When you receive an escrow surplus check from your mortgage lender, you do not need to report it on your tax return. That check isn't income to you. It's simply a refund of money that you provided to the lender to use to pay bills on your behalf. A look at how mortgage escrow works makes clear why a surplus check is not taxable income.
Escrow Funds are Not Income, and an Escrow Refund is not Taxable
If you're like most other homeowners with a mortgage, your monthly mortgage payment includes more than just principal (the borrowed money you're paying back )and interest (what the bank is charging you for using its money). Your payment also includes part of your annual property tax bill and a portion of your annual premium for homeowners insurance. Your lender collects this money from you in 12 equal installments over the course of a year, puts it in a special account – an escrow account – and uses it to pay your taxes and insurance premiums when they come due.
By the time a tax or insurance bill comes due, the account must have enough money in it to pay the bill. To ensure this is the case, your lender sets your escrow payments so the account is funded to that level. However, the lender can also require you to keep an additional amount in the account – a "cushion" – to absorb unexpected cost increases.
Federal law limits how much your lender can require you to contribute to your escrow account and create that escrow cushion. Under the Real Estate Settlement Procedures Act, the lender can require a cushion equal to one-sixth of the total amount paid out of escrow each year. Because each monthly payment accounts for one-twelfth of your combined annual tax and insurance bill, the maximum cushion is essentially two months' worth of escrow payments.
Since the money being refunded in the case of an escrow surplus is money you paid to the lender, it's not considered taxable income, because you're simply getting that money back after paying it in. If you get a refund when you return a toaster to the store, that money is not taxable income; the principle here is the same.
Refund of an Escrow Surplus
If the amount of excess money in your escrow account grows to be larger than the allowable cushion, you've got an "escrow surplus." The lender can take a surplus of up to $50 and apply that money to your future escrow payments. But you have the right to receive a refund escrow check for any surplus over $50.
As an example, assume that your property taxes for 2018 will total $4,000 and your homeowner's insurance for the year is $800. This means your escrow account must contain at least $4,800 to cover these costs. The mortgage company is allowed to create an escrow cushion of 1/6 of that amount, which is $800, for a total escrow of $5,600 for 2018. If your mortgage payment includes $500 per month for escrow, you will contribute $6,000 to your escrow account for 2018, which is $400 greater than the allowed cushion. That $400 will be refunded to you. If you don't want a refund, your lender may give you the option of using a larger surplus to reduce future payments or to pay down your loan principal.
If you sell your home and have unused money left in your escrow account, the full amount of that surplus must be refunded to you, even if it's less than the cushion, because future property taxes will be prorated and become the responsibility of the buyer. Any unpaid taxes will come out of the purchase price at closing.
Escrow Surplus and Property Tax Deductions
Some homeowners may wonder whether escrow refunds affect their property tax deductions. After all, money is set aside in escrow to pay property taxes, and those taxes are deductible on your income taxes. However, you can only deduct the taxes that are paid out of the escrow account – the amount of money the bank actually pays to the taxing authority. You don't deduct the money you put into escrow, so the unused portion that gets returned as a refund doesn't have any effect on your property tax deduction.