Real Estate 101: Earnest money and escrow deposits

Buyers are typically asked to place earnest money under a real estate purchase contract, residential and commercial. But who is holding this deposit? Can the buyer ever get it back?  Can the seller ever retrieve it out of escrow?  And is this a measure of or limit on damages on breach of contract by either the buyer or seller?

For contracts negotiated through Realtors for existing housing, the deposit is typically held in the Realtor’s escrow account pending closing. This means that neither the buyer nor the seller have access to those funds until surrendered to the seller at closing or returned to the buyer as a result of the failure of one or more contingencies.

Even though the Realtor is the “agent” of one party in the transaction, when acting as escrow agent, he must follow the escrow instructions – i.e., not surrender the earnest money to his client just because he is ordered to do so.  The escrow instructions are contractual provisions – either in the purchase contract or a separate escrow agreement – detailing how the escrow agent is to deal with the escrowed funds, or other escrowed property and documents.

In contrast, contracts with home builders, and For-Sale-By-Owner sellers (“FSBOs”) typically will call for the earnest money to be paid as a deposit directly to the builder or seller. In that circumstance, the seller has the money, and getting it back – even when the contract requires it – could prove problematic. For example, we have represented buyers in contracts in which the builder was headed into insolvency or bankruptcy.  In that circumstance, the earnest money deposit could be completely at risk if precautions have not been made against that eventuality.

Finally, a common misunderstanding of parties to a purchase contract is that the escrow money is some sort of measure of or limitation on damages for the buyer’s breach, or, conversely, that the return of the earnest money “cures” the seller’s breach and is the limitation on his damages as well. However, unless the real estate purchase contract specifically calls out either of those limitations, neither of those propositions is true.

We will explore in a separate blog entry the damages for which a buyer can be exposed for breach of a purchase contract. But as a general proposition, the seller is to be put in a position that he would be in but for buyer’s breach. That means the buyer is responsible for the reduced purchase price when the house sells to a second buyer, and may be exposed for the holding costs (insurance, taxes and maintenance costs) until the property re-sells. The seller, similarly, cannot just ignore his contractual promise to a buyer, and sell the property to another buyer.  He will be responsible to the original buyer for the lost value above the sale price and perhaps other damages to a buyer. The important point is that the earnest money – unless the contract specifically says otherwise – is not a definition of or limitation or either party’s damages upon breach.

Read more here: Myth busters: Further on earnest money >>