8.3 Proration, Transfer Tax, and Investment Math
Key Takeaways
- Daily proration rate = annual cost / 360 (banker's year) or / 365; always use the method the question states.
- Accrued unpaid expenses debit the seller and credit the buyer; prepaid expenses credit the seller and debit the buyer.
- Transfer tax = taxable consideration / unit size x rate per unit; round consideration up to the next whole unit.
- Net to seller = sale price - seller costs; cost to buyer = sale price + buyer costs.
- ROI = annual profit / investment; GRM = price / gross annual rent, so value = GRM x gross annual rent.
Settlement math allocates shared costs between buyer and seller as of the closing date, and investment math measures how well a property performs. Both reward careful unit tracking. For prorations, the first task is always to identify the day-count convention the problem specifies.
Prorations
A proration splits a recurring cost between the parties based on who owns the property on each day.
Daily Rate = Annual Cost / 360 or 365.
- The 360-day (banker's) year treats every month as 30 days and is common on exams.
- The 365-day (actual) year counts real calendar days.
Example: Annual taxes are $3,600 using a 360-day year. Daily rate = 3,600 / 360 = $10/day. If the seller owned the property for 120 days before closing, the seller's share = 120 x 10 = $1,200.
Debits and Credits at Closing
A debit increases what a party owes; a credit decreases it. The direction depends on whether the expense was prepaid or has accrued.
| Situation | Seller | Buyer |
|---|---|---|
| Taxes unpaid (accrued) | Debit (seller owes for days owned) | Credit |
| Taxes prepaid by seller | Credit (seller is reimbursed) | Debit |
| Buyer assumes a security deposit | (no change) | Credit |
The rule of thumb: whoever consumed the benefit pays for it.
Proration Worked Example
Annual taxes of $2,920 are unpaid and the closing is on day 90 of a 365-day year.
Daily rate = 2,920 / 365 = $8/day. Seller's accrued share = 90 x 8 = $720.
Because the taxes are unpaid, the seller is debited $720 and the buyer is credited $720, since the buyer will pay the full bill later but only owned the property after closing.
Annual property taxes are $3,650 and remain unpaid. Using a 365-day year, closing occurs on day 100. Which entry is correct for the unpaid taxes?
Transfer (Conveyance) Tax
Many jurisdictions impose a transfer tax on the consideration paid, quoted as a rate per unit of value (for example, $0.50 per $500). The general method:
- Take the taxable consideration (often the sale price, sometimes less assumed debt).
- Divide by the unit size, rounding up to the next whole unit.
- Multiply the number of units by the rate per unit.
Transfer Tax Worked Example
A home sells for $312,500 and the transfer tax is $0.75 per $500 of price.
Units = 312,500 / 500 = 625 units (a whole number, no rounding needed). Tax = 625 x 0.75 = $468.75.
If the price were $312,600, divide by 500 to get 625.2, round up to 626 units, then 626 x 0.75 = $469.50. Always round the number of taxable units up before multiplying.
Net to Seller and Cost to Buyer
These summarize the closing statement.
- Net to Seller = Sale Price - Seller Costs (commission, transfer tax, payoff, prorations owed).
- Cost to Buyer = Sale Price + Buyer Costs (loan fees, title, escrow, prepaids).
Example: A $400,000 sale with $30,000 of seller costs nets 400,000 - 30,000 = $370,000. A buyer with $11,000 of closing costs pays 400,000 + 11,000 = $411,000.
Investment Performance
Three quick metrics appear on the national exam.
- ROI = Annual Profit / Investment. $14,000 profit on $140,000 invested = 10%.
- Cash-on-cash return = Annual Before-Tax Cash Flow / Cash Invested. $12,000 cash flow on $100,000 cash invested = 12%.
- Gross Rent Multiplier (GRM) = Price / Gross Annual Rent. A $540,000 property with $60,000 gross annual rent has a GRM of 9; reversing it, Value = GRM x Gross Annual Rent.
An investor wants a property valued using a gross rent multiplier of 8. If the property's gross annual rent is $75,000, what value does the GRM indicate?
Equity, Capitalization, and Percentage Change
Equity = market value minus debt. A home worth $400,000 with a $260,000 mortgage balance carries $400,000 - $260,000 = $140,000 of equity.
Capitalization (solving for value): A property's NOI is $36,000 and the market cap rate is 9%. Value = NOI / rate = $36,000 / 0.09 = $400,000.
Percentage change: A property bought for $250,000 and sold for $300,000 gained $50,000. Percent gain = $50,000 / $250,000 = 20%. Always divide the change by the original (smaller, earlier) figure, not the sale price.
Exam trap: For profit percentage, the denominator is what you started with (cost), not what you sold for. Dividing by the sale price understates the gain.
Cash Flow, Cap Rate, and Loan Constant
Investment questions extend beyond simple equity. Build the numbers in order:
- Before-tax cash flow = NOI minus annual debt service (the loan's yearly principal and interest).
- Cash-on-cash return = before-tax cash flow divided by the cash invested (the down payment plus costs).
Worked example: A property's NOI is $48,000 and annual debt service is $30,000, so before-tax cash flow is $48,000 - $30,000 = $18,000. If the investor put in $150,000 cash, the cash-on-cash return is $18,000 / $150,000 = 12%.
Worked example (transfer tax recap): On a $400,000 sale at a combined state-plus-municipal conveyance rate of 1.0%, the conveyance tax is $400,000 x 0.01 = $4,000, paid by the seller. Always apply the rate to the sale price, and remember the conveyance tax is a seller cost in Connecticut.
Exam trap: Cap rate uses NOI (before financing); cash-on-cash return uses cash flow after debt service. Do not mix the two bases.
Depreciation and Basis (Investment)
For income property, the IRS allows annual cost-recovery (depreciation) on the improvements only, never the land. Residential rental improvements are depreciated over 27.5 years. A $275,000 building (land excluded) yields $275,000 / 27.5 = $10,000 of annual depreciation, a paper deduction that shelters cash flow.
Exam trap: Only improvements depreciate for tax purposes; land is never depreciated because it is considered to last indefinitely.