Given the situation I would return the deposit but encourage him to still take the car once you can prove that there are no longer any issues with the sale.

Personally I wouldn't feel to comfortable with someone having taken some of my hard earned and then hear it is encumbered.

By giving the deposit back you prove that you have nothing to hide and he will quite likely decide you are above board and consider still taking the car after you have proof of it not being encumbered.

Make it clear it is an issue that was out of your control BUT be very apologetic to the potential buyer and you might still have a sale.

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Stoner & Webber 2011 World Champions