Liquidated Damages in a Real Estate Contract…What Does it Really Mean?

Westcoe Realtors, Riverside California…There is a nifty little paragraph in the standard  Residential Purchase Agreement (paragraph 16 for those who prefer the numerical reference) labeled LIQUIDATED DAMAGES.  It is not a long winded explanation as some other references in a standard contract, but  it does affect who gets the money on deposit in case the escrow fails to close, and like the saying goes, dynamite comes in small packages…so beware to both the buyer and seller.  We thought a detailed discussion here might help those who are concerned, confused, or both regarding this important part of your real estate contract.

First…some background.  Prior to the advent of this ”liquidated damages” portion of the contract, when an escrow failed to close, there was always a dispute as to whom was at fault…and more importantly, who was to get the money on deposit.  No matter the real reason or culprit for the escrow fall-out, both parties generally retreated to their prospective camps and dug in for the eventual battle between good and evil.  The seller would insist they were entitled to the money for whatever reason, and the buyers would become equally entrenched in their belief that the money should revert to them.  In the end, the money languished in escrow until either an agreement could be reached, or the matter wound up in court (see blog of 5/27…What Happens to the Deposit Money When Escrow Fails to Close).  To avoid all this “interpretation-of-the-law” stuff, the Liquidated Damages clause was invented and added to all standard real estate contracts…BUT IT MUST BE INITIALLED BY BOTH THE BUYER AND SELLER TO BE VALID.  You have a choice on whether it is an agreed upon part of your contract.

In generalized terms, what this clause states is that since damages cannot be foretold at the beginning of the escrow period, both parties agree to use the amount of the deposit as the actual damages to be given to the seller…thereby avoiding any interpretation at a later date.  Limitations are placed at no more than 3% of the sales price (any excess money is to be returned to the buyer), and the property must be a single family dwelling of 1-4 units.  The intent here was to establish the “worst case scenario” up front, and then if the property failed to close due to the buyers default, then everyone knew what the damages would be.  Sounds fair and reasonable…and at times, it is.

So what is the problem?  Well, like so many contractual issues, sometimes we solve one problem and create the possibility for a few others.  Let’s look below at some of the issues here from the standpoint of both the buyer and the seller.

BUYERS PROSPECTIVE

In essence, what this paragraph now does is completely limit your damages should you decide to bail out of the contract after your 17 day inspection period has expired…even if you cancel at the last minute.  The seller is agreeing to not sue you, but to accept the deposit money instead.  Clean, simple, and neat.  Depending on the size of your deposit, you can get complete relief from any continuing legal issues the seller may have with your failure to complete the contract for as little as one or two thousand dollars.

In essence, this paragraph was designed to make you a bit more reticent to cancel a contract by imposing a penalty on you if you bailed, but in reality, it gives you a total way out of the transaction without risking a lot of money.  We realize that you don’t want to lose any of your deposit money, but read below in the “sellers” section to see why this can be a large benefit to a buyer.

SELLER’S PROSPECTIVE

Obtaining the buyer’s deposit may, on the surface, seem like a good thing..but understand fully what you are agreeing to do.  The intent of this clause was to protect sellers from the buyers arbitrary decision on day 44 of a 45 day escrow to simply decide to walk away and say “I’m sorry.”  The originators of this part of the contract rightly felt that was  not fair to a seller to just get “dumped-on” so late in an escrow, so the Liquidated Damages clause was designed to get the seller some money if the buyer simply breached the contract and walked away.  However, beware.

In the above example, let us assume that the buyer has $2,000 on deposit, and on day 44 they bail out for whatever reason.  You have now just won the right to the $2,000 deposit if all parties have initialled this clause in your contract.  But what if this $2,000 is merely a drop in the bucket for what your actual damages are?  What if you and your spouse have quit your jobs, hired a moving truck, have already packed (since you are closing escrow tomorrow), put deposits down on your new home, sent the kids ahead, etc.  Sound far fetched?  Not really.  Is the $2,000 even remotely going to cover the costs you have incurred…and will continue to incur while you resell the home?  Of course not, but you have agreed ahead of time that it will, so you are stuck.  You have waived your right to sue the buyer…and while no one is litigation happy, sometimes the threat of litigation gets people back on track.  But you do not have that here…you have a buyer who can literally walk away and leave you with a mess for a mere $2,000.  Doesn’t sound fair, does it?

So what should buyers and sellers do?

In the theoretical world, it would be nice if everyone was fair about situations that arise in a real estate transaction, but we are not that naive.  If you are a seller, the solution is to refuse to initial the Liquidated Damages clause unless the buyer has a large enough deposit that it will hurt if they walk away…and benefit you should they do so.  You are limited to 3% of your sales price, SO IF YOU SIGN THE LIQUIDATED DAMAGES CLAUSE, MAKE SURE YOU ARE GETTING ENOUGH MONEY TO COMPENSATE YOU FOR THE POTENTIAL LOSSES THAT COULD OCCUR IN THE WORST CASE.  Also, by making the deposit large enough to hurt the buyer if they walked away, then perhaps you can get them to rethink their decision to “walk away”, and save the transaction…which is the best thing that could happen anyway.

 In the end, while we are advocates for our clients, no matter whether buyer or seller, the best real estate transactions are fair to both parties.  Remember…pigs get fat, hogs get slaughtered!  The buyers deposit should be large enough to signal that they are serious about purchasing the property, since the seller will have the home off the market and make plans to move based upon the buyers promise to purchase.  If the buyer fails to close for a legitimate reason…well, that happens.  But if the buyer has removed all contingencies, and then fails to close, there should be a financial repercussion because the seller will no doubt incur some potential large costs to go back to square one.

We hope this real estate situation never happens to you, but if it does, at least now you are aware of all the ramifications of deciding up front on what happens to the deposit.

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