8.3 Proration, Transfer Tax, and Investment Math

Proration Fundamentals

Proration divides a shared expense or credit between buyer and seller based on the portion of the period each one owns the property. Common prorated items include property taxes, mortgage interest, rent, and HOA dues.

Three-Step Proration Method

1. Find the daily (or monthly) rate by dividing the annual amount by the number of days (or months).
2. Count the days owned by the responsible party up to or from closing.
3. Multiply the rate by the days to find each party's share.

Day-Count Conventions

Most licensing exams use a 360-day banker's year with 30 days per month. Some problems specify a 365-day (statutory) year. Always use the convention the question states; do not assume.

Arrears vs. Advance

• Paid in arrears (e.g., most property taxes): the seller owes the buyer for days the seller owned but has not yet paid.
• Paid in advance (e.g., rent, some HOA dues): the seller has already paid, so the buyer reimburses the seller for the unused portion.

Tax Proration Example

Annual taxes are $3,600, paid in arrears, and closing is on the last day of the 6th month (180 days into a 360-day year). Daily rate = 3,600 / 360 = $10. The seller owes the buyer 180 x 10 = $1,800 as a credit to the buyer and a debit to the seller.

Rent Proration Example

Monthly rent of $1,500 is collected in advance on the 1st, and closing is on the 16th of a 30-day month. The seller has collected rent for the full month but owns the property only through the 15th. The buyer is entitled to days 16-30, which is 15 days. Daily rent = 1,500 / 30 = $50. The seller credits the buyer 15 x 50 = $750.

Transfer and Conveyance Taxes

A transfer tax (also called a conveyance or documentary tax) is charged when title transfers, usually as a rate per fixed dollar unit of the price.

Transfer Tax = (Taxable Price / Tax Unit) x Rate per Unit

Transfer Tax Example

A state charges $1.50 per $500 of sales price. A home sells for $325,000. Number of units = 325,000 / 500 = 650. Tax = 650 x 1.50 = $975.

If the price does not divide evenly into the unit, round up to the next whole unit before multiplying. A $325,200 price still uses 651 units (325,200 / 500 = 650.4, rounded up).

Who Pays the Transfer Tax

The party responsible for transfer tax varies by jurisdiction and is a state-portion detail, but the national math is identical: divide the taxable price by the tax unit, round up, then multiply by the rate. Some states exempt the first portion of the price or treat refinances differently, so read the fact pattern for the taxable base before dividing.

Investment Math: NOI and Capitalization

Net operating income (NOI) is the income a property produces after operating expenses but before mortgage payments (debt service) and income taxes.

NOI = Effective Gross Income - Operating Expenses

NOI Example

A building collects $90,000 in effective gross income with $34,000 of operating expenses. NOI = 90,000 - 34,000 = $56,000. A $20,000 annual mortgage payment is not subtracted, because debt service is excluded from NOI.

The Capitalization Formula

The IRV triangle ties Income, Rate, and Value together:

• Value = NOI / Cap Rate
• Cap Rate = NOI / Value
• NOI = Value x Cap Rate

Cap Rate Example

With NOI of $56,000 and a market cap rate of 7%, Value = 56,000 / 0.07 = $800,000. If two buildings have equal NOI, the one with the lower cap rate carries the higher value and lower perceived risk.

Other Investment Measures

• Gross Rent Multiplier (GRM) = Sales Price / Gross Annual (or Monthly) Rent; a quick screening tool, not a precise value.
• Equity = Market Value - Loan Balance.
• Return (cash-on-cash) = Annual Cash Flow / Cash Invested.

GRM Example

A fourplex sells for $640,000 and produces $80,000 in gross annual rent. GRM = 640,000 / 80,000 = 8. To estimate value for a similar building renting at $75,000 per year, multiply: 75,000 x 8 = $600,000. GRM ignores expenses, so it only screens comparable properties; it never replaces a cap-rate analysis.

Common Exam Traps

• Subtracting mortgage payments from NOI; debt service is excluded.
• Using the wrong day count; follow 360 vs. 365 as stated.
• Forgetting to round transfer-tax units up to the next whole unit.
• Confusing GRM (uses gross rent and price) with cap rate (uses NOI and value).

Building the Effective Gross Income

NOI starts above the expense line with income, not the rent roll alone. Begin with potential gross income (all units fully rented), subtract a vacancy and collection loss allowance, then add any other income such as laundry or parking to reach effective gross income (EGI).

EGI Worked Example

Twelve units rent for $1,000 each per month, giving potential gross income of 12 x 1,000 x 12 = $144,000 per year. A 5% vacancy allowance is 144,000 x 0.05 = $7,200. Add $3,000 in laundry income: EGI = 144,000 - 7,200 + 3,000 = $139,800. Subtract operating expenses from this figure, not from potential gross income.

Depreciation for Tax (Cost Recovery)

Investors recover the cost of income-property improvements through straight-line depreciation: annual deduction = depreciable basis / recovery period. Residential rental uses a 27.5-year period and commercial uses 39 years; land is never depreciated. A building with a $275,000 depreciable basis yields 275,000 / 27.5 = $10,000 of annual depreciation. This is a tax concept and does not reduce NOI.

Settlement Debits and Credits

At closing, a prorated item is a debit to one party and a credit to the other. A tax credit to the buyer is the mirror debit to the seller, which keeps the settlement statement balanced. Identify the direction of each proration before assigning dollars.