Earnest Money Basics

The finer details can depend on state and local law

Home buyers writing a check with an agent holding a key.
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When a buyer purchases real property, she'll typically offer deposit money to be held in escrow to indicate that she's sincere and that she intends to go through with the purchase process. This is fittingly referred to as "earnest money." The word "earnest" is a synonym for "sincere."

Offer a lot of it, and you'll get the seller's attention. Offer just a little, and the seller isn't likely to take you very seriously.

The Implications of a Contract

The concept of earnest money rests on the premise that a contract is not an ironclad obligation for the buyer to purchase the property in question. A lot can go wrong between making an offer and closing. Home inspections can turn up deal-breaking flaws. Appraisals can come in startlingly low. In these cases, the buyer might be entitled to take his earnest money back, or at least reclaim a portion of it.

When a seller accepts an offer to purchase, she is contractually bound to take the property off the market for a period of time while contingencies like inspections and appraisals are taken care of. She needs some sense of security that the deal will go through.

How Much Money Is It?

The amount offered usually correlates somewhat with the purchase price of the property, but this can vary by locality and custom. The amount of earnest money is also normally negotiable—it's not contractually or legally carved in stone.

As a practical matter, deposits typically range from 1 to 3 percent of the purchase price, but this can increase in a hot seller's market.

The seller doesn't have to accept the initial amount offered by the prospective buyer. Sellers might require an increase in earnest money for various reasons. Maybe the buyer has requested an extended period until closing, or he's offering zero or a very low down payment. The seller might have other offers on the property, or maybe the buyer just offered too little money overall. The seller might be concerned about the buyer's ability to get a mortgage.

Some Sellers Have Upfront Requirements

In some cases, sellers might set minimum earnest money amounts in their listing advertisements. New home builders also often have certain minimum upfront deposit requirements.

Where and How Is the Money Held?

Most states have very strict rules regarding the handling of and accounting for earnest money deposits. The money is usually held in an escrow company account, a title company account, the buyer's broker's trust account, or the seller's broker's trust account. Both the buyer and the seller have a legal right to the money once it's deposited.

That said, the money is ultimately used to offset the buyer's costs in the transaction at the end of the day. It appears as a credit on the settlement statement, so it reverts to being her money at that point.

What If the Deal Falls Through?

The disposition of earnest money in a dispute and in the event of a failed transaction is also spelled out in state law and in real estate regulations.

In many real estate contracts, the buyer and seller agree to mediate before going to court and taking further legal action. Mediation usually results in an agreement by the parties as to how the earnest money will be distributed in a failed deal. In many cases, just avoiding the cost of mediation will result in an agreement between the parties.

As a general rule, however, the deposit is typically forfeited if the buyer doesn't perform under the terms of the contract, such as having the property appraised in a timely manner or if he simply gets cold feet and wants to cancel the contract.

Everyone involved in a real estate transaction should be familiar with his state's rules regarding the handling of earnest money, particularly in the event of a failed transaction.

When You Have Competition

Buyers might find themselves competing for a property when the real estate market is hot, and earnest money can help here. If you're sure you can perform and you're certain that you can get your mortgage and close on the deal, earnest money is simply a front-end deposit on your down payment and closing costs.

Should you end up in a bidding situation and you really want the home, and if you know that you can get the mortgage and close on the deal, consider upping your earnest money. The seller might be comparing several offers, and there might even be one on the table that's higher than yours. But if you're offering significantly more earnest money, you may get the home!

Tax Implications

Remember, an escrow account is no different from your personal bank account when it comes to paying interest. For the most part, any interest earned should be negligible because the money won't be on deposit for an extended period of time. Even so, that interest is taxable to the buyer as income.

The buyer would have to file Form W-9 with the Internal Revenue Service to claim that interest should the deal drag out forever and the account earn more than $5,000.

Earnest Money in Investment Situations

Real estate investment involves a number of strategies, and each strategy has unique characteristics. Some are better if the investor can keep his earnest money deposit to a minimum. Of course, this has a lot to do with the game plan the seller has in place.

The goal is to invest as little as possible when it comes to wholesale. A wholesaler who uses an assignment contract should put up some earnest money, but she'll want to keep it low. The good news is that you're generally working with a highly motivated seller in these cases. They might accept very low earnest money deposits because they haven't been able to sell and they want out of the property.

You can cut a deal on the other end with your buyer to cover your earnest money, but that will only happen if both deals end up closing.