Penitential earnest money received due to buyer breach is taxed as general income

The legal nature of the amounts received under an earnest money contract (contrato de arras) has raised doubts regarding their correct integration into the income tax return. Following a query regarding the taxation of these operations in Personal Income Tax (IRPF), the administration has clarified the applicable tax treatment when the transfer of the asset does not take place.

What the DGT has ruled

The Dirección General de Tributos (DGT) establishes that the signing of an earnest money contract does not produce a change in wealth through an alteration of the composition of assets. In cases where the transfer of the property or asset is not formalized due to reasons attributable to the buyer, the amounts retained by the seller as penitential earnest money should not be classified as capital gains.

Since there is no effective transfer of the asset, the necessary requirement to apply the capital gains regime is not met. Instead, these amounts are classified as income that must be integrated into the taxpayer's general taxable base. Regarding the timing of taxation, the gain will be attributed to the tax period in which the seller has the power to proceed with its execution as stipulated in the contract.

What this means for you

If you are an individual and sign an earnest money contract for the sale of an asset, you must take into account that the tax treatment of the amounts received depends on whether the sale is completed or not:

• If the sale is completed: The difference between the transfer value and the acquisition value will be treated as a capital gain.
• If the sale fails due to the buyer's fault: The amount of earnest money you receive will not be a capital gain, but rather income that will increase your general taxable base.

This change in classification implies that the tax burden could be different, as the general taxable base is usually subject to tax rates that can vary significantly compared to the scale for capital gains.

What you should do

Given the possibility that an earnest money contract may result in termination due to breach, it is necessary to analyze the wording of the execution clauses and the impact that receiving said money will have on the income tax return for the corresponding fiscal year. Each contractual situation must be analyzed to determine the exact moment of income attribution and to ensure compliance with current regulations.