What Happens To Earnest Money When A Real Estate Contract Falls Apart?

What Happens To Earnest Money When A Real Estate Contract Falls Apart?

In all the years we've been in business we've done hundreds of real estate transactions so we've seen our share of deals fall apart. In the Chicago market I estimate that 15 - 20% of all contracts written die on the vine and I believe our own experience is relatively consistent with that. Out of all those transactions I've only seen one case where the buyer actually lost their earnest money.

A Buyer Has Several Legitimate Ways Of Breaking A Real Estate Contract

In a typical Chicago real estate contract (referred to as the multi-board 6.1 contract) the buyer can get out of the deal and THEORETICALLY walk away with their earnest money if any of the following events occur (and I'm simplifying here):

  • The buyer is unable to get a mortgage under the terms specified in the contract. This could be for any number of reasons including, but not limited to, the home not appraising for the contract amount.
  • Inspection issues come up that cannot be resolved to both parties' satisfaction. In theory these should be material issues but that's squishy.
  • A material issue comes up at the final walk-through that cannot be resolved to both parties' satisfaction.
  • An issue comes up during attorney review (usually a 5 business day window) that cannot be resolved to both parties' satisfaction. In addition to the inspection issues mentioned above this can include issues around contract language.
  • They are not able to get title insurance on the property.
  • Under any circumstances where the buyer and seller both agree to break the contract and agree in writing to return the earnest money or "upon an entry of an order by a court of competent jurisdiction".

That last bullet point is basically a catch-all for any situation where the buyer and seller mutually decide to terminate the contract and walk away.

In order for the earnest money to be returned to the buyer under one of these situations both the buyer and seller have to agree in writing to release the earnest money. 99% of the time, when one of the above bullet points have occurred, both parties will willingly agree to the release of the earnest money to the buyer. However, if for some crazy reason the seller simply refuses to sign the release then the buyer will need to sue the seller. But since the above situations are specifically spelled out in the contract the buyer would have an extremely strong case.

So, How Can A Buyer Lose Their Earnest Money?

If the buyer simply wants out of the contract for some reason not found in the above list then they have a problem. Theoretically they need to forfeit their earnest money. That's why, almost always, they will pick something from that approved menu to use as an excuse to terminate the contract. Heck, ever seen an inspection report? They almost always have like 75 issues on them. If you want out of a contract you can just be a total jerk about the inspection items and have your attorney get you released.

However, I will say that when I first started in this business an attorney told us to not proceed as if your attorney can always get you out of a contract. There are no guarantees in life.

The one case where we saw a buyer lose their earnest money we were the listing agent. The buyer played it wrong, they had a really bad agent (and that's the case 80% of the time), and the seller was an attorney. That's a lethal combination.

Shortly after the contract was signed we started getting word from the buyer's agent that the buyer was having buyer's remorse, thinking that they had overpaid. Eventually they tried to terminate the contract for some ridiculous inspection issue. Then the buyer's agent continued to tell us how the buyer thought they overpaid. Our seller refused to release the earnest money, accusing the buyer of breach of contract.

The buyer tried threatening and begging to get the money back. When that didn't work they eventually filed a lawsuit. The entire process took about 4 years and the buyer lost, presumably because it had been established that the real reason for getting out of the contract was that the buyer feared they had overpaid. It was easy to establish this reason because the buyer's real estate agent had totally undermined their case for terminating the contract due to inspection issues. Everyone on the buyer's team should have been going along with the inspection issue story from the very beginning. They also should have picked a more credible inspection issue with which to go to battle.

But, There's A Catch When The Seller Wants To Keep The Earnest Money

Yes, the seller can keep the earnest money if the buyer really mishandles the transaction but there is a cost for doing this. There are obviously the legal costs the seller (and the buyer) might incur for themselves. However, they, and even the buyer, are also responsible for covering the escrowee's (quite often the listing brokerage) costs in handling the dispute. The earnest money can be used to cover these costs. This right is spelled out in two documents. First, the listing agreement has the following language in it pertaining to a dispute where the listing brokerage is acting as escrowee:

Seller agrees that Sponsoring Broker may deposit the funds with the Clerk of the Circuit Court by the filing of an action in the nature of an Interpleader. Seller agrees that Sponsoring Broker may be reimbursed from the earnest money for all costs, including reasonable attorneys' fees and court costs, related to the filing of the Interpleader and hereby agrees to indemnify and hold Sponsoring Broker harmless from any and all claims and demands, including the payment of reasonable attorneys' fees, costs and expenses arising out of the default, claims and demands.

In addition the 6.1 sales contract itself has the following language in it:

Escrowee may file a Suit for Interpleader and deposit any funds held into the Court for distribution after resolution of the dispute between Seller and Buyer by the Court. Escrowee may retain from the funds deposited with the Court the amount necessary to reimburse Escrowee for court costs and reasonable attorney’s fees incurred due to the filing of the Interpleader. If the amount held in escrow is inadequate to reimburse Escrowee for the costs and attorney’s fees, Buyer and Seller shall jointly and severally indemnify Escrowee for additional costs and fees incurred in filing the Interpleader action.

So you see the seller might win in the end but it could end up being a Pyrrhic victory.

#RealEstateContracts #EarnestMoney

Gary Lucido is the President of Lucid Realty, the Chicago area's full service discount real estate brokerage. If you want to keep up to date on the Chicago real estate market, get an insider's view of the seamy underbelly of the real estate industry, or you just think he's the next Kurt Vonnegut you can Subscribe to Getting Real by Email using the form below. Please be sure to verify your email address when you receive the verification notice.

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