Dropped Domian

If it's a one way link from their site to your site, you are not at risk by accepting their link. If Google penalized sites/URLs for inbound links then I could get all of my competitors kicked out of the SERPs simply by buying links or obtaining links from bad neighborhoods, pointing the links to competitor sites, and reporting the competitor for having the 'bad' inbound link.

If they are asking for a reciprocal link, then linking to a bad neighborhood can lead to a penalty on your site. Proceed at your own risk.

If the domain has changed hands since being banned/penalized and appears to rank well for the niche keyword phrase you are probably okay to link back to them. But I would only trade links with them if they are a relevant site and having a link to them on your site will benefit your site's visitors.

If the domain was never banned/penalized and its original owner simply let it expire and someone else picked it up, you should be fine to reciprocal link. Again, I would only trade links with them if they are a relevant site and having a link to them on your site will benefit your site's visitors.

dropped domian? dropped domain.