Understanding Liquidated Damages in a Home Purchase Transaction

By: Keaton Turnipseed, Esq.

April 4, 2023

The Federal Reserve continues to ratchet up interest rates and as a result the once hopping housing market has begun to constrict rapidly. Along with the rising interest rates, consumer demand for homes has fallen and seems likely to continue to fall. When the market does an about face as it seems to be doing now, a host of new legal issues arise. One such issue occurs when a buyer pulls out after entering into contract for the purchase of a home. This results in a dispute over “liquidated damages.”

As a threshold issue, liquidated damages are damages set by the contract itself. For example, in most residential purchases the seller keeps the amount of the buyer’s deposit if the buyer breaches the contract. The beauty of liquidated damages provisions are that they set the price for a buyer to get out of the purchase and give the seller easy recourse for a breach, all while eliminating litigation fees for both sides if the provision is not challenged.

We are seeing an increase in the number of disputes over liquidated damages as buyers, especially buyers who have entered into contract to purchase new builds, are seeing the value of the property fall well below the price they are set to pay. As such, they elect to breach. Thus, disputes arise over the liquidated damages provisions in the purchase contracts when builders or sellers attempt to retain substantial sums of money, often times in violation of California law.

Under California law, liquidated damages provisions in contracts for the purchase of real property must comply with general legal principles as well as a number of civil code sections. At common law, all liquidated damages in any kind of contract must be reasonable. (See Better Food Markets v. Am. Dist. Tel. Co., 40 Cal. 2d 179, 253 P.2d 10 (1953)). With that said, the California legislature, provides some guidance in Civil Code section 1675 subsections (c) and (d) as to what is “reasonable.” Under subsection (c) the amount of liquidated damages is presumptively reasonable if it is three percent of the purchase price or lower. A buyer who is subject to a compliant provision still retains the right to challenge the amount of damages but will bear the burden of proof. On the flip side, if the liquidated damages amount is over three percent, under subsection (d) it is presumptively invalid and the seller bears the burden of showing the amount was reasonable in the context of that transaction.

In the context of multiple deposits that are added together to make up the amount of liquidated damages, Civil Code section 1678 becomes applicable and requires the seller to take additional steps if the liquidated damages provision is to be compliant. Two deposits are not common outside the context of new builds thus, this issue is more limited but at the same time often deals with higher dollar amounts.

Section 1678 requires the amount of liquidated damages to comply with section 1675 so the same analysis as described above must be done. Section 1678 further requires that a separate liquidated damages provision be “separately signed or initialed by each party to the contract for each such subsequent payment.” If the proponent of the liquidated damages provision did not comply with the steps in section 1678 in the context of a multi deposit contract, the non-compliant deposits risk being invalidated, and the seller will risk losing that money even if the provision is otherwise compliant with section 1675.

Whether the dispute over liquidated damages arises under Section 1975 or 1978 or as the buyer or the seller it is advisable to seek competent legal counsel to assist in navigating these technical legal waters. Failure to comply with the terms of the Residential Purchase Agreement generally or any provision of California law can have rather significant adverse impacts.

The information presented in this Article is not to be taken as legal advice. Every person’s situation is different. If you are facing a legal issue of any kind, get competent legal advice in your State immediately so that you can determine your best options.

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