DEAR BERNICE: We are buying our first home in California. Prices have finally come down to where we can afford them. Our agent asked us to review the purchase agreement now so that we wouldn’t feel rushed when we are ready to write an offer. One of the provisions called for "liquidated damages." I’ve never heard of that before. Is this something we should agree to? –Sam K.

DEAR SAM: Congratulations on buying your first home. The "liquidated damages" provision allows the buyer and the seller to agree in advance as to the amount of damages that will be paid in the event of a breach to buy or sell real property.

DEAR BERNICE: We are buying our first home in California. Prices have finally come down to where we can afford them. Our agent asked us to review the purchase agreement now so that we wouldn’t feel rushed when we are ready to write an offer. One of the provisions called for "liquidated damages." I’ve never heard of that before. Is this something we should agree to? –Sam K.

DEAR SAM: Congratulations on buying your first home. The "liquidated damages" provision allows the buyer and the seller to agree in advance as to the amount of damages that will be paid in the event of a breach to buy or sell real property. There are quite a few states that don’t have this provision in their standard purchase contracts. In California, however, the liquidated damages provision is commonly used in residential purchases and is limited to 3 percent of the sales price.

I can’t give you legal advice as to whether this is a good idea for you or not. Nevertheless, I can share what has happened to past buyers and sellers with respect to this provision.

At the company I worked for, we used the standard California Association of Realtors deposit receipt that included a liquidated damages provision. Both the buyer and the seller had to separately initial the provision for it to be valid. We normally collected a minimum of a 3 percent deposit from the buyer. Once the buyer’s offer was accepted, the deposit was placed in escrow. Most of our clients signed the provision.

The liquidated damages provision comes into play if you fail to close the transaction by canceling. For example, say that you enter into an agreement to purchase 123 Main St. You have obtained loan approval and you have removed all other contingencies. You then discover that there is a much better deal at 156 Elm St. You decide to cancel your contract on Main Street and buy Elm Street instead. If you cancel the Main Street escrow, you could be sued for breach of contract. When the liquidated damages provision is signed, however, the buyer normally forfeits the 3 percent deposit and both parties walk away.

While this sounds pretty straightforward, that’s not always the case in practice. We had one case in our office where the buyers decided to cancel because the prices were plummeting. They did not sign the liquidated damages provision. The cancellation took place after all contingencies in the contract had been removed. (The liquidated damages provision does not normally apply if you were unable to obtain a loan within the time specified in the contract or if you disapprove the physical inspection of the property.) …CONTINUED

The sellers put the property back on the market and then sold it seven months later for $100,000 less than the first buyers had contracted to pay. The sellers took the first buyers to court. The court ruled against the buyers and awarded the sellers $100,000 in damages (based upon the property’s loss in value). If the buyers had signed the liquidated damages provision, the cost of canceling would have been limited to 3 percent of the purchase price, or about $20,000.

In another case, the buyers canceled the transaction and refused to release the 3 percent deposit to the seller. In California, the escrow cannot release funds to either party until there is an amendment to the escrow directing them to do so. The sellers had to sell and they obtained another offer. The first set of buyers refused to sign cancellation instructions unless the sellers released them from paying the liquidated damages. The cost of obtaining an attorney and going to court was a poor option from the sellers’ perspective, so they released the buyers’ deposit.

Sellers also need to be aware that if they sign the liquidated damages provision, they may be obligated to pay a portion of the liquidated damages to the brokers. The laws governing the payment of real estate commissions often state that the commissions are due and payable when the agent/broker produces a ready, willing and able buyer. What happens in practice, of course, is that the agents don’t get paid unless the transaction closes.

If you are purchasing an REO (real estate owned by a bank after they have foreclosed upon it) or a foreclosure property, limiting your liability may be a good idea. For example, many REO, foreclosure and probate sales are "as is." There is no physical inspection contingency. Most buyers do conduct a physical inspection, but not until they have agreed to purchase. If the inspection turns up major problems, the buyer may find it less costly to cancel and pay the seller liquidated damages than to continue in the transaction. Clearly, there are a host of legal issues here. The smart move is to check with an attorney to determine the best course of action in your specific case.

If you are interested in the exact wording of the statute pertaining to liquidated damages in California, it is available in the California Civil Code §§1675–1681.

Bernice Ross, CEO of RealEstateCoach.com, is a national speaker, trainer and author of "Real Estate Dough: Your Recipe for Real Estate Success" and other books. You can reach her at Bernice@RealEstateCoach.com.

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