What Are Liquidated Damages in Real Property Contracts?

Updated on April 4, 2024

Liquidated damages in real estate are a critical aspect of contract law, particularly in California. These damages are predetermined amounts specified in a contract to compensate for losses that are difficult to quantify in the event of a breach.

This article delves into the intricacies of liquidated damages, focusing on their application in California real estate, guided by the provisions of California Civil Code Section 1671.

It also offers practical advice for navigating these provisions, drawing on the expertise of Schorr Law, a firm with extensive experience in real estate disputes.

Key Takeaways:

1. Definition and Purpose: Liquidated damages in real estate contracts are pre-agreed sums to compensate for losses that are hard to quantify if a contract is breached.
2. Legal Framework (California Civil Code Section 1671):
   • Generally, a liquidated damages clause is valid unless deemed unreasonable at the contract’s inception.
   • For retail purchases, rentals, or leases for personal use, such clauses are void unless an agreed-upon amount is presumed as the damage for breach.
   • In real estate sales of owner-occupied residential property (up to 4 units), these clauses are presumed valid if compliant with the Civil Code.
   • Liquidated damages exceeding 3% of the purchase price are typically invalid unless proven reasonable.
3. Determining Reasonableness: Factors like market conditions, seller’s costs, and time off the market influence the reasonableness of liquidated damages in real estate.
4. Contractual Requirements:
   • Liquidated damages clauses must be in at least 10-point bold font or 8-point red bold font and separately initialed by each party (Civil Code section 1677).

What are Liquidated Damages in Real Estate?

Liquidated damages are a pre-negotiated set amount of damages contained in a contract that is available to the injured party to compensate them for otherwise difficult to calculate losses stemming from a breach of contract. 

In other words, they are agreed upon set amount of damages that the parties agree upon at the beginning of the contract before any breach occurs.  Liquidated damages are a common part of almost all real estate contracts in the State of California.

The Law on the Validity of Liquidated Damages – Civil Code Section 1671

California Civil Code Section 1671 provides the rules for interpreting liquidated damages as follows:

(a)This section does not apply in any case where another statute expressly applicable to the contract prescribes the rules or standard for determining the validity of a provision in the contract liquidating the damages for the breach of the contract.

(b) Except as provided in subdivision 

(c), a provision in a contract liquidating the damages for the breach of the contract is valid unless the party seeking to invalidate the provision establishes that the provision was unreasonable under the circumstances existing at the time the contract was made.

(c) The validity of a liquidated damages provision shall be determined under subdivision (d) and not under subdivision (b) where the liquidated damages are sought to be recovered from either:

(1) A party to a contract for the retail purchase, or rental, by such party of personal property or services, primarily for the party’s personal, family, or household purposes; or

(2) A party to a lease of real property for use as a dwelling by the party or those dependent upon the party for support.

(d) In the cases described in subdivision (c), a provision in a contract liquidating damages for the breach of the contract is void except that the parties to such a contract may agree therein upon an amount which shall be presumed to be the amount of damage sustained by a breach thereof, when, from the nature of the case, it would be impracticable or extremely difficult to fix the actual damage.

In other words, the law provides that the liquidated damages provision is valid provided the terms of the liquidated damages were not unreasonable at the time the original contract was made.

Application to Real Property

A clause calling for liquidated damages is presumed valid in a real estate sales contract for the sale of owner occupied residential real property consisting of 4 units or less provided the parties comply with the terms of the California Civil Code.

In California purchase and sale truncations, the liquidated damages provision is invalid if it exceeds 3% of the purchase price unless the party seeking to enforce the liquidated damages provision establishes that the liquidated damages are reasonable.

This begs the question of how you determine reasonableness. In real practice, reasonableness may be determined by factors like market conditions, seller’s carrying costs, time off the market, and other consequential damages the seller may experience if the sale falls apart.  

Formatting of Liquidated Damages Provision

Most purchase and sale transactions in California, whether commercial or residential use standardized forms.  Regardless, the liquidated damages provision must be separately signed or initialed by each party to the contract and must be 10 point bold type font or red print of at least 8 point bold type font. Civil Code section 1677.

Practical Tips on Liquidated Damages

At Schorr Law, we frequently see and litigate disputes concerning a seller of real property’s attempt to retain the buyer’s initial deposit as liquidated damages. Here are a few tips we can offer regarding liquidated damages:

1. Read the contract carefully. Because the Civil Code requires a special font and at least 10 point type face along with separate initials, take the extra time to read the liquidated damages provision. If you do not agree with it, don’t sign it. In competitive markets in California a buyer will be hard pressed to get a liquidated damages provision of less than 3% of the overall purchase price, but in less competitive markets you may be able to negotiate the amount down. Or, if the purchase price is very high, the need for 3% may not be there.
2. Pay attention to your contingencies. Liquidated damages provisions are not on their own island, they are a part of the mainland contract. Most of the time, the buyer has certain contingencies that allow the buyer to back out of the sale while still retaining the amount of money that has been pre-determined to be the liquidated damages. This is why removing your contingencies is such a big decision.
3. You have to mediate. If you wind up in a dispute over the liquidated damages provision in a California Association of Realtors form contract, then the parties are required to mediate any dispute over the liquidated damages provision before suing to enforce it. This is true if the parties want to preserve their right to recover prevailing party attorneys’ fees if they win the dispute.
4. Escrow will not release the liquidated damages without a joint instruction. Even though the parties sign off on the contract and separately sign or initial the liquidated damages provision, escrow will not release the previously agreed upon liquidated damages without a joint instruction from the parties regarding the same. This may seem absurd, given the liquidated damages provision, and arguably it is, but that is the practical reality. Which means the parties essentially have to agree a second time on the liquidated damages otherwise the money will be kept in escrow until the dispute is resolved.
5. Just because there is a dispute about liquidated damages does not mean the seller cannot sell the property to a new seller. As long as the buyer is not claiming the right to buy the property, and only arguing about the liquidated damages, the seller is free to sell the property to someone else. That said, you may need to make provisions to clearly cancel the first escrow subject to the dispute over the money held as liquidated damages.

Need Legal Representation?

At Schorr Law, we have done a high volume of cases involving disputes over liquidated damages. Our robust real estate practice involves decades of experience helping parties resolve these escrow disputes. For help with your dispute, please do not hesitate to contact us: [email protected], 310-954-1877.