Any advice on how to proceed, or how to calculate deposit return, etc?  

Having the city change the entire block to match the nearby U-TU is a good idea - I'll have to think about that more as a plan B. 

Or should I just take it out of their security deposit?

Do they usually ask for a deposit?

Unless you have a commitment, the deposit is useless.

Hi Megan, for seller financing I would offer the seller some type of interest that is better than what banks are offering and perhaps a little less than typical hard money financing, say 8%.That way if the seller isn't in a big rush to get all his money up front this is an opportunity for seller to make a bit more money.I would also propose a non-refundable (ie hard) deposit to give the seller some confidence in your ability to manage the deal and see it through.I hope that helps!

Wells Fargo is our favorite bank for setting up deposit accounts for our plans.

All money should go through escrow - even deposits if they are not being held by a licensed broker that represents one of the parties to the transaction.

I've worked with providing only Performing Notes for the past six years and those that buy these notes are completely passive, besides watching their monthly deposits happen and receiving their 1099s each year.  

We had a 2 month deposit for them, so as part of the agreement, we made 1/2 of that deposit nonrefundable too.