Earnest money is a buyer’s deposit that’s held in trust, pending ultimate acceptance or rejection of the offer. It is parked in a trust account where it’s not used for any purpose before or during escrow, which is the time when the purchase contract is in effect.

Few other types of purchases involve buyers depositing earnest money.

Real-estate brokers, representing either buyer or seller (but usually the latter), hold these deposits in trust. Real-estate lawyers also have trust accounts. I’ve always felt most comfortable as a buyer putting my earnest money in my lawyer’s trust account, and I’ve never had a seller complain.

A buyer dealing with For-Sale-By-Owner sellers should use his own lawyer’s trust account. Buyers should never give earnest money directly to sellers. I have seen FSBO sellers pocket such deposits when the sale fell apart.

Earnest money is applied to the agreed-on purchase price when buyer and seller close the sale. If no sale agreement is reached, earnest money is returned to the buyer in full. Interest may or may not accrue to the buyer, depending on the state.

If a buyer defaults on a signed purchase contract, the common remedy is forfeiture of the earnest money to the seller. This forfeiture payment is the usual reason given for sellers wanting large deposits from buyers. The bigger the deposit, the reasoning goes, the less likely a buyer will back out and the greater the compensation to the seller if it happens.

But this remedy comes into play only when the buyer has language in the contract that says words to the effect that in the event of buyer default, the seller’s sole and exclusive remedy is to receive the forfeited deposit held in trust. Absent such language, the seller can sue the defaulting buyer for full performance on the terms of their contract.

Forfeiture is, in other words, a liability-limiting provision.

Some sellers prefer the right to sue for performance instead of a limited remedy like forfeiture. The threat of suing for full performance may get more money out of a defaulting buyer than the forfeiture of earnest money. Some sellers use contracts that give them the choice of either taking the deposit or suing.

A contract reflects a meeting of the minds between buyer and seller. And one element of a buy-sell contract is that the seller should receive some agreed “consideration” from the buyer in return for whatever he has sold. Consideration is usually money, but it could be property, the promise of future payment or a combination of things.

Buyer and seller can have a legally valid contract for a real-estate sale without having any earnest money deposited as part of their agreement. The consideration in such a case is the buyer’s promise to pay the seller the agreed-on price and fulfill other contract terms in the future. If the buyer defaults, the seller will sue for performance with all costs paid by the buyer. I’ve seen very large deals structured this way.

What purpose, then, is served by earnest money?

The conventional answer is that the buyer shows the seller his degree of seriousness by the size of his deposit.

Several questions might be raised about this answer.

First, the size of the deposit may or may not indicate buyer seriousness. It depends on the wording and types of contingencies attached to the buyer’s offer, among other items.

Generally speaking, a contingency should be worded in a way that allows the buyer to judge whether or not its results are acceptable to him. If the results of a contingency investigation are not acceptable, the buyer’s earnest money should be returned in full and without penalty whereupon the buyer and seller have no further obligation to each other.

The buyer’s earnest money is not at risk until the parties reach an agreement on terms. No agreement, no risk of loss to the buyer. The buyer’s money is not at risk during the time the seller is considering his offer after it is first proposed or when they are trying to hammer out an agreement.

For that reason, I have proposed contracts to sellers that are packaged with $100 in earnest money and a sizeable increase once I have removed all contingencies. The seller is not shorted in this arrangement, since he cannot get his hands on the earnest money as a remedy until all contingencies are removed and I then default. Before default, the money is locked away from the seller in the trust account. From the buyer’s point of view, a two-step deposit is a better arrangement than having to come up with a bunch of cash that sits unproductively in escrow and is then applied to the sale.

A small earnest-money deposit can also be coupled with the buyer’s promise to pay some defined sum in the event of a default after contingencies are removed and a contract is in effect. That sum should be set up as the seller’s sole remedy for default. If the buyer is short of cash, he might pledge personal property or equities as sole compensation for default rather than cash.

A highly motivated buyer who has done all of his due diligence before submitting an offer might show his earnestness by not using any results-acceptable-to-the-buyer contingencies. In that case, the buyer may be able to bring about a contract with a very small deposit, or none at all. This is a high-risk maneuver, however, because it assumes that the buyer has or can get the money to buy the property and that he has thoroughly scoped its assets and liabilities. The upside is that a contract proposed with no contingencies can often bring the seller to a lower price because the offer is seen as a sure sale.

I’ve found it useful to explain in writing to a seller why I’m offering the amount of earnest money and the reason behind the two-step structure if I’m using that.

Second, earnest money is often mainly about psychology. Sellers think a “real” buyer is one who ponies up a big deposit. Often, a buyer uses that belief against a seller.

I’ve seen buyers put in big deposits that are combined with a three- to six-month “research period” for due diligence. This gives the buyer a very long look. It keeps the seller psychologically invested with this buyer. If the buyer exercises a back-out contingency, the buyer’s loses interest on his cash deposit plus his research expenses—but neither may amount to much. The seller, however, may lose his best season for selling or the market may have turned against him. I’ve seen buyers extract a lower price after a large deposit hypnotized their sellers into agreeing to an extra-long study period.

The size of a deposit may or may not indicate a buyer’s ability to perform on a contract. Many of us have run into buyers who appear to be wealthy but aren’t. I’ve seen buyers play this role, stretch out a seller with a long research period and threaten to exercise a blow-up-the-deal contingency—all in order to beat down the eventual selling price.

Sellers need to remember that buyers often use information developed as part of their contingency-related due diligence to reduce the final selling price. The seller agrees, because he figures he’s better off lowering the price than to start the selling process from scratch.

A third point to consider is that sellers can propose lower earnest-money deposits in return for concessions on other buyer-proposed terms. As a seller, I’d take a $1 deposit and a short escrow in return for zero back-out contingencies any day of any week. A low deposit can be coupled with a fixed-fee penalty for a buyer’s failure to perform.

Buyers, of course, can raise their deposit in return for seller concessions as part of pre-contract bargaining. A buyer who knows that he’s able and willing to make the purchase may be able to negotiate better terms by starting with a low deposit and then raising it in return for better terms from the seller.

Sellers who dismiss a low deposit out of hand may be “reading” a buyer’s intentions and capabilities incorrectly. Were I a seller facing a low-deposit proposal, I would ask the buyer for a written explanation.

And I might propose a double-down alternative: $1 deposit with either a huge penalty in the event of a default as the sole remedy or an agreement that the buyer pays all costs of enforcing performance on himself.

An earnest-money deposit — its size and structure — is a tactic in buyer-seller negotiations. Theoretically, a deposit could range from $1 (or even no dollars) to one dollar less than the proposed purchase price. Deposit language may or may not put the buyer’s money at risk—and risk comes in degrees. I’ve seen a contract where the parties agreed that the buyer’s deposit would be returned in full in the event of default. And for that Get-Out-Of-Jail-Free card, the buyer willingly agreed to and paid a higher price.

Like other tactics, the size, structure and wording of a deposit should be thought through in relation to the set of objectives that buyers and sellers want to reach.

In the next few weeks, I’ll discuss the contract snags that can catch buyers unawares.

Who is the seller and what does he own? In the first or second paragraph of the standard purchase contract, the names of the seller and the buyer are filled in. If the seller is represented by a broker or agent, that individual will insert the seller’s name.

This seems simple enough, but, occasionally, it gets complicated.

The buyer wants the exact name(s) of the seller(s) who owns the property. The buyer does not want a name of an individual included as a seller who is not a legal owner, nor does the buyer want the name of a legal owner left out.

Country property often involves one or more generations of heirs. As the family farm was passed down in equal ownership shares to children and then their children, each ownership share became a smaller percentage of the whole. A dozen heirs is common; two or three times that number is not uncommon in rural communities. I’ve seen one property conveyed by 256 owners.

Sometimes, informality reigns. The seller may be identified in the listing agreement and in the purchase contract as John Doe when the actual legal owner is something like JD LLC, or the Doe Family Limited Partnership. If the seller is named incorrectly, a buyer may find himself trying to enforce an unenforceable contract, or one that takes a lot of legal time to enforce. Keep things simple: Get the seller right.

Sometimes courthouse research is needed to nail down the legal owner before an offer can be submitted. Heirs have to be followed through wills and other records. Divorce and remarriage further complicate ownership.

Brokers are not lawyers or title searchers as a rule. They will make a good-faith effort to get all lawful owners signed onto their listing agreement, but this may not be good enough.

A buyer can protect himself by including language in the purchase offer that places the burden of ownership on the seller, which is exactly where it belongs. The purchase-offer contract should include language whereby the parties agree that the seller guarantees the following:

1. No other party (individual, business entity, trust, estate, etc.) holds an ownership interest in the property the buyer proposes to purchase other than those parties named as sellers in the buyer’s purchase contract;

2. The seller warrants (promises) that he legally owns the property in full, subject only to limitations on ownership of record. Commonly found limitations of record are items such as a utility easement, right-of-way easement that allows another party to use a road on the seller’s land, life estate, hunting lease or mineral lease.

“Of record” means the limitation must be on file and recorded in the county clerk’s office. I’m using “county” in a generic sense to represent whichever local jurisdiction — city, town, parish — manages property transactions. Recordation provides public notice of claims of ownership and claims of rights on property. The clerk may also be called the “registrar.”

In some situations, a careful buyer may want a seller to promise that no unrecorded limitations on ownership exist. Rural property seems to have more than its share of unrecorded encumbrances, that is, a right or interest in land that affects its value. The buyer may need to state further that both buyer and seller agree as part of their purchase contract that the buyer will be bound only by limitations of record.

3. The seller promises that he will deliver or convey the property with marketable title. This phrase means that the seller’s title is so free of defect that a court will enforce its acquisition by the buyer.

A property title that’s marketable is one that:

A. contains no serious defects or flaws;

B. does not depend on a doubtful question of law or fact to establish its validity;

C. does not expose the buyer to litigation over title or threaten the buyer’s quiet possession and enjoyment of the property; and

D. would convince a reasonable buyer, acting reasonably and in accord with accepted business principles and in knowledge of the facts and their legal significance, that he could, by virtue of the title he holds, sell or mortgage the purchased property.

A deed by itself is not sufficient proof of ownership. A deed, even a general warranty deed, does not legally establish the condition of the seller’s title at the time that the purchase-offer contract is signed or the sale consummated. A buyer needs something more than a deed.

The buyer’s purchase-offer contract should specify that he is purchasing and acquiring both ownership and marketable title. This is often done by having a lawyer, title company or licensed abstractor issue a certificate of title (an opinion) that says, after an examination of public records, the seller’s title appears to be good and marketable.

A certificate does not look for or cover unrecorded liens, limitations or rights of other parties, and therefore, it is not a perfect guarantee of ownership. Buyers can buttress a certificate by insisting in a purchase-offer contract that the seller disclose all unrecorded limitations on title that he knows of. But a certificate is still not perfect.

Title insurance is the best protection a buyer can get to defend against problems in ownership and title. But it, too, is not comprehensive. A standard-coverage policy insures the title based on an examination of public records and against some hidden defects, such as a forged document, among others. An extended-coverage policy also protects against things that can be discovered by inspecting the property, such as some unrecorded liens, adverse possession and inspection of a survey. Both types of policies include exclusions that are not covered, such as a claim against the property involving a zoning ordinance, restrictive covenant, some easements, some water rights, among others.

Lenders often require a buyer to purchase title insurance that protects them. Insurance that protects the buyer is usually worth the money.

The Torrens system verifies and guarantees ownership. It guarantees title by registration in the system, and provides evidence of title without additional searching. Iowa is the only state that has all its land under this system, while nine others have implemented it in part.

My opinion is that a buyer should always have a local real-estate lawyer by his side when he is filling in a standard purchase-offer contract. The lawyer should include language to make sure that all lawful sellers are party to the buyer’s contract and that these sellers own what is being sold and will convey that ownership through marketable title.

Next: How should property to be sold be described in a purchase-offer contract?