This article digests a buyer’s liabilities to a seller arising out of the buyer’s breach of a purchase agreemen, for property value decreases, operating and carrying costs, and losses on a resale.
A recessionary period, with real estate prices declining faster than buyers were driving them up during the preceding boom years, exposes buyers who enter into purchase agreements with sellers to nearly certain liability to the seller should they fail to close escrow and pay the agreed price. Not so during a seller’s market of rising prices.
A dearth of buyers in contrast to a super abundance of properties for sale is the footprint of a buyer’s market. However, the risk of liability for failing to close escrow without legal justification or excuse during a market turndown requires the buyer and his selling agent to be cautious about the price agreed to, the buyer’s cancellation, and contract limitations on buyer liability in purchase agreements should a bad case of buyer’s remorse set in causing the buyer to cancel or fail to close escrow without justification or excuse.
This article addresses the various conditions which represent a money loss for the seller when a purchase agreement fails to close, for whatever reason, and which are recoverable by the seller from the buyer.
For the buyer to protect himself and the buyer’s agent to comply with his duty owed the buyer to care for and protect the buyer in a transaction, the price set in the purchase agreement must reflect their best comparable market analysis of the value of the subject property at the time escrow is scheduled to close. Pricing of real estate in a recessionary period often finds the buyer who is under contract on one property becoming aware of an equivalent or better property available at a significantly lower price and realizing he has agreed to pay too much for the property. The reaction of a buyer in this situation is to cancel the escrow and buy the better priced property.
If this scenario is considered a probability when contracting to purchase, then contingency and limitation of liability provisions become necessary inclusions in a purchase agreement. Contingencies call for further approval, and the condition to be approved or the contract cancelled could be an appraisal confirming value equal to the agreed price or approval by a third party, such as the buyer’s attorney or CPA.
The ultimate cover for the buyer’s risk of liability for money losses the seller may actually suffer on a resale of the property at a lower price is a provision in the purchase agreement setting a ceiling for the amount of money the seller can recover if the buyer breaches the purchase agreement by cancelling without legal justification or excuse.
Two variations of a liability limitation provision exists in purchase agreements:
- a liquidated damages provision, usually making the cash deposit the ceiling for recovery as a forfeiture, allowing the seller to recover actual money losses up to the amount set as the forfeiture and no more; and
- a contract limitation on recovery of actual money losses incurred by the sellers not to exceed the amount of liability agreed to in the purchase agreement. [See first tuesday Form 150 §10.7]
First, there must be a money loss
Consider a prospective buyer of a residence who is informed the seller has already entered into a purchase agreement to acquire a replacement residence. The seller is relying on the sale of his current residence to fund his purchase of the replacement residence.
The prospective buyer makes a written offer agreeing to pay cash for the seller’s equity and assume the existing trust deed loan, called a cash-to-loan transaction. The seller accepts the offer. Escrow instructions are prepared and signed, and the buyer’s good-faith deposit is placed in escrow.
Later, as agreed, the buyer deposits additional funds in escrow. Although escrow is not yet ready to close, the buyer agrees to release some of the downpayment money held in escrow so the seller can close his purchase of the replacement residence. The funds are released and the seller acquires his new residence.
The seller vacates the old residence he has sold and moves his family and belongings into the new residence.
To consent to the buyer’s application to assume the seller’s existing loan, the lender demands a modification of the interest rate and payment schedule, and an assumption fee. The buyer refuses to proceed with the loan assumption and cancels escrow.
The buyer makes a demand on the seller to return all funds the buyer deposited into escrow, which the seller rejects.
The seller then makes a demand to be paid the funds remaining in escrow. The seller claims the buyer has forfeited all funds since he breached the purchase agreement by not assuming the loan.
The seller promptly relists the property and it is resold for the same price, but on terms calling for payoff of the existing loan, requiring the seller to pay a prepayment penalty. The seller also agrees to pay the new buyer’s nonrecurring closing costs and one point on new financing to be obtained by the new buyer. On closing the resale transaction, the seller’s net proceeds are less than he would have received on the sale to the original buyer under the breached purchase agreement.
Can the seller recover any money from the original buyer by either:
- retaining all the funds deposited by the buyer; or
- accounting for offsets against the buyer’s deposits for the seller’s losses?
Here, the seller is entitled to recover his losses. However, he must account for his actual money losses caused by the buyer’s breach since a forfeiture of deposits is not allowed, no matter the wording or initialing of the forfeiture provisions. Depending on the amount of the seller’s total recoverable losses on the resale, the buyer’s deposit will be partially or totally offset by the amount of the seller’s losses caused by the breaching buyer. [Allen v. Enomoto (1964) 228 CA2d 798]
Recoverable seller losses
A seller’s total recoverable losses, summarized here and analyzed in detail in this article, include:
- the operating and carrying costs of trust deed interest payments, taxes, insurance, maintenance and utilities, which were incurred by the seller during the period between the date of the breach and the date escrow closed on the resale;
- the increased closing costs due to the seller’s payment of the new buyer’s nonrecurring closing costs and financing fees on the resale which reduced the seller’s net proceeds compared to the net proceeds the seller would have received from the breaching buyer;
- the additional resale costs of the prepayment penalty demanded by the lender on the loan payoff; and
- interest on the seller’s net equity from the date escrow was to close to the date of closing on the resale.
Resell or retain the property
A seller of real estate who is faced with a breaching buyer and the loss of the sales transaction must first decide whether to:
- enforce the purchase agreement and have a court order the buyer to close escrow, called specific performance;
- remarket the property for sale promptly and diligently seek to locate a buyer; or
- retain the property and postpone or entirely forego any resale effort.
Editor’s note — This article illustrates money losses recoverable by the seller who chooses either to retain the property or resell it. Thus, the specific performance remedy is not considered here.
Only a money loss is recoverable
A buyer, due to his breach of the purchase agreement, owes the seller actual money losses, called damages, which are classified as:
- general damages, also called normal damages, being the dollar amount of any decline in the property’s fair market value as of the date of the buyer’s breach below the price agreed to in the purchase agreement;
- special damages, also called consequential damages, being 1) transactional costs incurred by the seller while preparing to close under the breached purchase agreement, 2) marketing expenses, increased closing costs, and ownership and operating costs incurred to remarket and sell the property, and 3) any further drop in property value after the buyer’s breach for so long as the buyer interferes and stalls the seller’s resale effort; and
- interest from the date of the buyer’s breach to the closing date of a resale of the property on all money and any carryback note the seller was to receive [Calif. Civil Code §3307]; less
- offsets or credits due the buyer for 1) any rent received from tenants or the implicit rent for the owner’s use of the property, 2) the amount of any price increase on the resale, and 3) the amount of any reduction in the seller’s expenses on the resale, so the seller will not be placed in a better financial position than he would have been in had the breaching buyer fully performed. [Smith v. Mady (1983) 146 CA3d 129]
Price-to-value as a money loss
When a seller decides to resell the property after the buyer breaches their purchase agreement and the property’s value has declined below the price set in the purchase agreement, the seller has incurred a loss in value which is recoverable from the buyer. However, the amount of future value decline recoverable after the buyer’s breach is limited to two time periods:
- the initial decline in value below the purchase price during the period before the breach, which is recoverable as general damages or more commonly called a price-to-value loss; and
- any further decline in value after the breach, which is recoverable only if the buyer interferes with the seller’s resale effort, also called special damages or more commonly called additional damages, damages being money. [CC §3307]
The price-to-value loss on the date of breach is recoverable by the seller whether the property is retained, remarketed or resold by the seller.
During periods of reduced regional economic activity, the boom-bust cyclical nature of real estate sales typically causes California property values to drop dramatically below the price the buyer agreed to pay just a few months earlier. Further, the intangible impacts on a property’s market value, due to its “shop-worn” listing status and the “fall-out syndrome” of a lost sale, give the property an aura in the local real estate market which negatively affects some buyers and their brokers. This aura is often reflected in a further dampening of the property’s value on the date of breach. [Bouchard v. Orange (1960) 177 CA2d 521]
To limit the breaching buyer’s liability, the seller’s loss on a resale at a price lower than the price agreed to by the breaching buyer is limited to the amount of the value decline which occurs by the date of the buyer’s breach, not the date of resale. Any further decline in value after the date of breach to the date of resale (or trial, if the property is not yet resold) is recoverable only if the buyer interferes with the seller’s diligent resale efforts.
Same or greater price on resale
When property is resold for the same price agreed to by a breaching buyer, or more, and the net proceeds from the resale are the same or the cash equivalent, or more, the price-to-value decline on the date of breach is no longer recoverable. With equal or greater net proceeds on a resale, the seller incurs no money loss, called general damages, since he has no loss of value to recover.
To set the dollar amount of the price-to-value loss on the date of breach, any “noncash” terms for payment of the purchase price by the breaching buyer and any “noncash” terms for payment of the resale price are adjusted to their cash equivalency.
For example, if terms for payment of a sale price include a seller carryback note, the principal amount of the carryback note is adjusted downward to reflect any discount required to convert the carryback paper to its cash equivalent, i.e., its present worth in cash.
Interfering with the resale
A seller might diligently remarket the property and still be unable to resell it due to interference from the breaching buyer. Buyer interference with resale efforts usually consists of filing a specific performance action and recording a Notice of Lis Pendens, or taking possession and refusing to vacate.
When the breaching buyer interferes with the resale, the seller recovers any decline in the property’s value after the date of breach until the buyer stops interfering with the seller’s resale efforts.
For example, a buyer sues a seller seeking specific performance of the purchase agreement. The seller claims the buyer breached the purchase agreement by failing to satisfy contingencies as scheduled. The buyer claims the seller breached when he canceled, thus excusing the buyer from further performing. The buyer sues to recover the property and records a Notice of Lis Pendens, which clouds the marketability of title.
Ultimately, the buyer is held to have breached the agreement and the lis pendens is removed from the record, called expungement.
A seller, whether he attempts to resell the property or retains it, generally bears the risk of any fluctuation in the value of the property after the buyer breaches. The breach is the cutoff date for recovery of a decline in value, unless the buyer later interferes.
However, the risk of loss due to a decline in value after the date of breach is shifted to the buyer until the date title is cleared of the recorded lis pendens if the recording interferes with the seller’s prompt and diligent efforts to resell the property. [Askari v. R & R Land Company (1986) 179 CA3d 1101]
A seller who takes the property off the market or is not prompt and diligent in his efforts to remarket and resell it after the buyer’s breach is limited in his recovery of money to his actual transactional expenses and any operating expenses incurred to fulfill the seller’s performance under the purchase agreement up to the time of the buyer’s breach.
Recoverable money losses the seller might incur as transactional expenditures include:
- escrow and title charges;
- lender charges for beneficiary statements or payoff demands;
- lender or carryback seller charges to process the buyer’s credit clearance, loan application or loan assumption; and
- other expenses and property reports incurred in reasonable reliance on the buyer’s full performance of the purchase agreement.
However, ownership and operating expenses incurred by a seller who chooses to either retain the property or delay reselling the property are not recoverable. The seller, as the owner of the property, remains responsible for the expenses of carrying and maintaining the property since these expenses are not incurred by the seller due to a buyer’s agreement to purchase or a breach by the buyer. These expenses are incurred because the seller owns the property.
However, some operating losses incurred by a seller due solely to his compliance with the terms of a purchase agreement are recoverable, including:
- the seller’s relocation expenses to reoccupy the property if he vacated after all contingencies allowing the buyer to cancel were eliminated;
- rental income lost after the breach on units left vacant or vacated by the terms of the purchase agreement;
- a crop revenue loss due to the planting season having passed at the time of the buyer’s breach; and
- a price drop on the late harvest of a crop due to the buyer’s breach. [Wade v. Lake County Title Company (1970) 6 CA3d 824]
Consider a buyer who enters into a purchase agreement knowing the seller intends to acquire replacement real estate with the net proceeds from the sale. After all the buyer’s contingencies are eliminated and no uncertainties remain about the buyer’s full performance, the seller enters into a purchase agreement to buy replacement property without conditioning his purchase on the “sale of other property.”
The buyer then breaches and the seller is unable to complete his purchase of the replacement property. The seller incurs expenses and losses to avoid liability for having unconditionally agreed to purchase the replacement property.
Expenses incurred on the replacement property transaction are recoverable since:
- the buyer knew when he entered into the purchase agreement that the seller intended to contract to purchase replacement property based on the buyer’s agreement to purchase; and
- the seller agreed to purchase other property in reasonable reliance on his buyer closing the sales escrow since all contingencies had been removed and no obstacles to closing existed, except for the breach. [Jensen v. Dalton (1970) 9 CA3d 654]
Operating losses during the resale period
A seller who, after his buyer breaches, promptly takes steps to diligently remarket the property for sale may recover his operating expenses and carrying costs of the property incurred after the date of breach, subject to offsets for rent credit, owner’s use, etc.
Recoverable operating losses and carrying costs are limited to those the seller incurs during the period beginning on the buyer’s breach and ending on the earlier of:
- the date a resale closes;
- the trial judgment on the breach; or
- the date of withdrawal of the property from the resale market.
The seller who decides to promptly resell the property and then recover any losses from the buyer has a duty to the breaching buyer to limit the operating and ownership losses, called mitigation of damages. To do so, the seller must take immediate steps to market the property for resale within the shortest possible time. [Spurgeon v. Drumheller (1985) 174 CA3d 659]
To begin calculating the seller’s net loss, the seller’s costs of maintaining his ownership are totalled. However, the recoverable operating expenses and carrying costs of the property incurred by the seller during the resale period are limited to operating and ownership expenses understood by the buyer to exist at the time he entered into the purchase agreement.
However, the buyer is due a credit for the rental value of the seller’s occupancy, called implicit rent, and any rental income received by the seller from the property after the buyer’s breach.
Thus, for a seller to recover on-going losses incurred to carry the ownership of the property before resale or trial, a full accounting of income, expenses and the carrying costs of financing is required.
Interest on recovered losses
A seller is also entitled to interest on the losses and expenditures he recovers for the decline in the property’s value, expenses of the breached transaction, resale related expenses and the carrying costs of the property during the resale effort. [CC §3307]
Unless the purchase agreement states otherwise, the interest is collectable at the legal annual rate of 10%, accruing from the date the recoverable loss or expenditure was incurred, called prejudgment interest. [CC §3289(b)]
If the seller retains the property, no property operating or value losses after the breach are recoverable on which interest can accrue.
For the seller who diligently remarkets the property for resale, recoverable resale costs and out-of-pocket carrying costs of the property not offset by rental income or the rental value of the seller’s use of the property accrue interest from the date of each expenditure.
Had the buyer performed and closed escrow, the seller would no longer own the property. The seller would have received the net sales proceeds for his equity in the property.
Since escrow did not close and the seller did not receive the net sales proceeds for his equity, the question of whether he is entitled to interest on his net equity turns on the seller’s use of the property at the time the purchase agreement was entered into.
For example, a seller’s use of the subject property falls into one of two categories:
- income-producing property used as the seller’s residence or to house the seller’s trade or business (implicit rent) or held out as a residential or nonresidential rental; or
- nonincome-producing property, such as vacant land or the seller’s vacant residence.
Rents received from income producing property are the economic equivalent of interest on the dollar amount of the equity. Thus, for the seller to also receive interest on his equity in income-producing property until it resells would be a nonrecoverable windfall, a double recovery on his equity in the form of interest and rent, which are economic equivalents. Should the seller occupy the property until it is resold, the value of his use is implicit rent and the amount is an offset against all money recoverable from the breaching buyer, including interest on the seller’s equity.
For vacant unused land or the seller’s vacant residence, a breach by the buyer again fails to convert the seller’s equity into cash or cash equivalent. Thus, the seller temporarily retains ownership of the equity, which may be increasing, decreasing or remaining the same depending on price fluctuations for the property’s market value until it is resold.
Since the resale seller cannot recover his equity in vacant property from the breaching buyer (except by specific performance), can interest be collected on the equity?
First, any interest due on the dollar amount of the net equity can only accrue from the scheduled closing date of the breached contract — the date the benefits from the breached sale in the form of cash for the seller’s net equity would have been received by the seller — up to and ending on the date of resale or trial. Any interest due accrues at the legal rate of 10%. However, if the seller agreed to an installment sale, the note rate for the carryback paper would be the controlling rate.
Next, if the breached purchase agreement contains a provision limiting the dollar amount of losses the seller can collect, the losses recoverable would be controlled by the agreed-to limit, except for the accrual of interest which would be an additional amount.
Thus, when the buyer breaches an agreement to purchase vacant, nonincome-producing property, interest is due on the net sales proceeds the seller would have received on the sale, until the property is resold.