If you plan to buy or sell a home in California, you will eventually need to sign a contract with the other party (the seller or buyer respectively). In most scenarios, you will use the California Residential Purchase Agreement and Joint Escrow Instructions (RPA-CA) to specify the terms of the deal. For example, this contract is used to set the purchase price, identify how many days the buyer has to inspect the property, and if all goes well, when the home’s keys will change hands. When signed by you and the other party, this form creates a legally binding contract.
An important specification in the RPA-CA is the found in the Liquidated Damages clause. This short paragraph is designed to protect both the buyer and the seller should the buyer not fulfill their obligations under the terms of the contract (aka a buyer default). For buyers, the liquidated damages clause limits your loss if you need to back-out of the deal; For sellers, this clause ensures that you are compensated for the time and money lost while the property was off of the market, and ensures those funds are delivered in a timely manner.
Liquidated Damages Clause in the RPA-CA
In the RPA-CA, the section titled Remedies for Buyer’s Breach of Contract states:
“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 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 the Buyer. Except as provided in paragraph 14H, release of funds will require mutual, signed release instructions for both Buyer and Seller, judicial decision or arbitration award. At the Time of any increased deposit Buyer and Seller shall sign a separate liquidated damages provision incorporating the increased deposit as liquidated damages.“
If signed, this clause requires that, if the buyer(s) breaches the terms of the contract, he/she/they must relinquish the lesser of their deposit or 3% of the purchase price (if property has less than 4 units).
In the absence of the Liquidated Damages clause, the seller would have to prove the actual amount lost in dollars when the buyer breached – a costly and time-intensive process for both parties. The intention of this clause is to save both sides the legal burden of resolving these types of issues in court.
Getting Out of the Deal Without Breaching the Contract
If you are buying a house, signing a contract does not necessarily mean that you are obligated to buy the property. More often than not, buyers will opt for an inspection contingency period – a time in which they can evaluate the condition of the property and the cost for repairs. You will still have time to backout of the deal during this agreed-upon period without paying liquidated damages.
Additionally, if you are taking out a mortgage, there will be a loan contingency period – a time period that the lender uses to assess the condition of the property. After receiving the estimated value of the property from an appraiser, the lender will finalize your loan offer. If this amount comes out to be less than expected, you can walk away from the deal, obligation free.
With that said, once contingencies are removed or if no contingencies are agreed upon in the initial contract, if you do need to get out of the deal and the clause above is signed, will have to pay liquidated damages.
What If the Seller Defaults?
It’s not as common for sellers to default on the contract, but it does happen. The liquidated damages clause above only applies to the buyers, and so if the seller defaults both the buyer and seller will have to come to an agreement with mediation or arbitration if they want to avoid going to court.
It is situations like these when the arbitration clause becomes increasingly important. You can read more about that here.
Please note: The information contained within this article is provided for informational purposes only and is not intended to substitute for obtaining accounting, tax, legal or financial advice from a professional accountant or lawyer.