8.3 Proration, Transfer Tax, and Investment Math
Key Takeaways
- Proration splits shared costs by days owned: find the daily rate, count the days, multiply, and respect the stated 360-day versus 365-day convention.
- Prepaid expenses credit the seller and debit the buyer; arrears expenses do the reverse, so decide prepaid vs. arrears before assigning the credit.
- Transfer tax applies a rate per $500 or per $1,000 of sale price; read the unit carefully and round units up if the jurisdiction taxes any fraction as a full unit.
- Cap rate links net operating income to value (Value = NOI / Cap Rate), and NOI is income after operating expenses but before debt service.
- GRM uses gross rent while cap rate uses NOI; never mix the two income figures.
Settlement and investment math
The final cluster of exam math covers what happens at closing and how investors evaluate property. Proration splits ongoing costs fairly between buyer and seller, transfer tax applies a per-unit rate to the sale, and investment math measures whether a property earns its keep. Each uses a clear formula, but each also carries a signature trap about who owes what and which value the rate applies to.
How proration works
Proration divides a shared expense or income based on the days each party owns the property. The seller pays through the day of closing on most exams (confirm the convention given in the question).
The standard steps are:
- Find the daily rate: Annual Amount / 360 (banker's year) or / 365 (calendar year).
- Count the days that belong to one party.
- Multiply daily rate x days = that party's share.
The exam usually states whether to use a 360-day or 365-day year. Read carefully, because the choice changes the daily rate.
Worked proration example
Annual property taxes are $3,600, already paid by the seller for the full year. Closing is on September 1 using a 360-day year (30 days per month). The buyer owns the property for the remainder of the year and must reimburse the seller.
- Daily rate = 3,600 / 360 = $10 per day.
- Buyer's days = September through December = 4 months x 30 = 120 days.
- Buyer reimburses seller = 10 x 120 = $1,200.
This appears on the settlement statement as a debit to the buyer and a credit to the seller.
Debits and credits, the proration trap
The direction of a proration depends on whether the expense was prepaid or is owed in arrears.
| Situation | Buyer | Seller |
|---|---|---|
| Seller prepaid taxes | Debit (reimburses seller) | Credit |
| Taxes owed in arrears | Credit (will pay later) | Debit |
The exam tests whether you know who gets the credit. A prepaid expense favors the seller; an unpaid expense the seller used favors the buyer. Decide prepaid vs. arrears before assigning the credit.
Transfer tax and recordation
Transfer tax is charged on the sale price, usually as a rate per $500 or per $1,000 of value. Read the unit carefully.
- Number of taxable units = Sale Price / Unit Size.
- Transfer tax = Units x Rate per unit.
Example: a $400,000 sale taxed at $1.50 per $500 has 400,000 / 500 = 800 units, so the tax is 800 x 1.50 = $1,200. If the same property were taxed per $1,000, there would be 400 units. Always round the unit count up if the local rule taxes any fraction as a full unit, as many jurisdictions do.
Investment math: capitalization rate
Investors value income property with the cap rate, linking net operating income (NOI) to value.
- Cap Rate = NOI / Value.
- Value = NOI / Cap Rate.
- NOI = Value x Cap Rate.
NOI is income after operating expenses but before debt service (mortgage payments) and income tax. Example: a property with $48,000 NOI valued using an 8% cap rate is worth 48,000 / 0.08 = $600,000. A lower cap rate implies a higher price for the same income, signaling a lower-risk market.
Gross rent multiplier and basic return
The gross rent multiplier (GRM) is a quick screen that ignores expenses: GRM = Sale Price / Gross Annual (or Monthly) Rent. A $500,000 property renting for $50,000 a year has a GRM of 10.
For an investor's cash return, divide annual cash flow by cash invested. If a buyer puts $100,000 down and nets $8,000 in annual cash flow after debt service, the cash-on-cash return is 8,000 / 100,000 = 8%. Note that GRM uses gross rent while cap rate uses NOI; mixing the two is a common error.
Worked Example: Transfer Tax, Equity, and Investment Return
Transfer (conveyance) tax is charged per increment of price; if a jurisdiction charges $1.10 per $1,000 of value, a $640,000 sale owes 640 x $1.10 = $704. Always divide the price by the increment first, then multiply by the rate.
Equity equals market value minus the debt against the property: a home worth $850,000 with a $520,000 mortgage carries $330,000 of equity. Capitalization rate ties income to value: cap rate = net operating income / value, so a building with $60,000 NOI valued at $750,000 has a cap rate of 8%. Return on investment measures performance: an investor who nets $42,000 annually on $600,000 invested earns 7% ($42,000 / $600,000). To find value from a desired return, divide income by the rate: to earn 9% on $54,000 of income, an investor would pay no more than $54,000 / 0.09 = $600,000.
Annual property taxes of $4,380 were prepaid by the seller using a 365-day year. Closing occurs with 73 days remaining in the year, all belonging to the buyer. How much does the buyer owe the seller, and how is it entered?
An income property generates $36,000 in net operating income and the market cap rate is 9%. What is the indicated value?
keyTakeaways
- Proration splits shared costs by days owned; find the daily rate, count days, multiply, and respect the 360 vs. 365 day convention.
- Prepaid expenses credit the seller and debit the buyer; arrears expenses do the reverse.
- Transfer tax applies a rate per $500 or per $1,000 of sale price; read the unit and round units up if required.
- Cap rate links NOI to value (Value = NOI / Cap Rate); NOI is before debt service.
- GRM uses gross rent and cap rate uses NOI; never mix the two income figures.
Summary
Settlement and investment math close out the national-portion calculations. Proration is a days-owned split whose direction depends on prepaid versus arrears; transfer tax is a per-unit rate on sale price; and investment value flows from NOI through the cap rate. The traps are reversing debits and credits, misreading the transfer-tax unit, and confusing gross rent with net operating income. Anchor each problem on its formula, identify the correct base value, and the closing-statement and investment items become routine.