Question: We entered into a contract to purchase a new home in a subdivision in the San Tan area for $300,000. We deposited $30,000 earnest money in escrow. After 45 days while the home was still in the framing stage, my wife decided that she wanted to quit her job and return to school. With only one income we will not be able to afford this new home now, and we want the return of our $30,000 earnest money.
Due to strong demand in our subdivision, the homebuilder has just raised the base price for our model home, and the homebuilder should therefore make a large profit when the home is built and sold to a new buyer.
Is the homebuilder entitled to keep our $30,000 earnest money, even though the homebuilder is now going to make a large profit on our home because we canceled our purchase contract? If we lose our $30,000 earnest money, can we at least deduct this $30,000 loss from our income taxes?
Answer: The theory behind earnest money is that, because damages would be difficult to determine if the buyer defaults under a purchase contract to buy a home, the seller and buyer can agree at the time of the signing of the purchase contract on a reasonable amount of earnest money that will be forfeited as damages if the buyer defaults, whether the value of the home has increased or decreased. These damages are called liquidated damages. If the amount of the earnest money, however, is so disproportionate to the price of the home, e.g., $60,000 earnest money for the purchase of an $80,000 home, a court would probably not enforce the forfeiture of this $60,000 earnest money.
Therefore, even if you could show that your homebuilder would make a profit now on the sale of your home when your home is completed, the homebuilder is probably still entitled to retain your $30,000 earnest money as liquidated damages for not buying a $300,000 home.
Finally, the general rule is that the loss of earnest money in the purchase of a personal home is not tax deductible. If an investor is engaged in the business of purchasing homes as investment properties, however, the loss of earnest money may be deductible as a business loss.