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Anatomy of Earnest Money Disputes

Earnest Money Disputes Arise When Real Estate Contracts Go Sideways 

Let’s face it, a large number of real estate contracts do not close. No matter how pure the intentions of the buyer and seller, many variables pose hazards to consummation of real estate deals. The path to closing is littered with terminated contracts and the wreckage of earnest money disputes.

Some of the deal-killing factors are within the control of the parties. For instance,  Sellers sometimes decide not to sell and opt to remain in the property for personal reasons such as loss of a job prospect or changed relocation plans. Other times they get “seller’s remorse” after signing a contract and decide to accept or seek out a higher offer.

Buyers are equally guilty when it comes to purposeful breaches of contract.  On occasion a buyer will find another property that they like better (after the option period has expired) and seek a “clever” way to terminate.  Sometimes buyers decide that writing a now-accepted contract was a rash decision. Cold feet set in, and the idea of taking on the challenges (and expense) of making a contracted-for property their own becomes overwhelming.

Most often, factors beyond the parties’ control are the barrier to closing. Failure to obtain Buyer Approval from the buyer’s lender, failure of the property to appraise at the contract price, title defects and survey defects are the most common culprits.

When a real estate contract falls through – whether through a party’s fault or otherwise —  disposition of the earnest money frequently becomes a point of contention. Of the many calls we receive each week, a large number of them relate to Earnest Money Disputes.

The following is how we analyze earnest money disputes when deciding whether to accept a case involving an earnest money dispute.

What is Earnest Money?

Understanding earnest money and its purpose is crucial to comprehending of how it is disbursed when a real estate contract goes sideways.

Earnest money is deposit of funds by a Buyer to demonstrate that the Buyer is serious (i.e. “earnest”) about purchasing a particular property for which he/she contracts. Deposited earnest money is sometimes referred to as a “good faith deposit” since its purpose is to show the Seller that the Buyer is negotiating in good faith.

A Buyer’s deposit of earnest money is an acknowledgement that the Seller is relying on the Buyer’s “earnestness” by temporarily removing the property from the market while the contract is pending.  Each time that the Seller pulls the property from the market based upon a contract, there is some degree of risk that a contract will not be consummated, and that the Seller will miss the opportunity to sell to another prospective buyer.  In this way, the earnest money also provides the Seller with a small degree of financial protection in the event that the deal falls through.

Who Holds the Earnest Money?

A Buyer typically deposits earnest money with an escrow agent affiliated with the title company that will oversee the contract and ultimate conveyance of the property. The escrow agent holds the earnest money in trust until the contract is “closed” (the sale is finalized) or terminated.

If the sale is completed, the earnest money is typically applied as a credit against the purchase price of the property. When a contract is terminated, however, entitlement to the earnest money can become contested.

Who Gets the Earnest Money When a Real Estate Contract is Terminated?

The plain language of real estate purchase and sale agreements typically set-out which party receives the earnest money in the event of termination. In Texas, the contract forms promulgated by the Texas Real Estate Commission (“TREC”) generally provide as follows:

  • If the Buyer terminates as a matter of right during a contracted-for Option Period (also sometimes referred to as an “inspection” or “due diligence” period) or Contingency Period (such as the time to obtain Lender Approval), then the earnest money is refunded to the Buyer.
  • If the Buyer timely terminates for a permissible reason (defects revealed in the survey, title defects that remain uncured, failure to timely obtain property approval, etc.) then the earnest money is refunded to the Buyer.
  • If the Seller defaults, then the Buyer may accept a refund of the earnest money as its liquidated damages. Common examples of seller defaults include refusing to close, failing to make agreed-upon repairs.
  • If the Buyer defaults, then the Seller may accept a refund of the earnest money as its liquidated damages. Examples of buyer defaults include refusing to close and attempting to terminate the contract outside of a contracted-for Option or Contingency Period.

Sounds pretty simple, huh?  Unfortunately, it’s usually not simple at all.

Disputes arise every day over the timing of and reason for termination. The “facts” of almost every termination or default situation can be twisted to in favor of a party seeking to receive the earnest money. Thus, most earnest money dispute claims coming to our attention involve competing claims for the earnest money, with both Buyer and Seller alleging that the other party has defaulted under the real estate contract.

Evaluating Earnest Money Disputes

We have found that the only way to objectively evaluate earnest money disputes is through implementation of a flowchart type analysis and carefully constructed timeline. As with every legal analysis we perform, we start with the basics:

WHO terminated?  Was is the Buyer or Seller who initiated termination?

WHEN did they terminate?  Did the termination occur during or beyond a permissible option or contingency period?

WHY did they terminate?  What reason was specified for the termination, if any?

HOW did they terminate?  What was the manner of communication of the notice of termination, and to whom was it sent?

Of these factors, WHEN is frequently the most outcome determinative. Relevant dates for the timeline include the effective date of the contract, the date that the option and any applicable contingencies expired, the closing date, and date of termination or default.  “Time is of the essence” in real estate contracts. For this reason, many earnest money claims can be disposed of by understanding the timing and sequence of events:  When a party terminates the real estate contract outside of a permissible