Don’t buy house without these 3 contract contingencies

Protect yourself from financial disaster

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DEAR BENNY: I am in the midst of house hunting right now. Do you have an example of contingency language for financing and inspections that you have used in the past? We are about to make an offer and would like to include this language in the contract if possible. –Ryan

DEAR RYAN: I am a firm believer that if you plan to buy a house (or a condo or house in a community association), your sales contract should contain three important contingencies. A contingency means that if the matter is not resolved to your satisfaction, you have the absolute right to terminate the sales contract and get your earnest money deposit returned to you immediately.

The three contingencies are:

(1) contingent on the property being appraised at a minimum for the contract price. Why is this important? Let’s say your contract price is $300,000, and you plan to get an 80 percent loan in the amount of $240,000. You plan to put down your own money in the amount of $60,000. But if the appraisal comes in low (as it is now happening around the country), say at $275,000, your lender will lend you only $220,000; this means that you will need $20,000 more to close the deal.

(2) contingent on financing: This is obvious. If you cannot get a mortgage loan, you want to have the contract declared null and void and get your deposit back; and

(3) contingent on a satisfactory home inspection. You don’t want to buy the property only to find out that a new roof is needed, or that the electricity is not up to par, or that the plumbing does not function properly. If your seller objects to such a contingency, run (do not walk) away from the deal.

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I can’t really provide you with forms, since I do not provide specific legal advice in this column. However, I am sure that a local real estate agent or your attorney can craft the appropriate language for your specific situation. And although I have not looked, you might actually find sample language somewhere on the Internet.

DEAR BENNY: California’s statutes that address liquidated damages create a presumption that damages not exceeding 3 percent are reasonable. If the buyer’s deposit exceeds that amount, then the burden of justifying that figure shifts to the seller. Is that true? –Steve

DEAR STEVE: I am not licensed to practice in the state of California and have not confirmed the information you provided. You claim that is the law in California, and thus most earnest deposits do not exceed 3 percent.

That may be the law in California, but I am a firm believer that sellers should get as high an earnest deposit as possible — at least 5 percent. Why? To make it clear to their prospective buyers that should they get "buyer’s remorse" and want to change their mind, they will lose that money.

Obviously, if they have contingencies that cannot be met, such as financing, appraisal or inspection, then they can cancel the contract and get their deposit back.

But all too often, just before closing (escrow) takes place, a buyer gets cold feet and wants out. In my opinion, the seller should not be penalized. He will have to put the house back on the market, and he will have to pay his mortgage, taxes and insurance. He should be compensated by the errant buyer regardless of whether his out-of-pocket damages are over or under that 3 percent benchmark.

DEAR BENNY: My neighbor on the Outer Banks of North Carolina listed his lot with bulkhead, pier and boat lift for $350,000 five years ago. Our local government approved a permit allowing a four-bedroom house to be built on the lot. I don’t want the lot, but I don’t want a big box house next door casting a shadow on my two-bedroom house. I was contemplating an installment offer of $25,000 for eight years. What should I be mindful of before making a formal offer? –Walter

DEAR WALTER: You don’t want the lot but you don’t want someone to build that "big box" directly next door. I agree that you want to protect your investment.

However, I have a number of questions. You indicate that five years ago the property was listed at $350,000. Is the property still for sale? Has it gone up or down in value? I suspect it has gone down. You really should obtain an independent appraisal before you make an offer to your neighbor.

Everything in real estate is negotiable, and if your neighbor accepts your $25,000 yearly payment, more power to you. However, I seriously doubt that he will accept such terms.

You are proposing what is known as an installment sale. There are taxable benefits for the seller, and he can get a lot of information from IRS Publication 537, entitled "Installment Sales."

From your point of view, the seller will require that you agree to a deed of trust (the mortgage document), which will be recorded against the property on the land records in the county where the property is located. If you do not make the payments on a timely basis, your neighbor will be able to foreclose on the lot and you will be out of luck.

You will, of course, have to pay the applicable real estate tax on the property since you will now be the owner. And you should discuss your situation with an insurance agent, since you should protect yourself, especially since there is a pier and a boat lift; someone can get hurt. You may also have to obtain flood hazard insurance.

Before you approach your neighbor, I would discuss your situation with your financial and legal advisers.

DEAR BENNY: If I leave my house to my youngest son and it still has a mortgage on it, will he have to pay capital gains tax? –J.E.

DEAR J.E.: If your son inherits the house after you die, he will get what is known as the "stepped-up" basis. That’s the value of the property on the date of your death. If, for example, it is valued at $300,000, his basis for tax purposes becomes $300,000. If he sells for that amount, he has made no profit and thus pays no tax.

If he sells for $400,000 down the road, and has owned and lived ("use and occupancy") in the property for two out of the five years before sale, he can exclude up to $250,000 of his gain (or if he is married and files a joint tax return, up to $500,000).

If, however, he cannot meet the "use and occupancy" test, then he would have to pay capital gains tax on the profit.

Benny L. Kass is a practicing attorney in Washington, D.C., and Maryland. No legal relationship is created by this column. Questions for this column can be submitted to benny@inman.com.

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