Escrow Money Treated As Income For Taxes

A reader wants to know if excess escrow money that is returned is likely to be taxed

Q: I’m wondering if escrow funds I deposited but were later returned to me will be treated as income for tax purposes. Here’s what happened: I was selling a large piece of land to a developer. The developer signed an option to purchase contract and deposited $70,000 annually into an escrow account for five years.

With the real estate market downturn, the developer defaulted on the contract and I will receive $350,000 in escrow money. Is this money ordinary income or capital gain income for IRS purposes?

What happens if escrow money is treated as income for tax return

A: Unfortunately for you, this cash would be considered ordinary income. You did not sell a capital asset but rather received a payment under the contract.

When you own investment property (including stocks, investment real estate, and other long term holdings) and have held it for a year or more, any profits from the sale of that property would be taxed at a lower tax rate than what most people earn as salary or other income.

Currently for higher income amounts the tax rate for capital gains is 15 percent and the highest rate for ordinary income is 35 percent. In addition to any federal tax owed, you may owe state tax on this income.

In your case, your income is derived from the termination of the contract rather than the sale of the land. You should talk to your accountant further as to whether your contract was structured in a way that would permit you to consider the cash payments as anything other than ordinary income. But for most contract cancelations, that money should be considered ordinary income.