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Why Every Seller Needs to Know About the Liquidated Damages Clause

October 31 2018
by Leisl Bailey

Hands of a person writing a check

As you go through the real estate buying or selling process, you may find that you become more invested as time wears on. Maybe with the initial offer, it’s like that iffy first date: You committed, but there’s still time to back out for both parties.

But as time wears on, deposits are laid down, and contingencies are waived, it starts to get real. You start to tidy up your current house more, maybe pack a box or two, and schedule some movers.

What happens if the other party backs out, though? If it was a relationship, you’d pack up your toys and go home, maybe cry a little and indulge in a good book or box of chocolates. In a real estate transaction, however, there are damages to pay—or get paid for. And that’s why you need a liquidated damages clause.

What are liquidated damages in real estate?

You can list many things as damages in a real estate transaction: strife, money the buyer or seller has put into the property, other offers that the seller turns down, or effort in behalf of the buying or selling process. This can include things like moving fees, notices given for jobs or rentals, and any special accommodations that were made for either party.

The amount of liquidated damages is the amount of liquidated funds you are entitled to, due to those damages.

Liquidated Damages Clause

Buyers and sellers often use liquidated damages clause in residential real estate and construction contracts as it protects both the buyer and seller if the sale falls through.

This is how it goes down:

Once the seller accepts the buyer’s offer, the buyer puts an amount in escrow called earnest money. This money is a sign of good faith and essentially holds the buyer’s spot in the sale. The buyer and seller then initial the liquidated damages clause that states the cap amount of liquidated damages.

The clause states that if there is a breach of contract and the buyer backs out, the clause will protect the buyer by giving the earnest money or up to 3% of the purchase price (whichever is lower) to the buyer.

This protects the buyer because from the time both parties sign the contract. In the event that the buyer breaches the contract, the seller may come after the buyer for a lot of money. Occasionally when this happens, the seller takes the buyer is to court and may have to pay a large amount of money to the seller. The seller then turns around and sells the property for a profit, making out like a bandit on the sale.

The California courts put a stop to that with the liquidation damages clause.

What does the liquidation damages clause say?

The clause as outlined by the California Association of Realtors in their standard residential property purchase contract looks like this:

  1. REMEDIES FOR BUYER’S BREACH OF CONTRACT:

  2. Any clause added by the Parties specifying a remedy (such as release or forfeiture of deposit or making a deposit non-refundable) for failure of Buyer to complete the purchase in violation of this Agreement shall be deemed invalid unless the clause independently satisfied the statutory liquidated damages requirement of the Civil Code.

  3. LIQUIDATED DAMAGES: If Buyer fails to complete this purchase because of Buyer’s default, Seller shall retain, as liquidated damages the deposit actually paid. If the property is a dwelling with no more than four units, one of which Buyer intends to occupy, then the amount retained shall be no more than 3% of the purchase price. Any excess shall be returned to Buyer. Release of funds will require mutual, signed release instructions from both Buyer and Seller, judicial decision or arbitration award. AT TIME OF ANY INCREASED DEPOSIT BUYER AND SELLER SHALL SIGN A SEPARATE LIQUIDATED DAMAGES PROVISION INCORPORATING THE INCREASED DEPOSIT AS LIQUIDATED DAMAGES (C.A.R. FORM RID).

What This Means for Buyers

Notice the clause only mentions what happens if the buyer breaches the contract, not if the seller breaches the contract. If the seller backs out of the sale for any non-contingent reason, the liquidated damages provisions do not cover it. The buyer will need to take the seller to court if they want compensation for damages.

Is the liquidated damage clause a good thing?

This clause is only enforceable if both the buyer and seller initial the clause. If the buyer puts more money into escrow during the process, both the buyer and seller need to initial a second clause. If the buyer breaches the contract, both the buyer and seller must sign the contract stating there are damages.

Because of all of these “ifs,” you’re probably wondering if the liquidated damage clause is actually a good thing.

The answer? It depends.

It could turn into a sticky situation with or without the liquidation clause. One good thing is certain about the liquidation clause, however. If both parties sign it, at least they know what will happen if one of them breaches the contract.

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