The kind of tenant who 1. allows another to occupy without permission, 2. is dishonest (or at least withholding) about his occupancy, and 3. allows him to smoke inside - probably not the best in the long-term.

Owe nothing to anyone except to love one another; for he who loves his neighbor has fulfilled the law.Proverbs 3:27-28    Do not withhold good from those to whom it is due, When it is in your power to do it. 

What I see far too often, especially with newer investors, are they overlook many of the fees associated with holding a property long-term.

You will be responsible for factoring in the $12,500 penalty.The withholding from your $90,000 earning W-2 may be higher than that penalty resulting in a refund.

If I end up issuing this payment, do I also get the exiting tenant to fill out a w9 for their income or do we report this distribution as short term capital gains or do we withhold taxes.  

Many apartment managers are claiming they don't get paid for overtime, don't get Wage Earning Statements and they claim they are employees and not independent contractors meaning they sue you for filing them as Exempt from paying taxes when you should be withholding taxes from their earning, matching their payroll taxes and paying into social security, medicare, etc..

Account ClosedLook up form 593 - there may be some scenarios where you are exempt from having to withhold taxes upon sale.However, you may still have to pay the tax when you file your return.

In many states, even more landlord friendly states, you must give written notice of the amount you're withholding from the security deposit, and why it is being withheld.

Make sure you take plenty of photos of every bit of damage if you decide to withhold anything from her security deposit aside from unpaid rent.

If more, withhold the entire thing.