Two Reasons for the Deposit
By Brian Madigan LL.B.
There are actually two basic reasons for a deposit in a real estate transaction:
1) to constitute security for payment, and
2) to establish a pre-estimate of the damages in the event of default.
There are other commonly held beliefs like the deposit is a “sign of good faith”. It shows “sincerity” on the part of the purchaser. It is the “consideration” that makes the deal.
However, none of that really makes any sense. Real estate contracts are in writing and usually executed under seal. That means that they are binding with or without consideration. And, when you examine the contract, they provide for the exchange of the title to the land for money. That is a “promise in exchange for a promise”, which naturally constitutes consideration. So, there is no need for a deposit to seal the deal, or make a contract enforceable.
In fact, a deposit is not necessary at all. But, from the seller’s perspective it’s always wise to have a real, or substantial deposit.
The difficulty seems to arise in practice. In Toronto and the GTA (Greater Toronto Area), a deposit in the range of about 5% of the purchase price is quite common and expected with most residential transactions.
For commercial transactions, the practice varies somewhat because frequently, the deposit will be “non-fundable” and will essentially amount to an option to purchase.
In more rural settings, and smaller areas, the local practice appears to be the use of a nominal deposit, that is, $500.00 to $1,000.00 regardless of the size of the transaction. That is often the custom and local practice. Buyers don’t offer any more, and sellers are counselled to accept such a deposit as “regular”.
In my opinion, such a local practice is unacceptable!
So, we are really back to the two primary reasons for the deposit in the first place.
There needs to be some money set in place with a third party to ensure that if the transaction is not completed due to the purchaser’s default, then these funds will be available to the seller.
The funds are placed with a third party stakeholder, and cannot be released until there is mutual consent or a Court Order.
A nominal deposit does not force the buyer to deal with his breach, only a substantial deposit will.
Pre-estimate of Damages
In the case of a claim where the damages can vary from one transaction to the next, the parties are permitted to establish by contract an amount that would estimate the vendor’s expected minimum loss.
This has been handled through the use of the deposit for hundreds of years. The deposit is the pre-selected, pre-negotiated and agreed upon estimate of the minimum amount of the vendor’s damages. No actual proof of damages is required. The amount of the deposit is accepted in contract law to be the genuine pre-estimate.
Actual Damages Sustained
In addition to keeping the deposit as a pre-estimate of the amount of damages, the vendor is entitled to claim additional damages provided they can be proven.
Let’s consider a situation in which Bob sells his $300,000.00 house to Bill, expecting to be in a position to close on his $500,000.00 new house, the same day.
If the deal falls through on the closing day, due to Bill’s fault, what has Bob lost in terms of money?
Let’s estimate the following:
1) real estate commission on the sale,
2) legal expenses on the sale,
3) mortgage prepayment expenses on the sale,
4) moving expenses,
5) loss of deposit on the purchase,
6) possible real estate commission on the purchase,
7) legal fees on the purchase,
8) mortgage arranging fees on purchase,
9) temporary accommodation expenses,
10)carrying charges, utilities, taxes and mortgage payments on sale until disposition of this property,
11)liability for carrying charges, utilities, taxes and mortgage payments on new property until it can be re-sold by the owner
12)moving expenses associated with second move,
13)interim storage expenses,
14)other expenses attributable to the failure of the sale and the subsequent purchase.
As you will appreciate, quite easily the actual financial losses suffered by Bob will be quite steep, amounting to $25,000.00 or more, in most cases.
A $10,000.00 deposit really wouldn’t go that far.
A 5% of $300,000.00 or $15,000.00 deposit would be helpful, but is still short of the mark.
When it comes to a $500.00 or $1,000.00 deposit; it really isn’t worth having. Marginally, such a deposit has no value in these circumstances.
Sellers must be made aware of the significance of the deposit and the role that it plays in real estate transactions. Agents must seek the “informed consent” of their sellers if they are to structure a transaction with a low, modest or meaningless deposit.
If the seller agrees to a low deposit based upon “local custom”, then this should be specifically noted by the agent in the file.
In my view, there should be one standard practice for all of Ontario, and such local customs should be discontinued.
As an alternative, a provision in the agreement requiring a second deposit or increased deposit on the closing date would help to solve #2, but not #1. So, in areas where there is such a custom, at the very least the second deposit clause should be included.
Brian Madigan LL.B., Broker is an author and commentator on real estate matters, if you are interested in residential or commercial properties in Mississauga, Toronto or the GTA, you may contact him through RE/MAX West Realty Inc., Brokerage 416-745-2300.