8.3 Proration, Transfer Tax, and Investment Math
Key Takeaways
- Prorations split a shared cost between buyer and seller as of the closing date; the seller owns the day of closing in most exam conventions.
- Prepaid items credit the seller; accrued (unpaid) items credit the buyer.
- Transfer tax is computed per increment of value (commonly per $500 or per $1,000) on the sale price.
- Capitalization rate equals net operating income divided by value; rearrange to find any missing piece.
- Always state whether a proration uses a 360-day banker's year or a 365-day calendar year.
Proration basics
Proration divides a recurring cost — property taxes, HOA dues, prepaid rent, or interest — between buyer and seller based on who benefited during each part of the period. Two conventions appear on exams:
- 360-day (banker's) year: 12 months of 30 days each; divide annual cost by 360 for a daily rate.
- 365-day (calendar) year: use actual days; divide by 365.
Unless told otherwise, the standard exam assumption is the seller pays through and owns the day of closing.
A step-by-step proration method
Every proration follows the same four moves:
- Find the annual amount of the shared item.
- Divide by 360 or 365 to get the daily rate.
- Count the number of days each party is responsible for.
- Multiply days × daily rate, then decide who is credited and who is debited.
Mixing the day-count convention is a frequent trap: a $7,300 annual item is $20/day on a 365-day year but $20.28/day on a 360-day year. Read the problem for which year it specifies before dividing.
Prepaid vs. accrued
| Item type | Definition | Closing effect |
|---|---|---|
| Prepaid | Seller paid ahead (e.g., taxes paid in full) | Credit seller / debit buyer |
| Accrued | Owed but unpaid (e.g., taxes in arrears) | Credit buyer / debit seller |
Example (360-day year): annual tax $3,600 paid in arrears, closing June 30 (180 days elapsed). Daily rate = 3,600 ÷ 360 = $10. Seller owes 180 × $10 = $1,800 as a credit to the buyer, who will pay the full bill later.
Remember the direction logic: a credit increases what a party brings or takes away at the table, while a debit is a charge against that party. The seller's debit and the buyer's credit are equal and opposite for the same prorated item, so a proration is always a paired entry on the closing statement.
Transfer tax and recording charges
Transfer (conveyance) tax is charged per increment of the sale price. A typical setup: $1.00 per $500 of price, or a flat percentage.
Sale price $264,000 at $1.00 per $500: 264,000 ÷ 500 = 528 increments × $1.00 = $528. If the rate is per $1,000, divide by 1,000 instead.
Trap: round the number of increments up to a whole increment when a jurisdiction requires it, and confirm whether the figure is per $500 or per $1,000 — the two differ by a factor of two.
When transfer tax is quoted as a flat percentage instead of an increment, treat it like any other rate. A 0.5% transfer tax on a $264,000 sale is 264,000 × 0.005 = $1,320. Recording fees, by contrast, are usually flat dollar amounts per document and are not percentage-based — do not multiply them by the sale price.
Investment math: the cap rate
The capitalization rate ties a property's income to its value through one rearrangeable formula:
- Value = Net Operating Income (NOI) ÷ Cap rate
- NOI = Value × Cap rate
- Cap rate = NOI ÷ Value
NOI is income after operating expenses but before debt service and income tax. A property with $48,000 NOI at an 8% cap rate is worth 48,000 ÷ 0.08 = $600,000. Raise the cap rate and value falls; investors demanding higher returns pay less per dollar of income.
Building NOI correctly
Many cap-rate questions hide the work in computing NOI itself:
- Start with potential gross income (all units fully rented).
- Subtract vacancy and collection loss to get effective gross income.
- Subtract operating expenses (taxes, insurance, maintenance, management) to get NOI.
- Do not subtract mortgage payments, depreciation, or capital improvements.
Potential gross $80,000, less 5% vacancy ($4,000) = $76,000 effective; less $28,000 operating expenses = $48,000 NOI. Subtracting the loan payment here is the classic error that wrecks the cap-rate answer.
Cash flow, equity, and return on investment
Once NOI is set, the investor's own return depends on financing:
- Annual debt service = monthly payment × 12.
- Before-tax cash flow = NOI − annual debt service.
- Cash-on-cash return = cash flow ÷ cash invested (the down payment plus costs).
If NOI is $48,000 and debt service is $33,000, cash flow is $15,000. On a $150,000 cash investment, cash-on-cash return is 15,000 ÷ 150,000 = 10%. Note this differs from the 8% cap rate, because the cap rate ignores financing while cash-on-cash reflects the actual mortgage. Keep the two returns separate.
Yield, basis, and profit
- Gross rent multiplier (GRM) = Price ÷ annual (or monthly) gross rent — a quick comparison tool that ignores expenses.
- Percentage of profit/loss = (Sale price − Cost) ÷ Cost. A property bought for $200,000 and sold for $230,000 gained 30,000 ÷ 200,000 = 15%.
- Equity = Market value − loan balance.
Trap: percentage gain divides by the original cost (the base), not by the sale price. Dividing by the larger sale price understates the true return.
GRM problems run in both directions. If a $240,000 building rents for $2,000 a month, the monthly GRM is 240,000 ÷ 2,000 = 120; the annual GRM is 240,000 ÷ 24,000 = 10. Reverse it to estimate value: a comparable with an annual GRM of 10 and $30,000 yearly rent is worth 30,000 × 10 = $300,000. Always match the GRM to the same income period — monthly GRM with monthly rent, annual with annual.
Using a 360-day year, annual property taxes of $4,320 are unpaid (in arrears). The closing is at the end of the fourth month (120 days elapsed), with the seller responsible through closing. What is the proration credited to the buyer?
An income property generates $60,000 in net operating income and sells at a 7.5% capitalization rate. What is its indicated value (rounded to the nearest thousand)?