Real Estate Closing; Real Estate Settlement Procedures Act (RESPA); Prorations

Real estate closing is the transfer of the real estate title from seller to buyer according to the sales contract—the buyer receives the title to the real estate and the seller receives the money. However, there are numerous requirements and costs associated with closing that make it more complex than buying something at a store. Both requirements and costs result from the sales contract itself, from tradition and local custom, and from local, state, and federal laws.

Preclosing Procedures

Right before the closing, the buyer will want to be sure that everything is in order. The buyer should inspect:

Most sales contracts allow the buyer to make a final inspection, or walk-through, of the property right before closing, usually with the broker, to ensure that the property has been maintained, that agreed-upon repairs were made, or that there were no other significant alterations of the realty that were not planned.

So that the buyer will know the exact boundaries of the property, a survey is usually done, which also shows the placement of buildings, driveways, fences, and other significant landmarks, and will also show any encroachments from or to adjoining property. Sometimes the buyer relies on old surveys of the property, but usually the lender or title company may require a new survey. The sales contract may specify who pays for the survey—buyer or seller.

Both buyer and seller will want to inspect the closing statement to ensure that everything is in order. The seller will also want to be assured that the buyer has the money to close the transaction.

If the seller has a mortgage or other liens, then he will have to obtain a payoff statement for each lien that lists the exact amount of money needed to pay off the mortgage or lien on the property as of the date of the closing. The payoff statement will usually include not only the remaining principal and interest, but also any prepayment penalties and the fee for issuing a certificate of satisfaction (aka satisfaction piece). The seller will receive credit for any reserves in escrow to pay for future taxes and insurance.

If the buyer is assuming the seller’s mortgage, then the buyer should get a mortgage reduction certificate from the mortgagee, which will list the exact amount of the balance as of the closing date, the interest rate, and the date of the last payment.

The main purpose of preclosing procedures is to ensure that everything is in order: surveys, property insurance, title insurance, title certificate, and the mortgage. The lender may also require that the buyer deposit money in an escrow account to pay for insurance and taxes for the property, to protect its collateral.

Title Procedures

To be sure that the buyer is receiving good title, the buyer and the lender require that the seller delivers either a current abstract of title, which will list most encumbrances, or a title commitment from a title insurance company. The seller generally pays for this title search.

If a title abstract is delivered, the buyer’s attorney should examine it to write an opinion of title, which will list all encumbrances—which includes liens, easements, and deed restrictions—that are in the title record, and whether the title is good. It is not, however, a guarantee of good title.

Since the seller’s title search is generally done weeks or months before the closing, the buyer should do a 2^nd search of the title record right before closing to ensure that no new encumbrances have been added to the record.

Because it takes time to record new encumbrances, the seller is generally required to sign an affidavit of title, in which the seller swears, to the best of his knowledge, that nothing has occurred since the seller’s title search to cloud the title, and that there have been no events that would possibly call into question the seller’s ownership rights or that would give others an interest in the real estate, such as would occur for unpaid property improvements, which could subject it to a mechanic’s lien.

If anything on the affidavit of title proves to be false, then the title insurance company or buyer can sue the seller for damages.

Closing

Closing is the actual settlement and transfer of the real estate. It can either be face to face, where all parties and their representatives meet in a room to exchange documents, or it can be done through an escrow agent, who, as a disinterested party, receives all of the documents and finalizes the settlement and transfer.

Most real estate closings must be reported to the Internal Revenue Service using Form 1099-S, listing the seller’s social security number, the sales price, and any reimbursements to the seller of prepaid property taxes.

Real Estate Settlement Procedures Act (RESPA)

The Real Estate Settlement Procedures Act was designed to inform the buyer of real estate about closing costs and to prevent abusive practices that inflate the costs of closing for the buyer.

This federal Act, administered by the Housing Urban and Development (HUD) agency, applies to any closing using first-lien federally related loans, which includes most mortgages, for residences, condominiums, and cooperatives consisting of 1 to 4 units.

It requires that the lender disclose the costs of the closing to the borrower and prohibits the lender from demanding excessive deposits for escrow accounts, which are accounts required by most lenders to pay for future real estate taxes and insurance premiums.

RESPA also prohibits referral fees, such as kickbacks, for directing the buyer to other services when no services are actually performed.

Some brokerages have a controlled business arrangement (CBA) that allows it to offer several related home-buying services, such as for title insurance, home inspections, and even moving. These business relationships must be disclosed. The brokerage may also offer computerized loan origination (CLO) services that allow a potential buyer to easily shop for a loan. However, RESPA requires that the broker inform the buyer that she can shop for those services elsewhere, and is not restricted to using only the settlement services provided by the CBA or the CLO.

The HUD-1 form itemizes all charges that are paid by either the buyer or the seller at closing. Items that were paid by either party outside of closing do not have to be listed. However, if the lender required that any charges be paid before closing, then these must be listed as paid outside of closing (POC).

Face-to-Face Closing

A face-to-face closing is where all parties and their representatives meet at a specific place and time, usually at an office of one of the party’s representatives, to exchange the documents and to ensure that all necessary steps have been taken so that the buyer can receive marketable title and the seller receives his money. Hence, this type of closing is often referred to as passing papers.

One person—the broker, an attorney, or a lender’s or title company’s representative—conducts the meeting.

When the documents are exchanged, they are recorded in the proper order so that the chain of title is not interrupted. For instance, the certificate of satisfaction must be recorded before the seller’s deed to the buyer. And only after the title is transferred to the buyer can the buyer pledge the property for a mortgage.

Closing in Escrow

Because the requirements of settlement and transfer are stipulated by the sales contract and by law, the procedure of closing in escrow is basically the same as a face-to-face closing except that all of the documents are sent to an escrow agent, who is a disinterested 3^rd party, with no relationship to either the buyer or the seller or their representatives. The main benefit of closing in escrow is that the parties and their representative do not have to meet—they just send the required documents to the escrow agent, who then examines to make sure everything is in order, then effects the settlement and transfer.

The escrow agent has the right to examine the title to ensure that there are no defects and that all conditions are satisfied. If everything is in order, the escrow agent sends the seller the purchase money, and records the deed for the buyer, and the mortgage, if any.

If the title has defects, the escrow agent will deduct the amount necessary to remove the liens from the seller’s money. If the title cannot be cured, then the agent will return everything to the senders of the material, effectively cancelling the sale.

Closing Statements

At closing, there are expenses that either the buyer or seller is wholly liable for and is expected to pay. Most of these costs are closing costs, which pay for closing itself rather than for the property or bills associated with the property. Some of these expenses include the following:

Prorations

There are some expenses at closing where both buyer and seller have some liability. When a sales contract is finally signed, the sales price is agreed upon. When buying an item at a store, the buyer pays the purchase price and maybe some sales tax in return for the item. But a real estate sale is not that simple because there are bills associated with the real estate that the seller has already paid for a certain period, during which both seller and buyer will have owned the property, or there will be bills covering the same period that the buyer will have to pay later on. A large part of the closing is the proration of these expenses between buyer and seller according to how long each will have owned the property during the time period covered by each bill.

Most closings use prorations that are calculated through the day of closing, meaning that the seller is assumed to own the property on the day of closing. If the prorations are to be calculated up to the day of closing, then the buyer is assumed to own the property on the day of closing. Which method is chosen depends on the sales contract, the traditional approach for the locale, or state law.

Proration results in credits and debits for both buyer and seller. A credit for the seller increases the amount that he is entitled to receive whereas a credit for the buyer decreases the amount that she must pay. A debit for the seller decreases the amount that he is entitled to receive whereas a debit for the buyer increases the amount that she must pay. The major credit for the seller is the sales price of the property, which is also the major debit for the buyer. The other credits and debits modify the amount of money that the buyer actually pays to the seller at closing.

Bills can be divided into prepaid items, which are expenses that have been paid by the seller at the beginning of the billing period, and accrued items, which are expenses that will be paid by the buyer at the end of the period. Prepaid items are credits to the seller and debits to the buyer; accrued items are debits to the seller and credits to the buyer. Hence, it is obvious that what is a credit to the seller is a debit to the buyer, and vice versa.

The proration of most expenses, including taxes, mortgage, interest, and insurance premiums, in most localities use a 360-day year, called a banker's year (aka statutory year), which is divided into 12 30-day months. The actual proration is then determined by summing the monthly bills and daily bills according to the following formulas:

Prorated Credit or Debit = (Number of Months x Monthly Rate) + (Number of Days x Daily Rate)

Example — Proration of an Accrued Item or Prepaid Item Using a Banker's Year

The buyer and seller close on October 18. Real estate taxes of $3,600 on the property are paid at the end of the year. Then, using a banking year, the calculations are as follows:

Monthly Prorated Rate = $3,600 / 12 = $300
Daily Prorated Rate = $300 / 30 = $10

Hence

Prorated Debit to Seller = $300 x 10 + 18 x $10 = $3,180 = Prorated Credit to Buyer.

If the real estate taxes had been prepaid by the seller, then the same amount would have been a credit to the seller and a debit to the buyer.

Some Prorations, such as for the division of rents from the property, use a 365-day year (366 in a leap year). In this case, a daily bill is calculated, then multiplied by the number of pertinent days:

Example — Proration of Rents

The buyer is closing on December 15 on a property that has a studio that is rented out for $310 per month. The sales contract calls for prorating the rent through the day of closing.

Rents are calculated using the actual number of days, but because rent is paid month to month, only the number of days in the month of the closing needs to be counted.