The following is based on a real case in California. Certain details have been changed for privacy.
Have you ever had to use the inspection contingency to get out of a contract? Or have you had one used against you? Whether (and how) a buyer can use the inspection contingency in a purchase and sale contract remains one of the most commonly misunderstood principles in real estate transactions.
Unfortunately, if agents don’t understand this principle, it can have serious consequences for both buyers and sellers (i.e., lost deposits, legal fees, and potentially bad branding). I say this as a lawyer who specializes in real estate litigation. I frequently receive questions about inspection contingency disputes from agents, and I believe that litigation in this area is trending upward as the market cools down.
Generally, when a buyer and seller enter into a contract to purchase or sell property, they negotiate contingencies in the contract (or agree that there shall be no contingencies in the contract). As a refresher, a contingency is a precondition that, if not satisfied, allows one party to cancel the deal. If the precondition isn’t met, or the party benefiting from the precondition doesn’t waive it, then it provides a reason for the transaction not to go forward.
There are different kinds of contingencies that the buyer and seller may negotiate, such as an appraisal contingency, a loan contingency, a contingency that buyers must sell their home first before they can complete the purchase, or an inspection contingency. With respect to an inspection contingency, the buyer has the right to investigate the condition of the property to identify any defects or conditions that were not disclosed prior to the ratification of the contract. Note that I said, “that were not disclosed,” as you’ll see in the example below.
A Real Example of an Inspection Contingency ‘Fail’
In the following case, the sellers put their home on the market in the fall of 2019 and were thrilled to receive multiple offers from interested buyers. After weighing the offers they received, the two highest bids came in at the exact same amount. Who to choose?
While they were both viable candidates for the property, one couple wrote them a heartfelt letter explaining why this house meant so much to them and the connections they had to the surrounding area. Naturally, the sellers chose them. Earnest money went into escrow, and the agreement was signed with only one contingency: an inspection contingency.
Prior to signing the P&S, the sellers had provided the buyers with full disclosures, including a written inspection report, which described in detail all the current conditions of the property and areas in need of repair. The inspection contingency in the contract afforded the buyers an opportunity to investigate the condition of the property and determine whether they were satisfied with it. The buyers in this case commissioned their own inspection report that summarized the conditions of the property. The conditions identified in the buyers’ inspection report were the same conditions identified in the sellers’ inspection report. In other words, the buyers’ inspection report revealed nothing materially new concerning the conditions of the property.
Despite this, three weeks after signing the P&S, the buyers attempted to cancel the contract using the inspection contingency as their stated basis. They claimed they felt things were moving too fast and wanted to back out. But changing their minds was not a valid reason to cancel the contract, and neither was the inspection contingency. The buyers were only allowed to exercise their inspection contingency if they discovered any new, unsatisfactory conditions on the property, which they didn’t find.
What happened next? The buyers bailed, and the sellers had to re-list their property. Unfortunately, they didn’t get the same great price for their home. Meanwhile, the original buyers had their deposit held in escrow, and in order to get their funds out, both parties had to agree to release them. The sellers refused and sued them for breach of contract.
Why the Inspection Contingency Is Not a Scapegoat
I’m seeing more and more real estate agents believe that the inspection contingency is a “get out of jail free” card and are allowing their clients to break a contract using this clause. A good way to think about the inspection contingency is by comparing it to the more straightforward “appraisal contingency.”
With an appraisal contingency, the buyer may back out only if the appraisal is lower than the purchase price. If the buyer no longer wishes to purchase the property, the buyer can’t exercise the appraisal contingency as a means to get out of the contract. The buyer is bound to close escrow if the property appraises for the purchase price, and there is no leeway here. The same is true of the inspection contingency: If no previously undiscovered material defects turn up, the buyer can’t use it to back out of the contract.
Furthermore, every contract across the U.S. has an implied duty of good faith and fair dealing. In effect, this means you can’t evade the spirit of the bargain, lack diligence or slack off, perform incorrectly on purpose, or interfere with the other party's performance. Thus, if your clients are trying to avoid their duty to perform in a contract and use the inspection contingency as an excuse, they are in breach of the implied duty of good faith and, in turn, the entire contract. And as the agent representing them, you could potentially be liable for negligence and be putting your reputation on the line.
So, say your appraisal came back the same as the purchase price. No one in their right mind should pull out of the contract citing the appraisal contingency. The same goes for the inspection contingency.
How the Inspection Contingency Can Hurt the Seller
A buyer’s use of the inspection contingency may not always damage the seller — but it can. In a robust market, sellers may fetch an even better price from new buyers. If a seller obtains a higher price from a new buyer, the seller is less likely to complain about the previous buyer’s illegal cancellation and may return the deposit. But as the market slows down, and as housing prices start to dip, re-listing a property often means lower prices.
In the case mentioned above, the sellers were forced to put the property up for sale again, this time in a less favorable housing market, right before the Thanksgiving holiday. As a result, the sellers suffered a price cut and also incurred expenses due to the delay in the sale of their property while they searched for a second buyer. Because the sellers incurred damages, they made a demand to recover the buyers’ deposit, which resulted in a dispute between the parties and legal fees. Eventually, the sellers recovered some — not all — of the buyers’ deposit through a negotiated settlement.
Conclusion
Real estate brokers owe a fiduciary duty to their clients in connection with a purchase of a home. It would be a breach of that fiduciary duty to allow a client buyer to believe an inspection contingency can be exercised for just any reason in order to get out of a purchase contract. It is important that brokers explain to their client buyers when an inspection contingency may or may not be exercised. And whenever a client buyer wishes to terminate a purchase contract, it’s our job as the real estate broker to alert them of possible risks and encourage them to seek legal advice if they are concerned about the legal consequences of any termination of contract.
This article is purely informational and does not constitute legal advice. There may be different outcomes depending on the laws governing the particular state where the property is located.
Image courtesy of iStock.com/Drazen Zigic