Internal Revenue Service
Revenue Ruling

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 Rev. Rul. 68-19

1968-1 C.B. 42

Sec. 61

IRS Headnote

When a lessee releases a lessor from the lessor's obligation to repay a security deposit as consideration for the cancellation of a lease, the entire amount realized by the lessor from the release is includible in his gross income in the year of the release under section 61 of the Internal Revenue Code of 1954. In this regard the Internal Revenue Service will not follow the decisions in Warren Service Corporation v. Commissioner , 110 F.2d 723 (1940), and Bradford Hotel Operating Company v. Commissioner , 244 F.2d 876 (1957).

Full Text

Rev. Rul. 68-19

Advice has been requested concerning the Federal income tax consequences of the release of a lease security deposit to a lessor by a lessee under the circumstances described below.

The parties agreed to a lease of real property to extend from 1955 through 1969, unless the lessee exercised an option to extend the lease through 1976. In accordance with the terms of the lease, the lessee deposited 18 x dollars with the lessor as security for all the terms, provisions, and conditions of the lease. It was agreed that if the lessee defaulted in respect to any of its obligations under the lease, the lessor could apply the security deposit to any sums as to which the lessee might be in default. The security deposit was to be returned to the lessee at the expiration of the lease, provided all covenants were fully performed by the lessee. In 1965, the lessee surrendered the leased premises and in consideration of the cancellation of the lease released the lessor from his obligation to repay the security deposit.

In the cases of Warren Service Corporation v. Commissioner , 110 F.2d 723 (1940), and Bradford Hotel Operating Company v. Commissioner , 244 F.2d 876 (1957), the lessor had the right to the general use of the security deposit during the term of the lease without the obligation to pay interest to the lessee. When the lessee relieved the lessor of its obligation to repay the security deposit as consideration for the cancellation of the lease, it was held in the cited cases that the lessor was deprived of the valuable right to use the security deposit, without interest, for the remaining term of the lease. Therefore, the income realized by the lessor was held to be reduced by the value of the loss of this right.

Section 61 of the Internal Revenue Code of 1954 defines gross income as all income from whatever source derived, unless excluded by law.

Section 1.61-8(b) of the Income Tax Regulations provides the general rule that an amount received by a lessor from a lessee for cancelling a lease constitutes gross income for the year in which it is received, since it is essentially a substitute for rental payments.

Accordingly, whether or not the lessor has the use of the security deposit, with or without the obligation to pay interest, the entire amount realized by the lessor from the release of his obligation to repay the security deposit in consideration of the cancellation of the lease, or 18 x dollars, is includible in the gross income of the lessor in the year of the release under the provisions of section 61 of the Code.

In this regard the Internal Revenue Service will not follow the decisions in the Warren Service Corporation and Bradford Hotel Operating Company cases.