If you buy real estate, odds are you have paid an Earnest Money Deposit at some point in time. And if you haven’t yet, then you will eventually.
What is an Earnest Money Deposit?
Earnest Money Deposits (EMDs) provide the seller with confidence that a buyer is not wasting their time. EMDs are common at both county auctions and bank auctions on foreclosed properties. And they are usually anywhere from 2%-10% of the property’s purchase price.
The buyer will need to read the fine print carefully, but in some cases, they can get a refund for the full amount (often with a small cancellation fee) if they decide not to go forward with the property purchase. There may be stipulations to the situations allowing a refund, such as new information discovered during an inspection. However, you may be able to receive a refund for an EDM no questions asked (and the buyer could bargain for this before the payment of the EMD).
The title company or broker will hold the EMD until the time of the final purchase, at which point they will disburse to the seller and will reduce the amount of cash due from the buyer. As a general rule, you should not give an EMD directly to the seller at the risk they will not return it after a cancellation of the purchase.
How do I Account for an Earnest Money Deposit?
To think about accounting for EMDs, you must first classify it. While it may be tempting to classify an EMD as an Expense, it is actually an Asset. The definition of an asset is "something that will provide value in the future."
Although an EMD is no longer in your possession once paid, it will give you a direct value in the near future whether you purchase a property or whether you receive a refund of your EMD. When you pay the EMD, you are creating a Current Asset, and when you purchase the property, the EMD reduces your cash payment that is a reduction of a Current Asset.
To account for the EMDs, I prefer to use two different asset accounts named in some variation of this: “Earnest Money Deposits – In Process” and “Earnest Money Deposits - Purchased”. When the EMD is first paid out, it is added to the “EMD - In Process” account, but once the property is purchased, it is retroactively changed to be the “EMD – Purchased” account. This becomes helpful because you can use the “EMD – In Process” to quickly see all of the EMDs that are outstanding. By changing the EMDs once purchased, you can separate all pending purchases from those that have already taken place.
Why is it so important to track these?
While it is very important to track EMDs for every investor, it becomes vitally important for flippers and investors who are purchasing real estate on a large scale. It’s easy to take this for granted if your purchasing scale is small enough that you never miss an EMD, but once the business scales and there are multiple purchases taking place in a short amount of time, EMDs can be overlooked. Taking the time to account for EMDs correctly now will help you as you grow and save you headaches down the road.