Why this matters: Learn to determine when a buyer’s breach of a purchase agreement and escrow instructions entitles a seller to recover monetary losses and intelligently discuss a seller’s recovery of losses on a resale following their buyer’s breach of a purchase agreement.
First the seller needs a monetary 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 their current residence to fund their 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 mortgage, 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 down payment money held in escrow so the seller can close their purchase of the replacement residence. The funds are released, and the seller acquires their new residence.
The seller vacates the residence the buyer has agreed to acquire and moves their family and belongings into the replacement residence.
To consent to the buyer’s application to assume the seller’s existing mortgage, the lender demands a modification of the interest rate and payment schedule, and an assumption fee. The buyer refuses to proceed with the mortgage 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 they breached the purchase agreement by not assuming the mortgage on the terms demanded by the mortgage holder.
Related Client Q&A:
Client Q&A: What happens when the buyer or seller breaches?
The recovery of loss
The seller promptly re-lists the property, and it is resold for the same price. However, the resale terms call for payoff of the existing mortgage, requiring the seller to pay a prepayment penalty. The seller also agrees to pay the new buyer’s nonrecurring closing costs and one point to buy down the interest rate on the buyer’s new mortgage.
On closing the resale transaction, the seller’s net sales proceeds are less than they were to receive on the sale under the breached purchase agreement.
May the seller recover any money from the original buyer by either:
retaining all the funds deposited by the buyer; oraccounting for the resale benefits the seller received on the resale as offsets against the buyer’s deposits?
Yes! While the seller is entitled to recover their loss, they need to account for their actual money loss caused by the buyer’s breach. As always, a forfeiture of deposits is not allowed as a judicially abhorred provision, no matter the wording or initialing of forfeiture provisions.
Depending on the amount of the seller’s total recoverable loss on the resale, the buyer’s deposit will be partially or totally offset by the amount of the seller’s loss caused by the buyer’s breach. [Allen v. Enomoto (1964) 228 CA2d 798]
Related article:
Buyer breach of contract in a decreasing price environment: Seller remedies
Money a breaching buyer owes the seller for losses
A seller’s total recoverable loss, summarized here and analyzed later in this chapter, as the result of offsets for any rental income received, includes the:
operating and carrying costs of mortgage interest payments, taxes, insurance, maintenance and utilities, incurred by the seller during the period between the date of the breach and the date escrow closed on resale of the property;increased closing costs paid by the seller to cover the new buyer’s nonrecurring closing costs and mortgage fees on the resale which reduced the seller’s net proceeds for a reduction in the net proceeds the seller was to receive from the breaching buyer;additional resale costs of the prepayment penalty on payoff of the seller’s mortgage; andinterest on the seller’s net equity from the schedule date for closing of the breached escrow to the date of closing on the resale.
Related article:
The liquidated damages provision and the breaching buyer’s deposit when prices decline
The owner’s pivotal decision: to resell or retain
A seller of real estate who is faced with a breaching buyer and failure of the sales transaction needs to promptly decide whether to:
enforce the purchase agreement by obtaining a court order requiring the buyer to close escrow, called specific performance;remarket the property for sale and diligently seek another buyer; orretain the property and postpone or entirely forego any resale effort.
Related article:
The breaching buyer’s responsibilities: Part 1
Only money losses are recoverable
A buyer, due to their breach of the purchase agreement, owes the seller their out-of-pocket money loss caused by the breach, called damages, which are classified as:
general damages which include the dollar amount of any decline in the property’s fair market value (FMV) on the date of the buyer’s breach below the price set in the purchase agreement;special damages, also called consequential damages, which include:transactional costs the seller incurred preparing to close the now-breached purchase agreement;remarketing expenses, increased closing costs, and ownership and operating costs incurred before closing a resale of the property; andany further drop in property value after the buyer’s breach for as long as and only when the buyer’s actions interfere and stall the seller’s resale effort; andinterest accruing from the date of the buyer’s breach through the closing date on the resale of the property on all money and any carryback note the seller was to receive [Calif. Civil Code §3307]; lessoffsets or credits due the buyer for:any rent received by the seller from tenants or the dollar amount of the implicit rent for any property used by the owner;the amount of any price increase on the resale; andthe amount of any reduction in the seller’s expenses on the resale.
The objective of this accounting is to avoid placing the seller in a better financial position than had the breaching buyer fully performed.
Related article:
The breaching buyer’s responsibilities: Part 2
Price-to-value losses in a declining market
A seller decides to resell the property after the buyer breaches their purchase agreement. The property’s value at the time of the breach had declined below the price set in the purchase agreement, a recessionary period experience. Here, the seller incurs a loss in the amount of the decline in value which is recoverable from the buyer.
However, the amount of lost market value experienced by the property which is recoverable is limited to value declines during two time periods:
the initial decline in value below the purchase price determined on the date of the breach, recoverable as general damages; andany further decline in value after the breach, recoverable only when the buyer’s actions interfere with the seller’s resale effort, also called special damages, being money. [CC §3307]
The seller recovers the price-to-value loss through to the date of the buyer’s breach, whether the seller retains the property, remarkets it or resells it.
Value fluctuations in the market
During periods of reduced regional economic activity, the boom-bust cyclical nature of real estate sales typically causes California property values to drop dramatically. Often, the price the buyer agreed to pay just a few weeks before the bust now appears to the buyer as excessive. Thus, the cancellation of the transaction, when no conditions remain to be eliminated, is the breach.
Further, there are intangible impacts on a property’s market value following the failure of a transaction to close due to a breach in a declining seller’s market. On a breach, the property placed back on the market as available for sale takes on a “shop-worn” status and the “fall-out syndrome” of a lost sale.
The property takes on 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]
However, the breaching buyer’s liability is limited to the seller’s loss on a resale. The loss is calculated as the difference between the price set in the purchase agreement with the breaching buyer and the value of the property on 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 when the buyer interferes with the seller’s diligent resale efforts. The message here to buyers who breach is this: when you are going to breach, breach as soon as possible.
When property is resold for the same price a breaching buyer agreed to pay, or more, and the net proceeds from the resale are the same or the cash equivalent, or more, the price-to-value difference on the date of breach is no longer recoverable. The seller receiving equal or greater net proceeds on a resale incurs no money losses. No lost value exists to recover.
To set the dollar amount of the price-to-value difference on the date of breach, any “noncash” items for payment of the breached purchase price and “noncash” items for payment of the resale price are adjusted to their cash equivalency.
For example, the terms for payment of a sale price include a seller carryback note with an interest rate below the applicable federal rate (AFR). Here, the principal amount of the carryback note is adjusted downward to reflect any discount required to convert the carryback paper to its cash equivalent, that is, its present worth in money.
Related video:
Read more about the breaching buyer’s responsibility for losses.
The buyer who interferes with the owner’s resale pays
A seller may diligently remarket the property and still be unable to resell it due to interference from the breaching buyer. Buyer interference with resale efforts typically 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, ending when the buyer’s interference with the resale efforts ends.
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 they canceled, thus excusing the buyer from further performing. The buyer sues to recover the property and records a Notice of Lis Pendens, which clouds title and interferes with the marketability of the property.
Ultimately, the buyer is held to have breached the agreement. The lis pendens is removed from the record, called expungement, allowing the property to be sold.
A seller, whether they attempt to resell or retain the property, 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.
Like in this example, 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 which interfered with the seller’s prompt and diligent efforts to resell the property. [Askari v. R & R Land Company (1986) 179 CA3d 1101]
Related video:
Read more about the lis pendens.
Seller’s expenses post-breach as a natural consequence
Rather than remarket and resell the property, a seller might take the property off the market or fail in their efforts to diligently resell it after the buyer breaches. Here, the seller’s recovery of money is limited to their 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 incurs 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, mortgage application or mortgage assumption; andother expenses and property reports incurred in reasonable reliance on the buyer’s full performance of the purchase agreement.
Related article:
Brokerage Reminder: Disbursement of funds when a transaction fails
Recoverable and nonrecoverable losses
The seller may choose to retain the property or delay reselling. Here, the ownership and operating expenses the seller might incur are not recoverable.
These expenses are not incurred as a result of a buyer’s agreement to purchase or a buyer’s breach, they are incurred because the seller owns the property with no intention to immediately resell it.
However, operating losses a seller incurs when they act to comply with the terms of a purchase agreement are recoverable, including:
the seller’s relocation expenses to reoccupy the property when they vacated after all contingencies allowing the buyer to cancel the purchase agreement 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; anda price drop on the late harvest of a crop brought about due to the buyer’s breach. [Wade Lake County Title Company (1970) 6 CA3d 824]
Related article:
No U-turn: liabilities to a seller in a breached purchase agreement
Using net sales proceeds to buy other property
Consider a buyer who enters into a purchase agreement knowing the seller intends to acquire replacement real estate using the net proceeds from the sale. After the buyer and seller eliminate all the buyer’s contingencies and no uncertainties remain about the buyer’s full performance, the seller enters into a purchase agreement to buy replacement property. Closing of the purchase is not conditioned on the “sale of other property.”
Later, the buyer breaches, and the seller is unable to complete their purchase of the replacement property. The seller incurs expenses and losses to avoid liability for having unconditionally agreed to purchase the replacement property.
Expenses the seller incurred on the replacement property transaction are recoverable since the:
buyer knew when they entered into the purchase agreement that the seller intended to contract to purchase replacement property based on the buyer’s agreement to purchase; andseller agreed to purchase other property relying on their buyer closing the sales escrow, since all contingencies had been removed and no obstacles to closing existed, except for the breach. [Jensen Dalton (1970) 9 CA3d 654]
Related article:
Tax Benefits of Ownership: Proposition 13 and the transfer of assessed value to a replacement residence
Operating losses during the resale period
A seller who promptly takes steps to diligently remarket the property for sale after the buyer breaches may recover their operating expenses and carrying costs of the property incurred after the date of breach. The amount of the recovery is subject to offsets for rent the owner receives, any use of the property by the owner and like valuable benefits of ownership.
The recoverable operating expenses 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;trial judgment on the breach; ordate 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 comply, the seller needs to take immediate steps to market the property for resale within the shortest possible time. [Spurgeon v. Drumheller (1985) 174 CA3d 659]
Related article:
Is a non-exempt private mortgage lender entitled to collect interest on unpaid principal accruing from the principal balance due date when the agreed rate of interest earnings on the loan is usurious?
Calculating the losses when resold
To begin calculating the seller’s net loss during the resale period, an agent totals the seller’s costs of maintaining their ownership. However, the recoverable operating expenses and carrying costs of the property the seller incurs during the resale period are limited to operating and ownership expenses the buyer understands exist at the time they entered into the purchase agreement.
Further, the buyer is due a credit for the rental value of the seller’s occupancy, called implicit rent, and any rental income the seller receives from the property after the buyer’s breach.
For the seller to recover these ongoing 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 provided to the buyer.
Related article:
A balance sheet real(i)ty check
Interest on recovered losses
A seller is also entitled to interest on the losses and expenditures they recover 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)]
However, when the seller retains the property rather than resells it, no property operating or value losses after the breach are recoverable and thus no interest accrues.
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 the expenditures.
Related article:
Is a private mortgage lender entitled to receive usurious interest on a non-brokered extension to a mortgage initially arranged by a broker?
Interest recovery depends on property use
When the buyer performs and closes escrow, the seller no longer owns the property. On closing, the seller receives the net sales proceeds for their equity in the property.
When escrow does not close due to the buyer’s breach, the seller does not receive the net sales proceeds for their equity. The question of whether the seller is entitled to interest on their net equity hinges 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 property falls into one of two categories:
income-producing property used as the seller’s residence or for operating the seller’s trade or business (implicit rent), or as a rental; ornon-income-producing property, such as vacant land or the seller’s vacant residence.
Rents received from an income-producing property and implicit rent for the owner’s use of property are the economic equivalent of interest on the dollar value of the property. Thus, were the seller to receive interest on their equity in income-producing property or property they occupied until it resells, they enjoy a nonrecoverable windfall. It is a double recovery on their equity in the form of both interest and rent, which are economic equivalents. One or the other, but not both.
The seller who occupies the property until it is resold is charged for the value of their use of the property, called implicit rent. The amount of implicit rent is an offset against all money recoverable from the breaching buyer, including interest on the seller’s equity.
Related article:
Fees for withdrawal or termination of a representation agreement
Collecting a loss on a failed sale of vacant land
For vacant unused land or the seller’s vacant residence, a buyer’s breach again fails to convert the seller’s equity into cash or cash equivalent as expected had the sale closed. Thus, until it is resold, the seller temporarily retains ownership of the equity, the price of which may be increasing, decreasing or remaining the same depending on price fluctuations in the local market.
The next question becomes whether the seller can collect interest on their equity in the property.
First, any interest due on the dollar amount of the net equity accrues from the scheduled closing date of the breached purchase agreement. On the expected closing, the seller was to receive the benefits from the sale in the form of cash for the seller’s net equity.
The accrual of interest during this period ends on the date of resale or trial. Any interest due accrues at the legal rate of 10%. However, when the breaching buyer agreed to an installment sale, the note rate for the carryback paper is the controlling rate.
Next, when the breached purchase agreement contains a provision limiting the dollar amount of loss the seller may collect, the agreed-to limit controls the limit of recoverable loss, except for the accrual of interest, an additional amount.
In conclusion, when the buyer breaches an agreement to purchase vacant or non-income producing property, interest is due on the net sales proceeds the seller was to receive on the sale, from the date scheduled for closing until the property is resold.
Related article:
The seller breaches the purchase agreement
