When a buyer defaults on his purchase contract, there can be substantial financial harm to the seller. The exact amount of the damage may be difficult to determine. A paragraph in the contract deals with the problem, but principals and agents often misunderstand it. This is the “Liquidated Damages” clause. 

What it says

A liquidated damage is an agreement, in advance, of what will happen if a buyer defaults. It becomes part of the contract only if both buyer and seller initial the clause. Once agreed upon, if a buyer “fails to complete” his purchase at a point where he no longer has grounds to withdraw, the seller may be able to keep the deposit. 

A buyer’s default happens after he has removed all of his contingencies (e.g., inspections and financing) and, subsequently, does not close the escrow. In general, if the buyer backs out because of a contingency, the seller is obligated to release the buyer’s deposit in a timely fashion. 

Although the clause explains, “release of funds will require mutual, signed release instructions from both buyer and seller,” some mistakenly assume the seller automatically receives the deposit upon the buyer’s default. The seller may have to pursue arbitration or a judicial decision if the buyer later refuses to release the Liquidated Damages portion of the deposit. 

From the seller’s perspective, once the buyer has waived all contingencies, the buyer has no valid reason to withdraw, regardless of what else is happening in his life. Bear in mind that a seller may rely on the buyer’s promise to perform and make plans accordingly. Whether or not this is always a good idea is another issue, and is why advice from an experienced, professional agent is indispensable. 

If the property contains no more than four “dwellings,” the maximum allowed under Liquidated Damages is three per cent of the purchase price. Contracts that include the Liquidated Damages clause are commonly written with a deposit of less than three per cent. Astute listing agents recommend, if Liquidated Damages are accepted, their sellers counter, increasing the deposit to three per cent. In order for the increased deposit to be counted as Liquidated Damages, however, a second form must be signed by both parties. Many times, this is overlooked.

To include or not include

In my career, only once have I seen a buyer voluntarily sign over Liquidated Damages to a seller. On a practical basis, the clause is not a “deal breaker” one way or the other. What is most important is that the buyer has a substantial deposit with the title company. More money in escrow usually equates to more incentive on the buyer’s part to close the sale. 

In the most popular neighborhoods, where prices start at $400,000 and go to well over a million dollars, the deposit may range from $10,000 to $35,000, depending on the offer amount. The seller should look on a low deposit with suspicion.

Remember, it is not always clear who benefits from Liquidated Damages. For example, a buyer may forfeit $15,000 on a $500,000 transaction. If the property later sold for $450,000, Liquidated Damages obviously did not make the seller whole. On the other hand, if the ultimate sales price was $495,000, the seller profited.

There have been many instances where I have presented a contract on behalf of a buyer with a deposit of much greater than three per cent, but with no Liquidated Damages. This would be appropriate in a multiple offer situation to strengthen the buyer’s bid. 

As an example, a $600,000 offer would have a $25,000 deposit. When the seller questions why the clause was not included, I explain that it is to the seller’s advantage. The buyer has not limited his liability to only $18,000.

Final thoughts

The key concept is what happens if the buyer does not follow through and close after he has no contingencies. Liquidated Damages limits the buyer’s liability, but may not be best for the seller. Conversely, on properties not in competition, some buyers would prefer to have no Liquidated Damages, but a smaller deposit.

Over the years, I have seen some agents either gloss over their explanation of Liquidated Damages, or simply not mention it at all. Before making or accepting an offer, be sure you are clear on the critical nature of the deposit amount. 

Related Articles: Unwritten Contingencies and It's All in the Details