This is an expanded version of an article that appeared in the July 2013 edition of The Myers Report newsletter published by the firm.
Don’t Overlook the Down Payment
By: James E. Robinson, Esq.
Even as the economy continues to recover, interest rates remain low and this helps to spur real estate sales. When negotiating a real estate deal, the price, condition of the property, closing date and a host of other important terms must be addressed, but in the process the amount of the down payment to be made by the buyer to the seller on contract signing can sometimes be given short shrift. Perhaps that’s because the vast majority of sales close successfully, but as illustrated in a recent decision by New York’s highest court (the Court of Appeals), the amount of the down payment can become quite significant if things don’t work out as planned.
The decision was rendered this past March in the case of White v. Farrell, 20 N.Y.3d 487, 987 N.E.2d 244, 964 N.Y.S.2d 467 (2013). The case involved a contract for the sale of a lakeside home in upstate New York for a price of $1,725,000, with respect to which the buyers made a down payment in the amount of $25,000. The buyers eventually backed out of the contract (claiming that there were undisclosed issues with respect to drainage) and purchased another property. The sellers were eventually able to sell the house to a different purchaser a year and a half later, but only for the lesser price of $1,376,550.
A lawsuit followed in which the original buyers sued to get their $25,000 down payment back and the sellers counter-sued for damages in the amount of $348,450, representing the difference between the original $1,725,000 contract price and the lower amount for which they ultimately sold the house.
The trial court found that the buyers had not been justified in backing out of the contract and that they were therefore not entitled to get their down payment back. With respect to the sellers’ claim for damages, the court held that the proper measure of damages was not the difference between the original contract price and the later reduced sale price; but rather, the difference between the contract price and the fair market value of the house at the time when the buyers breached the contract. Because there was testimony from a real estate broker that the fair market value of the house was the same as the contract price at the time of the buyers’ breach, the trial court found that the sellers were not entitled to any damages (other than the $25,000 down payment, which they were allowed to keep).
The sellers appealed from the trial court’s determination that they were not entitled to any damages, but the decision was upheld. In what’s a fairly rare occurrence, the sellers were then granted permission to take a further appeal to New York’s highest court. Unfortunately for the sellers, the Court of Appeals found that while it had never addressed the issue of how damages should be measured when a buyer breaches a contract for the sale of real property, the rule that had been applied by the trial court – that the seller’s damages are measured by the difference between the contract price and the fair market value of the property at the time of the breach – is the correct one, having been consistently applied by both the lower courts in this state and by the courts of most other states.
The Court did note, however, that the price for which a property is subsequently sold can in certain circumstances provide “very strong evidence” of what the fair market value of the property was at the time the original contract was breached. The Court explained that such circumstances would likely exist where: there is a relatively short time between the breach of the original contract and the sale of the property to another buyer; there has been no significant change in market conditions; and the terms of the original contact of sale and the later one are similar.
Nevertheless, there may as a practical matter be few instances in which a seller would be able to recover damages based on a difference in price. As one of the judges stated in a concurring opinion, it’s unlikely that there would be a significant difference between the contract price and the fair market value of the property because an arm’s-length buyer would in most instances not have agreed to pay more for a property than its fair market value. This seems a fair assumption given the ready availability through the Internet and other sources of comparable listings, tax assessments and other information concerning property values. Further, because the great majority of sales involve some form of bank or other financing there’s likely to be an appraisal involved, and that further reduces the likelihood that there would be a substantial variance between the contract price and the fair market value. The Court’s majority reached a similar conclusion, noting in the main decision that “it may well be that, in most cases where the buyer breaches a contract to sell real estate, the seller simply retains the down payment without resorting to the expense and uncertainty of litigating actual harm” – that is, in most cases it simply won’t be worth it to bring a lawsuit to try and prove that there was a difference between the contract price and the fair market value of the property. This is especially so because in connection with any award of damages the buyer would be entitled to a credit for the amount of the down payment (for example, even if the seller in a case could prove that it was entitled to $100,000 in damages because the contract price exceeded the fair market value of the property by that amount, if the buyer had made a down payment of $80,000, then the most that the seller could hope to gain from going to the time and expense of bringing a lawsuit would be the $20,000 difference).
Because the sale price for a piece of property will often be close to, if not the same as, the fair market value of the property, there may be little in the way of damages available to the seller apart from the down payment that was made by the buyer. Accordingly, the challenge is for the parties to agree in advance on an amount that will adequately cover the seller against potential losses should the buyer unjustifiably back out of the deal later on.
What are some of the factors that the parties should consider when setting the amount of the down payment?
From the seller’s point of view, consideration should be given to the amount of time, effort and expense that would be involved in re-selling the property in the event of a breach by the buyer given the fact that the down payment may well be the only source of funds available to the seller to offset these costs. The amount of the down payment should also be large enough in relation to the amount of the total purchase price to provide a meaningful deterrent against the purchaser’s backing out of the deal. The point is illustrated by the facts in White v. Farrell: if a buyer has the means to spend in excess of 1.7 million dollars on a vacation home, then it might be relatively easy for that person to walk away from a $25,000 down payment if they find a property that they like better. Finally, if there are unusual circumstances involved in the sale – for example, where the purchase price includes a significant premium over the fair market value of the property (perhaps because there have been multiple bidders), or where there is a concern that the real estate market is declining so that there could be a significant drop in market value before another buyer could be found – then there may be additional reason for the seller to seek a large down payment.
From the buyer’s point of view, it’s important to bear in mind the Court of Appeals’ emphasis of the rule that if a buyer fails to close without proper justification, then the buyer will lose its down payment. It’s interesting to note that in discussing this rule the Court referred to an earlier case, Maxton Builders, Inc. v. Lo Galbo, 68 N.Y.2d 373, 502 N.E.2d 184, 509 N.Y.S.2d 507 (1986), and that it was noted several times in that case that what was being discussed were real estate contracts involving a “traditional” down payment of approximately 10% of the purchase price. It’s possible, then, that a buyer who made a down payment significantly in excess of 10% could argue that the entire amount of the down payment should not be subject to forfeiture; but it would be unwise to rely on this, especially in light of the recent decision’s emphasis that loss of the down payment is the rule. Instead, buyers should simply endeavor to keep the down payment as low as possible. If there are reasons why a large down payment is required or desirable, then the buyer should try to see that the contract contains language that very specifically limits the amount of the down payment that the seller will be entitled to retain in the event of a breach to 10% of the purchase price or some other amount less than the full amount of the down payment that the parties agree upon as being reasonable.
The important lesson from White v. Farrell is that it’s worth taking a few moments when preparing a contract of sale to consider what would happen if there’s a breach by the buyer and what would be an appropriate amount for the down payment under the circumstances.
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Please note that this article is intended only as a general discussion of issues pertaining to real estate contracts and that it should not be taken as creating an attorney-client relationship or as legal advice with respect to any particular person, transaction or situation. Circumstances and the applicable legal principles vary and you should consult with an attorney regarding any questions you may have regarding your specific situation.