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What Is Retainage in Construction (& Why Is It Important)?

By Roy Rasmussen Reviewed By Erin Ryan
By Roy Rasmussen
By Roy Rasmussen Reviewed By Erin Ryan

Retention or retainage in construction is a portion of the money owed for a building project. This money is withheld until the substantial completion of the project. A retention payment is an incentive for contractors and subcontractors to finish a project. 

Let’s explore more details about what retainage means and what retainage in construction is all about, including how it can affect financial planning and what rules govern retainage fees.

What Is the Purpose of Retainage in Construction?

Retainage in construction contracts serves several purposes. Though it primarily benefits property owners, who can withhold a retainage fee from general contractors, contractors hiring other parties for labor or materials benefit as well.

How?

  • By including a retention guarantee in construction contracts, property owners and contractors incentivize other parties involved in the project to complete work on time.
  • Retainage gives property owners and contractors leverage in the event a project gets held up by lien claims from another party.
  • Property owners and contractors may use money withheld for retainage to finance projects, supplementing cash flow.

These benefits can make retainage agreements advantageous to property owners and general contractors.

How Retainage Affects Contractors

On the other side of the coin, those having retainage withheld from them may find their cash flow suffers as a result. For example, contractors with retainage withheld by property owners may in turn withhold retainage from subcontractors, delaying retainage payments to subcontractors until payments are received from property owners.

Alternatively, contractors may withhold more retainage from subcontractors to compensate for payments they’re waiting on themselves.

In light of this, many contractors and subcontractors charge higher rates or take other measures to offset retainage. This makes factoring in retainage a critical part of planning construction financing to avoid cash shortages.

A construction contractor wearing a hard hat is handed a stack of cash.

How Does Retainage Work in Construction?

The amount of retainage withheld may be based on a percentage of a total contract fee or on a percentage of partial payments known as progress payments. While retainage is often withheld at a rate of 5%-10%, it may be withheld from each payment as a partial or variable percentage until project completion, or it may be withheld differently for different line items. 

For example, a contract may stipulate subcontractors who complete their work early may receive their retainage payment when their contribution to the project achieves a designated benchmark. Typically, retainage is released when a project is considered substantially complete, meaning the property owner can take possession of the project or assume its use and occupation. Alternatively, the project may be released when it achieves another designated milestone stipulated in the construction contract.

Retainage Laws

Laws governing retention in construction vary by state. In some states, retainage is mandatory, but not in others. In some instances, property owners and contractors must reduce retainage rates or eliminate retainage after a certain amount of a project has been completed.

A number of states allow retainage funds to be held in escrow and repaid with interest. Additionally, certain states allow contractors and subcontractors to use securities instead of retainage.

How to Calculate Retainage in Construction

As mentioned, withholdings are often incremental and deducted from each installment payment. That is, when contractors receive their progress payments throughout the course of the project, the retainage fee percentage is held back each time.

For example, let’s say the retainage fee for an entire project is 10%, and the total cost of the job is $250,000. In this instance, $25,000 will have been withheld when all is said and done. However, if the client were to make a partial payment of $10,000, the amount withheld as the retainage fee would be $1,000, which is 10% of the installment. 

If the client continued to pay $10,000 per installment, it would take 25 installments to meet the total project cost of $250,000. Calculating the retainage over the course of the project would give you $25,000. In other words, each holdback of $1,000 multiplied 25 times would equal $25,000, or 10% of the total project cost of $250,000.

Bookkeeping: Retainage Receivable vs. Payable

When recording retainage for bookkeeping, it’s important to distinguish between retainage receivable and retainage payable. 

For a contractor, retention receivable construction funds consist of money that the contractor is owed by the property owner upon completion of a project. 

In contrast, retention payable funds consist of money that the contractor is obligated to pay subcontractors for retainage. 

These different categories of retainage should be recorded distinctly on your financial statements to keep your books accurate.

What Are the Rules of Retainage in Construction?

In general, retainage rules are governed by whatever the parties involved in a building project agree to in their construction contract. However, individual states may set varying restrictions on what types of retainage agreements are allowed. States also may issue penalties for violations of retainage regulations. 

For example, state regulations may set maximum retainage rate caps, prescribe conditions when retainage must be released and establish interest penalties when retainage caps are exceeded.

For federal contractors, retainage rules are governed by the Federal Acquisition Regulation (FAR), the set of regulations governing the procurement of U.S. government contracts. Under the FAR, the Code of Federal Regulations Title 48 Section 52.232-5 stipulates that progress payments normally should be made in full, with retainage reserved for cases where satisfactory progress has not been achieved and capped at 10%.

A stack of money rests next to a hard hat.

How Long Should Retainage Be Withheld?

Your construction contract retention provisions determine how long retainage should be withheld, subject to any applicable regulatory restrictions. With typical contracts, retainage is withheld until the project is substantially completed.

For practical purposes, this means retainage may be withheld for months and, in some cases, can be as long as a year.

What Happens When Someone Won’t Release Retainage Payments?

Say a party on a construction project won’t release their retainage payment to you. If so, the first step is to verify the work is complete. 

Providing documentation of task completion throughout the project can put you in a stronger position to:

  • Demonstrate project completion
  • Negotiate retainage release

Claiming a Mechanic’s Lien

If this fails to trigger retainage release, you may need to exercise your right to claim the property as collateral for unpaid payments. This process is known as claiming a mechanic’s lien. A lien is a claim against a property title asserting the right to sell the property as collateral to pay for unpaid debts. Such a claim puts the title to the property in dispute, making it difficult to refinance or sell. 

This provides a strong incentive for property owners and others involved in the payment chain to get retainage disputes settled.

Before you can claim a lien, you may have to first follow some preliminary procedures. At the start of a project, a best practice is to send a notification called a preliminary notice that establishes your right to declare a lien in the event of nonpayment. In some states under specific conditions, this may be required in order for you to declare a lien later.

When nonpayment happens, a best practice is to send a notice of intent to lien announcing that you will exercise your right to declare a lien if payment is not received by a deadline. In some states, this is required before you can declare a mechanic’s lien.

How Can You Negotiate Retainage in Construction Contracts?

Now that you know the definition of retainage in construction and how it affects the parties involved, learn how to reduce the risk of late retainage payments and negotiate more favorable retainage clauses into your construction contract. 

Have your attorney review your contract and consider the following:

  • Is your contract in conformity with applicable state regulations?
  • Will your retainage be held in escrow?
  • What percentage of retainage will be withheld?
  • Will withheld retainage earn interest, and if so, who’s entitled to it?
  • What are the conditions for the release of your retainage?
  • Can another project participant use retainage funds to compensate for unsatisfactory workmanship claims?
  • Can the property owner use retainage funds to offset collateral claims against the property for unpaid payments (known as discharging a lien claim)?

Identify items you’re concerned about and consider negotiating them with your client. You may be able to offer an alternative to retainage, such as a letter of credit, surety bond or retainage bond.

Roy Rasmussen Contributing Writer for Fast Capital 360
Roy is a respected, published author on topics including business coaching, small business management and business automation as well as an expert business plan writer and strategist.
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