Condominium Law Alert: New Washington Legislation Allows Condominium Developers to Use Earnest Money Deposits Towards Construction Costs

Washington recently enacted SB 5024 (the “Bill”), which allows developers to use earnest money deposits towards construction costs in certain circumstances. The Bill will become effective on July 25, 2021.

Under the new law, if (1) a purchase agreement discloses that earnest money deposits may be used for construction costs, and (2) the developer obtains a surety bond, then the developer may withdraw funds from escrow when construction has begun. The bond must be in an amount adequate to cover the amount of the earnest money deposit withdrawn, and the developer cannot withdraw more than the face amount of the bond. The developer can either obtain an individual bond for each deposit accepted by the developer, or a blanket bond ensuring the return of all deposits received by the developer. Earnest money deposits utilized under the Bill may not exceed five percent of the purchase price.

By allowing developers to access additional sources of funds, the Bill intends to decrease development costs and increase the supply of affordable housing. However, as written, the Bill appears to create certain unintended consequences.

First, the Bill seems to require that all deposits of any type — including customization deposits — must be held in escrow. Current Washington law only requires two types of deposits to be held in escrow: “earnest money deposits” and “reservation deposits.” Under RCW 64.04.005(2)(a), an earnest money deposit means “any deposit … for the purpose of binding the purchaser to the agreement and identified in the agreement as an earnest money deposit, and does not include other deposits or payments made by the purchaser.” (Emphasis added.) Under current law, other deposits need not be held in escrow and could be released to developers before closing. Unfortunately, the new Bill states that any deposit (not just an earnest money deposit or reservation deposit) must be placed in escrow and may not be used without bonding.

Second, the Bill appears to cap all deposits at five percent of the purchase price. The Bill states that “[a] deposit under this section may not exceed five percent of the purchase price.” It’s unclear whether the sentence caps a released deposit at five percent, caps each deposit at five percent (regardless of whether it is released), or caps the aggregate of all deposits at five percent. Under current Washington law, there is no cap on earnest money deposits. Earnest money deposits of five percent or less are immune to certain challenges under Washington’s “safe harbor” statute, RCW 64.04.005, and are presumptively a reasonable estimate of damages (and therefore enforceable). Larger earnest money deposits are allowed but are subject to case law regarding enforceability. By saying that “[a] deposit” “may not exceed five percent of the purchase price” the Bill appears to prohibit any deposit in excess of five percent of the purchase price (which is a very common practice in the condominium market). Our best guess is that the legislature only intended to limit the amount that could be released, rather than the amount that could be collected. Unfortunately, this is a consumer protection statute and may be interpreted broadly.

It remains to be seen if developers will use this new tool. Our sources tell us that the bonds are not likely to be expensive but that the headache associated with separate bonds for each buyer will be significant. Second, the five percent limit means that this tool is only likely to be attractive for large projects.

Although the Bill presents new opportunities for developers, it also introduces potential ambiguities and unintended consequences. It will be critical for developers who want to use the new law to draft their sales documents with care. If you have any questions, please contact us. We will be monitoring how this Bill is implemented and would be happy to discuss any parts of the new law that may apply to your situation.