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Financial Dictionary - Earnest money contracts

Earnest money contracts

Earnest money deposit contracts are agreements that regulate the amount that the buyer of a property will give to the seller to guarantee that the contract is fulfilled and that the sale goes through. It is like a reservation, deposit or preliminary agreement that prevents either party from withdrawing before signature of the public deed. Although it is part of the final price of the property, it is not just a down-payment, as it could be lost if the contract does not go through.

Although not mandatory, this is logically recommendable, as it implies a degree of guarantee of compliance. However, there are other commitment options in addition to earnest money deposits, such as sale commitments, sales with deferred payment and purchase options. 

The parts of an earnest money contract

Earnest money contracts must include:

  • The personal details of the buyer and seller.
  • The details of the property: characteristics, address, property registry reference, etc.
  • The reservation cost for the property.
  • The price of the property.
  • The purchase and sale costs and who is responsible for them: notary public, property register, TIP, VAT, etc.
  • The charges on the property.
  • The deadline for the sale.
  • The penalties for both parties if they do not fulfil the agreement.    

Types of earnest money contracts

There are three types of earnest money contracts

  • First, double-rate or withdrawal deposits, under article 1,454 of the Civil Code. These are the most common. They give the parties an option to back out of the sale. If the seller backs out, they have to return double the earnest money deposited. If the buyer backs out, they lose the earnest money deposited. The period for withdrawal lasts until signature of the deed of sale (this is a long time, as the buyer may need a long time for formalities with the notary, the mortgage, etc.), even if they have made other payments after the earnest money deposit.
  • Second, penalty deposits, under articles 1,152 and 1,152 of the Civil Code. These entail compensation in the event of non-performance, penalising the seller through loss of the deposit, or its return in duplicate, plus a requirement for compliance and compensation. In other words, failure to comply with the sale agreement does not mean that the sale will not go through.
  • Third, confirmatory deposits, under article 1,124 of the Civil Code. These guarantee the sale contract, representing a down-payment on the total price of the property. Compliance failures entail going to court.

Earnest money contracts must be drawn up carefully, as if they do not explicitly state the right to withdraw, it will be assumed that the earnest money is simply confirmatory, i.e. a down-payment.

How do you write an earnest money agreement?

First, decide on the type of earnest money deposit. We must think this through carefully, because each type has different implications. When the agreement is being drawn up, it must be signed on every page and any annexes must be added: certified copies of deeds, plans, etc. Each party must keep a copy. Reliable templates and models are available, such as that provided by OCU.

Is earnest money taxed?

Yes, but in various ways. In the case of new homes, buyers pay the deposit and corresponding VAT. With existing housing, the buyer pays the Asset Transfer Tax on the sale price, including the deposit, when the deed is formalised. If the purchase goes through, the seller has to pay the municipal capital gain and declare their gain on their personal income tax return. If the sale does not go through and there is a penalty deposit, the party who keeps the deposit declares it in their personal income tax return, while the party that loses it declares the loss in their personal income tax return.