Preliminary Agreement – A Legal Instrument Surrounded by Misunderstandings

The concept of a preliminary agreement (előszerződés) is as simple as can be: an agreement between the parties that they will conclude a contract with each other at a later date. Our article could end right here, if this simple concept were not the source of so many headaches in the preparation of real estate sale and purchase agreements.

What does a preliminary agreement oblige the parties to do?

Concluding a preliminary agreement is not just empty words, but a commitment that can even be enforced through the courts. If one party refuses without justification to conclude the final sale and purchase agreement, the other party may turn to the court. The court then creates the sale and purchase agreement on the terms set out in the preliminary agreement.

We always point out, however, that the possibility of enforcement through the courts is more a form of psychological pressure than a practical solution in the pragmatic sense, given the disproportionate costs involved and the unforeseeable length of the proceedings. Yet it is also a fact that even the theoretical existence of this option is an important weapon in out-of-court negotiations concerning a preliminary agreement.

Can a preliminary agreement be submitted to the land registry office? Can a preliminary agreement be registered in the real estate register?

One of the most important practical differences between a real estate preliminary sale agreement and a final sale and purchase agreement is that a preliminary agreement cannot be submitted to the land registry office (földhivatal). More precisely, it can be submitted to the land registry office. The postman will deliver it if that is what the address says. However, the poor preliminary agreement cannot produce any legal effect whatsoever in the real estate register (ingatlan-nyilvántartás).

A preliminary agreement cannot provide the buyer with the protective advantages of a real estate register “pending entry” (marginal note, széljegy), which would mean full protection of the property against multiple sales as well as against the registration of an encumbrance or an enforcement right. Therefore, when a preliminary agreement is concluded, one of the buyer’s most important considerations is that no money should change hands at all, or only the smallest possible amount. A good alternative may be depositing the earnest money in attorney escrow or, instead of earnest money, stipulating a penalty for frustration of the contract in the same amount as the earnest money, binding on both parties.

An even better solution than the above is not to conclude a preliminary agreement at all, and for the parties instead to sign the final real estate sale and purchase agreement straight away. As attorneys, we always examine to what extent it is justified to think in terms of a preliminary agreement. Even if genuine reasons for a preliminary agreement do arise, let us review whether there is an acceptable compromise that allows us to get rid of this legal stepchild.

Common misconceptions surrounding the preliminary agreement

A new enquiry often opens with the client saying they would like to instruct us to draw up both the preliminary agreement and then the real estate sale and purchase agreement. In the overwhelming majority of cases, this is merely a mistaken expression that has become entrenched in everyday language. The misunderstanding stems from thinking of the real estate sale and purchase agreement as a one-step act, in which the payment of the full purchase price is immediately accompanied by the handover of the property’s keys, with the registration of ownership following as a by-product. Everything that happens before that – handing over earnest money, arranging a loan and other excitements – is thought to fall under the umbrella of the preliminary agreement.

So as a first step – before we submit a quote for such a seemingly lucrative, complex engagement – it must be clarified what the reason for concluding a preliminary agreement is. In the overwhelming majority of cases, there is no special legal challenge involved, just the general misunderstanding described above. In reality, a preliminary agreement is needed only in quite exceptional cases.

When a preliminary agreement is definitely NOT the answer – earnest money, bank loan, encumbered property

In which cases is it actually not justified at all to think in terms of a preliminary agreement instead of a final sale and purchase agreement?

• In everyday language, the term preliminary agreement is often used in connection with earnest money (foglaló). In reality, earnest money can be handed over safely neither on the basis of a preliminary agreement nor on the basis of an “earnest money slip”, but solely and exclusively on the basis of a sale and purchase agreement worked out in every detail. Without one, the parties run an unnecessary – though unfortunately often unavoidable – risk when either the seller or the estate agent insists on signing a purchase offer or letter of intent to purchase labelled as a preliminary agreement, and on handing over earnest money at the same time.
• For a bank loan application, too, what you need is not a preliminary sale agreement but a final sale and purchase agreement. Not only is there nothing to prevent the loan from being regulated in the sale and purchase agreement – this is in fact an absolute and unquestionable precondition for taking out the loan.
• Nor is there any argument for a preliminary agreement in the case of an encumbered property. The process of the discharge of encumbrances on the property can be regulated in the sale and purchase agreement without any difficulty.

And when a preliminary agreement really is needed…

What are the rare cases in which it is genuinely justified to conclude a preliminary agreement instead of a final sale and purchase agreement?

• Concluding a preliminary agreement may be justified when a building plot is being purchased, but there is still some kind of structure on the plot and the plot’s official legal classification is not undeveloped land but, for example, a farm building or a weekend house with yard. The duty allowance available when undertaking to build on the land within 4 years can only be claimed if someone purchases undeveloped land. In this case, following the parties’ preliminary agreement – which relates, for example, to a property classified as a weekend house with yard – the seller has the building demolished and has the property reclassified as undeveloped land at the land registry office. After that, the parties can conclude the sale and purchase agreement, the subject of which will be undeveloped land, in line with the use of the duty allowance.
• Preliminary agreements are generally concluded in new-build projects, where the developer builds on an empty plot but contracts with the buyer for the finished condominium apartment. Although in such cases there would be no legal obstacle to concluding the final agreement straight away, it is more convenient for the developer to handle a preliminary agreement, which by its nature does not appear on the title deed (tulajdoni lap). A sale and purchase agreement appearing on the property’s title deed – which otherwise represents an important safeguard for the buyer – may create complicated legal-technical obstacles for the developer during the implementation of the project, when it comes to recording the building, registering the condominium, and handling the mortgage and other securities related to the project loan. Even if the buyer does not like this procedure, there is not much they can do about it.
• On income from the sale of a property, the seller is required to pay personal income tax, on a taxable portion of the income that decreases in bands, for 5 years from the acquisition of the property. For the purposes of when the income is earned, the date on which the sale and purchase agreement is submitted to the land registry office is decisive. Postponing this date until the next anniversary may mean a significant personal income tax saving for the seller. In such a case, if the seller does not want to miss out on a buyer who turns up a few weeks or one or two months before the anniversary, an acceptable compromise – with the appropriate safeguards already mentioned – may be to conclude a preliminary sale agreement and then conclude the final sale and purchase agreement after the anniversary.

Let us look at the formal and substantive requirements of a preliminary agreement

To be valid, a real estate preliminary sale agreement must meet the same formal requirements that the law prescribes for real estate sale and purchase agreements.

This is very easy to satisfy: the essential terms of the preliminary agreement must also be put in writing. Just as we saw with real estate sale and purchase agreements. Beyond this, there are no other requirements regarding the form of a preliminary agreement. So, for example, a preliminary agreement does just fine, thank you, without countersignature by an attorney or witnesses’ signatures.

Taking a lax approach to concluding a preliminary agreement is not advisable. This is because the parties can only demand that terms be included in the final sale and purchase agreement if they already agreed on them in the preliminary agreement. If a real estate preliminary sale agreement is a page and a half long, you should suspect that it does not meet this requirement. Since, after the preliminary agreement, concluding the final agreement requires the active cooperation of the parties and a new signature at a later date, it is important that there be no dispute between the parties regarding the terms of the final agreement, even if the final agreement is concluded months after the preliminary agreement.

Based on many years of experience, the only way to achieve this is if the preliminary agreement does not merely loosely outline the most important terms of the future sale and purchase agreement, but strictly contains the text of the final sale and purchase agreement word for word. In practice, the text of the final agreement can be an annex to the preliminary agreement, or it can even be inserted between quotation marks into the text of the preliminary agreement. The point is that, when the final agreement is concluded, the wording should no longer be up for negotiation; otherwise a falling-out and a bad aftertaste are guaranteed. And these are only the mildest consequences.