Putting Your Money Where Your Mouth Is: Deposits and Real Estate Contracts

by Stephen Haas

If you’ve ever bought or sold a home, one of the things you probably had to deal with was deposit money. Also sometimes referred to as earnest money, the deposit is money paid by the buyer at the time of the signing of the real estate contract. The remaining money is paid at closing, when title to the property is transferred. The deposit is what ensures that the seller is protected in case the estate buyer walks away and is what truly incentivizes the buyer to proceed with a contracted-for sale.

A Contracts Remedies Primer

In the case of most contracts, if there is a breach, we look to award “expectation” damages.^[1] This means that we seek to award damages to the aggrieved party that would put him or her in the position that he or she would have been had the contract been successfully performed.^[2]However, this is not generally practical in real property contract cases.

If the seller breaches, i.e., the seller refuses to close, monetary damages are not considered adequate. Because each parcel of real property is considered unique due to its location, the buyer can only truly receive the “benefit of his bargain” if the buyer is actually awarded the property. Therefore, in cases in which the seller breaches a valid real property sales agreement, courts will force the seller to go through with the sale called for by the agreement. This remedy is known as “specific performance.” ^[3]

On the other hand, when the buyer breaches and refuses to go through with the agreement, the expectation remedy is also often impractical because it is hard to measure. It is very difficult to determine with any precision the amount that a seller loses when a deal falls through. Expectation remedies require reasonable certainty before they can be awarded.^[4]

To overcome this problem, many real property contracts stipulate that the purchaser gives a certain percentage of the sales price as earnest money at the time of the signing of the agreement. If the buyer then breaches the agreement, the seller is entitled to keep the earnest money (deposit) as damages for the breach. This type of clause, that sets the amount of damages in the event of a breach, is called a “liquidated damages” clause. These clauses are generally considered valid as long as the situation is such that actual expectation damages are difficult to measure and if the amount of liquidated damages called for is a reasonable approximation of the seller's actual damages.^[5]

A typical real property contract provision that establishes the earnest money as liquidated damages specifies that these two conditions are met. Following is an example of such provision:

In the event that the purchaser fails to make payments due under this Contract, fails or refuses to sign any documents required to close title, refuses to pay any costs required by this Contract or fails to keep any promises made by buyer pursuant to this Contract, seller may terminate this Contract, and retain the down payment made hereunder. The amount retained by seller shall be considered "liquidated damages" based upon an understanding between the parties hereto that seller will have suffered damages due to the withdrawal of the property from sale to the general public. The damages suffered by the seller as a result will be substantial, but incapable of determination with mathematical precision. It is, therefore, agreed by the parties that the amount retained by the seller is not a penalty, but rather a mutually beneficial estimate of damages.^[6]

Who Holds the Deposit?

The earnest money is held by an escrow agent agreed to by the buyer and seller. In many cases, this is the seller's attorney, the real estate agent or an agent of the title company, but it can also be an unrelated third party. In the event of a breach, the escrow agent turns the money over to the seller. In the event that there is a dispute as to whether there was a breach, the escrow agent may hold the money pending the resolution of the dispute or the escrow agent may bring an interpleader action in an appropriate court to get a judgment as to whom is entitled to the escrow funds.^[7] Certainly, it would be unwise for the escrow agent to distribute monies to one party when there is a dispute, lest the other party sue the escrow agent for wrongful distribution of those monies.

Amount of Deposit

There is no hard and fast rule as to how much the earnest money has to be. Obviously, the seller wants more money to be put down and the purchaser wants to put less money down. The amount of the deposit can be a negotiating point at the time that contract is negotiated.

The National Association of Realtors tells buyers to expect to put down between 1% and 3% of the purchase price as earnest money.^[8] The author has seen real estate deals where as much as 10% of the purchase price was put down as earnest money. It depends on the custom of the region and also on the type of real estate transaction involved (commercial transactions often require higher deposits).

Contingencies

Losing the earnest money is a terrible result for a buyer. So, how does the buyer protect him or herself from the possibility of losing the deposit money if something does go wrong? The answer is that real estate contracts often contain contingencies that allow the purchaser to back out of the agreement and get his or her earnest money back upon the occurrence of some event or condition. These contingencies are good provisions for the buyer, but are provisions that the seller would rather do without.

Though a contingency clause can be based on almost anything, I will briefly discuss two of the most important types of contingency clauses.

A mortgage contingency clause is a virtual necessity when the purchaser is planning to seek financing to purchase the real estate at issue. Although prospective home buyers can get pre-approvals for mortgages, banks will not usually issue a final approval for a mortgage loan without a signed contract. To protect the purchaser in case the deal falls through, purchasers will typically seek a provision that states that the purchaser may back out and obtain a refund of the deposit if the purchaser applies in good faith for a mortgage, but is ultimately denied. A typical such provision (with extraneous language deleted) may read as follows:

PURCHASER's obligation under this Contract is contingent upon, the PURCHASER obtaining, at PURCHASER's own cost and expense, a mortgage commitment in the sum of $__________, repayable over a period of thirty (30) years with interest at the prevailing rate per annum, as shall be then charged by such lending institution, registered mortgage broker or licensed mortgage banker, plus any applicable "points", discount charges or loan origination fees. PURCHASER warrants and represents that PURCHASER will, diligently and in good faith, apply for said mortgage and will promptly furnish all reports, documents, verifications and/or fees required in connection therewith. In the event PURCHASER does not obtain said mortgage commitment by ____________ after the exercise of good faith, then this Contract shall be deemed null and void at the option of either party to this Contract and SELLER's sole liability thereunder shall be the return of all monies paid pursuant to this Contract. In such case, the deposit money paid under this contract shall be returned to PURCHASER.^[9]

Due the added layer of uncertainty inherent in a contract with a mortgage contingency clauses, sellers usually prefer purchasers who are willing to engage in a “cash” transaction (this is synonymous with there being no mortgage contingency clause). Many sellers will even take a slightly lower priced offer to avoid a mortgage contingency clause, given the choice.

An inspection clause allows the purchaser a certain period of time after the signing of the contract to conduct a home inspection by a home inspector or engineer. A typical inspection clause gives the purchaser the right to renegotiate or back out if there are found to be problems with the house.

Since the vast majority of residential homes have some minor or major problems or needed repairs, an inspection clause of this type, as a practical matter, allows the purchaser to back out of or renegotiate the agreement after the contract is signed. Therefore, this is a provision that is very friendly to the purchaser and potentially very harmful to the seller. Many sellers therefore insist that the home inspection and any subsequent negotiation occur prior to the signing of the agreement and that the agreement not contain an inspection clause.

If the contract falls through based on something that is the seller’s fault (e.g., the seller could not deliver marketable title or could not get necessary zoning approvals, etc.), it goes without saying that the deposit must be returned to the buyer. The buyer may also be able to successfully sue for further damages in such a case.

Conclusion

When used properly, earnest money protects the seller by giving the buyer a strong incentive to go through with the deal. It also helps the buyer by inducing the seller to take the house off the market by signing the contract while leaving the buyer necessary outs. It helps both parties gain cost certainty in the transaction rather than leaving complex damages computations for later determination by a judge or jury.

However, it is also very important that both parties to the transaction understand the role of the earnest money, how it protects them and how and when it does not protect them. As always, questions regarding a particular case or transaction should be discussed with a local attorney familiar with this area of law.