Legal: Deposits and Liquidated Damages

When buying or selling a home, you will want a basic understanding of the Earnest Money Deposit and Liquidated Damages sections of a purchase agreement, prior to negotiating an offer. Once an offer has been accepted by both parties, the Buyer’s deposit is to be paid into escrow (a neutral 3rd party who holds the funds) within 3 Business Days and is made in good faith to show the buyer is serious about purchasing the property. The deposit amount is typically 1-3% of the purchase price and the deposit will go toward the Buyer’s downpayment or closing costs upon a successful close of escrow. If a Buyer backs out of the transaction prior to removing all of their contingencies, their deposit funds are returned to them. However, if a Buyer removes all of their contingencies and thereafter defaults on the contract, the Seller may be entitled to damages. How much will typically depend on whether the liquidated damages provision was initialed and thereby made part of the contract. If it was, then the Seller will likely be entitled to the amount of the deposit. If not, then the seller will have to prove their losses.

What are liquidated damages? 

A liquidated damages provision in a purchase agreement provides that a buyer will owe a specified amount of money to a seller in the event the buyer breaches the contract. For example, if a deposit of $5,000 is placed in escrow, and the liquidated damages provision is initialed by both buyer and seller, and the buyer breaches the contract, the seller will be entitled to the $5,000 as liquidated damages. It does not matter whether the seller has incurred an actual loss that is more or less than $5,000. The purpose of the provision is to set the amount of damages in advance so that proof of actual loss is not necessary. 

Does a liquidated damages provision automatically entitle the seller to the buyer's deposit if a transaction does not close? 

Generally, no. A liquidated damages provision only determines the amount of money a seller can recover from a buyer, and only if the seller can prove the buyer breached the contract. A buyer may fail to close a transaction for a variety of acceptable reasons such as when there is a financing contingency and the buyer could not reasonably obtain financing. To recover liquidated damages, the seller generally must prove in court or arbitration that the buyer's failure to close the transaction was a breach of contract. 

What is the advantage of a liquidated damages provision to the buyer?

For the buyer, the main advantage of the liquidated damages provision is certainty. If the clause is part of the contract, the buyer knows in advance the maximum amount of money that he or she will owe to the seller in the event of a breach. If the amount of the deposit is $5,000 then that is the maximum the buyer will owe. A low deposit amount will, therefore, usually work to the advantage of the buyer. 

What is the advantage of a liquidated damages provision to the seller?

As for the seller, the advantage is similar in that it provides the seller with certainty as to what the buyer’s liability will be in case of breaching the contract. If the deposit is $5,000, the seller is, in most circumstances, assured of being legally entitled to the full deposit of $5,000 in the event of a buyer breach. Another important advantage is that the seller need not prove damages in court because the amount of the damages has been agreed to in advance. Proving the seller’s actual loss can be fairly complicated, but with the liquidated damages provision in place, the seller need only show that the buyer was in breach of contract.

Could a seller collect monetary damages from a buyer for breaching a real property purchase contract that did not contain a liquidated damages clause?

Yes. The fact that a purchase agreement does not contain a liquidated damages clause does not mean that a buyer could escape liability for failing to perform. It simply means that the amount of damages the seller could recover would not have been pre-negotiated, and therefore the seller will have to establish, in court or arbitration, the amount of his or her actual monetary injury. Establishing the financial loss resulting from a breach of contract can be a complex and expensive process, and it may require the presentation of evidence in court or arbitration. Generally, a seller will need the assistance of an attorney to properly calculate the actual damages he or she has sustained in a failed real estate transaction.

The decision to agree or not agree to a liquidated damages provision may depend on a combination of legal and economic factors, along with a client's own personal concerns. Though many REALTOR® clients decide to agree to liquidated damages clauses, a client with questions regarding such a clause should consider discussing the matter with an attorney if needed. 

*Excerpt of a California Association of REALTORS® legal article on Liquidated Damages and Disputes.