Mastering California Earnest Money and Escrow
In California real estate, earnest money (also known as a "good faith deposit") is the initial sum a buyer provides to demonstrate their commitment to a purchase agreement. Escrow is the neutral third-party process that holds these funds and legal documents until all conditions of the contract are met. For both the California Department of Real Estate (DRE) salesperson exam and daily practice, understanding the strict timelines and fiduciary duties associated with these funds is a core competency.
To remain compliant in California, licensees must adhere to specific "trust fund" handling procedures. Failure to properly manage earnest money is one of the most common grounds for disciplinary action by the DRE. Whether you are a candidate studying for the exam or a new licensee, mastering the three-business-day rule and the nuances of liquidated damages is essential for protecting your client and your license.
Official Source Check
The rules governing trust funds and escrow in California are established by the Business and Professions Code and the Commissioner’s Regulations. The following official resources provide the final authority on these topics:
How Earnest Money Works in California
When a buyer makes an offer, the earnest money serves as a financial bridge between the offer and the closing. In California, these funds are categorized as "Trust Funds"—money held by a licensee on behalf of others. The California Business and Professions Code mandates specific handling of these funds to prevent commingling (mixing client money with broker money) or conversion (spending client money).
The Three-Business-Day Rule
Unless the contract states otherwise, a broker who receives trust funds must, within three business days after receipt of the funds, do one of the following:
- Deposit the funds into a neutral escrow depository.
- Deposit the funds into the broker's trust fund account.
- Give the funds to the principal (the seller or owner) if authorized in writing.
Note: The clock starts the next business day after the broker (or their salesperson) receives the check. Weekends and bank holidays do not count toward this three-day limit.
"Compliance Note: Even if a buyer asks you to hold a check until an offer is accepted, the DRE requires you to record the receipt of the check in your logs immediately. Once the offer is accepted, the three-business-day countdown for depositing begins."
Escrow Procedures and Liquidated Damages
Escrow is a "limited agency" that follows the mutual instructions of the buyer and seller. In California, escrow companies are typically regulated by the Department of Financial Protection and Innovation (DFPI), though broker-controlled escrows are overseen by the DRE.
Liquidated Damages and the 3% Cap
If a buyer defaults on a contract for a 1-to-4 unit residential property that they intended to occupy, California Civil Code Section 1675 limits the amount of earnest money the seller can retain as "liquidated damages." Generally, this amount cannot exceed 3% of the purchase price, provided both parties initialed the liquidated damages clause in the contract.
| Concept | California Requirement | Key Limitation |
|---|---|---|
| Deposit Deadline | 3 Business Days | Starts day after receipt |
| Commingling | Strictly Prohibited | Cannot mix with personal/business funds |
| Liquidated Damages | Capped at 3% | Applies to 1-4 unit owner-occupied residential |
| Neutral Depository | Escrow or Trust Account | Must be a licensed entity |
What Candidates and Licensees Get Wrong
Confusion often arises regarding "receipt" of funds. On the exam, remember that a salesperson receives money on behalf of their broker. The broker is ultimately responsible for the trust fund records, even if the salesperson is the one who physically handles the check. Mistakes often include:
- Miscounting Days: Forgetting that "business days" exclude Saturday, Sunday, and holidays.
- Incomplete Records: Failing to maintain a "Columnar Record" of all trust funds received and not deposited into the broker's trust account.
- Unauthorized Disbursement: Attempting to release escrow funds to a seller without the buyer's written consent (or vice versa) when a dispute exists.
Practical Exam-Prep Takeaways
- Interpleader: If the buyer and seller cannot agree on who gets the earnest money after a failed deal, the escrow holder may file an "Interpleader" action to have a court decide.
- Trust Account Interest: Generally, trust accounts are non-interest bearing unless specific requirements are met, and the interest must usually be paid to the owner of the funds or a designated non-profit (California's IRP program).
- The $200 Rule: A broker is allowed to keep up to $200 of their own money in a trust account specifically to cover bank service charges without it being considered commingling.