable income from the IRS.

The appeals court didn’t buy the taxpayers argument. What is of interest in this case from a tax standpoint is why the appeals court reasoned the deposits were clearly taxable upon receipt even though the lease agreement stated the money would be returned at the end of the lease if the car was not purchased.

The taxpayer’s customers were low-income with low-credit. Customers typically financed their cars by entering into lease-to-buy agreements. The process kicked off with a large down payment. The lease agreement stated that if a customer decided not to purchase the car at the lease’s end, the customer would get a refund of the down payment under the contract.

However, the appeals court noted that the taxpayer issued virtually no refunds across decades. His dealership found ways to keep these down payments at its discretion. One worker at the car dealership stated that during his 30 years working there, he saw the down payment refunded “maybe, one, two, three” times total. The IRS special agent that investigated the case stated that from 2012 to 2014, there was only one refund, and that refund was the same day the customer paid it, perhaps because the customer changed his or her mind before finalizing the lease. Thus, in that time period, the dealership issued “zero” refunds to customers at the end of their leases.

The court noted that one way or another, the dealership engineered for itself “some guarantee” of keeping the down payments. The contract itself stated the dealership would refund the down payment, but only if the excess mileage fee and the cost of damages to the car did not exceed the down payment amount.

The dealership exploited customers to maintain control over the down payments. On excessive mileage, the contract imposed a fee equal to 50 cents per mile for miles to be computed at the end of the lease and balance due. But the contract failed to specify a base mileage. As a practical matter, this allowed the dealership to define the number of excess miles after the lease ended.

The contract also stated that damages beyond “ordinary wear and tear” come out of the deposit. As for calculating those costs, however, the contract places everything in the dealership’s hands. It specified that a representative of the dealership would be the sole judge and arbiter as to whether or not any disputed damage was due to ordinary wear and tear or due to some other cause.

These ambiguities enabled the dealership to jack up both variables on the back end to prevent a refund if it wished.

This case illustrates the point that a contract claiming something to be a deposit does not make it a deposit, if the contract is ambiguous enough to allow the taxpayer to never return it.