FINANCIAL SETTLEMENT OF THE
TRANSACTION

Settlement process

Selling terms and closing costs

Debits and credits

Prorated items

Computing prorations

 

Settlement process   

The process of settlement consists of five basic steps:

  1. Identify selling terms and closing costs.
  2. Determine non-prorated debits and credits.
  3. Determine prorated debits and credits.
  4. Complete the closing statement.
  5. Disburse funds.

Selling terms and closing costs              

Selling terms are the price of the property, the buyer’s deposit and downpayment, and the terms and amounts of the buyer’s financing arrangements. Closing costs are final expenses that buyer or seller must pay at closing to complete the transaction. The sale contract identifies all selling terms and who pays which costs. The apportionment of expenses is subject to negotiation, and in the absence of a specific agreement, is determined by custom. Closing costs include such items as brokerage fees, mortgage-related fees, title-related expenses, and real estate taxes.

Debits and credits      

The closing statement accounts for the debits and credits of the buyer and seller to settle and complete the transaction. A debit is an amount that one party must pay at closing or has already paid prior to closing. A credit is an amount that a party must receive at closing or that has already been received prior to closing.

The excess of the buyer’s debits over the buyer’s credits is the amount the buyer must bring to the closing. The excess of the seller’s credits over the seller’s debits is the amount the seller will receive at closing.

An individual expense item that one party owes to a party unrelated to the transaction, such as an attorney or the state, is treated as a debit to that party only. An income or expense item that affects both parties is apportioned, or prorated, to each party to reflect the proper amount that each owes or should receive. A prorated item is treated as a debit to one party and a credit to the other party for the same amount.

Prorated items            

Non-prorated items. Non-prorated items are costs incurred by one party only. Items not prorated include those listed in the next exhibit.

Non-Prorated Items

Buyer usually paysSeller usually pays
Mortgage recording feesStamp tax on deed
Documentary stamp taxTitle insurance
Intangible tax on mortgageBrokerage fee
Mortgage-related fees: appraisal, credit, survey, loan originationInspection fees Title-related expenses
Impound reserves: insurance, taxesAttorney fees
Attorney fees 

Prorated items. Many of the items to be settled at the closing are partly the responsibility of the buyer and partly of the seller. Some are expense items that the seller has paid in advance, where the buyer owes the seller part of the expense. Some are income items that the seller received in advance, and the seller owes the buyer a part of the income. Others are items the buyer will have to pay in arrears, and the seller owes the buyer part of the expense. The method of dividing financial responsibility for such items is proration. With a prorated item, there is always a debit to one party and a corresponding credit for the same amount to the other party.

Items paid in advance. At the time of closing, the seller has paid some items in advance that cover a period of time that goes beyond the closing date. In effect, the seller has prepaid some of the buyer’s expenses, and the buyer must reimburse the seller. Heating oil and natural gas are typical items. By the same token, the seller of a rental property may have received rent or rental deposits in advance, and must reimburse the buyer for the part that belongs to the buyer.

For an expense the seller paid in advance, the buyer receives a debit and the seller receives a credit.

For income the seller received in advance, the buyer receives a credit and the seller receives a debit.

Items paid in arrears. At the time of closing, the seller has incurred certain expenses that have not been billed or paid at the time of closing and that the buyer will have to pay later. A typical item is real estate taxes.

For an item the buyer will pay in arrears, the buyer receives a credit and the seller receives a debit.

Items Paid in Arrears and Advance

        arrears    advance
  real estate taxes           x   
  mortgage interest           x   
  rents received by seller              x
  utilities           x   

Charging shares. If the seller has paid the buyer’s share of an item, charge the buyer for the buyer’s share of the period (e.g., utilities). If the buyer will pay the seller’s share of an item, charge the seller for the seller’s share of the period (e.g., taxes). If the seller has received the buyer’s share of an income item, charge the seller for the buyer’s share of the period (e.g., rent).  

Computing prorations                   

The primary methods of calculating prorations are the 360/30-day method, which computes prorations on the basis of a 360-day year and 30-day month, and the 365-day method, which computes prorations on the basis of a 365-day year. The 360/30-day method is commonly used for prorating mortgage interest. Either method may be used for real estate taxes, depending on local practice.

It is customary in Florida that the seller owns the property up to midnight of the day before the closing date unless stated otherwise in the contract. Thus the closing day is apportioned to the buyer in computing prorations. The method of prorating, if not specified in the contract, will follow local custom.

 12-month / 30-day method. The 12-month/30-day method determines an average daily rate of payment for an item to be prorated based on a 30-day month and a 360-day year. The method consists of the following steps for annual and monthly items.

Annual items

  1. Identify the total amount to be prorated.
  2. Divide this amount by 12 to obtain an average monthly rate.
  3. Divide the monthly rate by 30 to obtain an average daily rate.
  4. Multiply the monthly amount times the seller’s number of months of ownership in the year of the sale up to the month of closing. For the month of closing, multiply the seller’s number of days of ownership times the daily amount and add the result to the previous result. The final result is the seller’s pro rata share of this item.
  5. The buyer’s pro rata share of an item is the total amount less the seller’s pro rata share.

Monthly items

  1. Identify the total amount to be prorated.
  2. Divide this amount by 30 to obtain the average daily amount.
  3. Multiply the daily amount times the seller’s number of days of ownership. The result is the seller’s pro rata share of this item.
  4. The buyer’s pro rata share of an item is the total amount less the seller’s pro rata share.

Prorating Annual Item: Real Estate Tax

12-month/30-day Method

A sale transaction on a single-family house closes on March 2. County taxes for the previous year, to be paid in arrears, amount to $1,730. The seller owns the house through the day of closing. What are the seller’s and buyer’s prorated shares of this item?

  
Total amount due: =$   1,730.00
Monthly amount:1,730 ÷ 12=$      144.17
Daily amount:144.17 ÷ 30=$          4.81
Seller’s share:144.17 x 2 mo.=$      288.34
 4.81   x 2 days= $          9.62
 288.34 + 9.62=$      297.96
Buyer’s share1,730 – 297.96=   $   1,432.04

Closing statement entries. The seller will be charged for the seller’s share of the proration; an amount of $297.96 will be entered as a debit to the seller and a credit to the buyer because the buyer will have to pay the seller’s share when the tax bill is received.

Prorating Monthly Item: Rent Received

12-month/30-day Method

The house in the previous example has been rented during the listing and selling period at a rate of $1800 per month. Rent for the month of March was paid to the seller on March 1. What is the buyer’s prorated share of this rent? The day of closing, March 2, belongs to the seller.

    
Total  received: =$   1,800.00
Daily amount:1800 ÷ 30=    $        60.00
Seller’s share:60.00 x 2 days=$      120.00
Buyer’s share1800.00 – 120.00=   $   1,680.00

Closing statement entries. The seller will be charged for the buyer’s share of the proration; an amount of $1,680.00 will be debited to the seller’s account and credited to the buyer’s account because the seller has received rent that belongs to the new owner after closing.

365-day method. The 365-day method uses the actual number of days in the calendar. The steps in the calculation are the same for annual and monthly prorations. The steps are:

  1. Identify the total annual or monthly amount to be prorated.
  2. For an annual proration, divide the total amount by 365 to obtain a daily amount (366 in a Leap Year). For a monthly proration, divide the total amount by the actual number of days in the month to obtain the daily amount.
  3. Multiply the daily amount times the seller’s number of days of ownership. The result is the seller’s pro rata share of the item.
  4. The buyer’s pro rata share of an item is the total amount less the seller’s pro rata share.