Washington Real Estate Fundamentals Lesson 13: Closing Real Estate Transactions © 2011 Rockwell Publishing

Closing Real Estate Transactions Closing: Final stage in a real estate transaction; also called settlement. Buyer pays seller purchase price. Seller transfers title to buyer. © 2011 Rockwell Publishing

Escrow In Washington, closing process usually handled through escrow. Escrow: Arrangement in which neutral third party holds money and documents for buyer and seller until transaction ready to close. © 2011 Rockwell Publishing

Escrow Appointment of escrow agent Escrow agent: Neutral third party selected to handle closing; also called closing agent. Chosen by agreement between buyer and seller. Often appointed in purchase agreement. Acts as dual agent. © 2011 Rockwell Publishing

Escrow Escrow instructions Escrow instructions: Document(s) signed by buyer and seller when escrow opened. Direct escrow agent to take steps necessary to close transaction. Reflect contingencies and other requirements in purchase agreement. Specify conditions that must be met before escrow agent releases funds or documents. © 2011 Rockwell Publishing

Escrow Purpose and benefits Escrow helps ensure that: seller receives purchase price buyer receives clear title lender’s security interest perfected Two main benefits: Convenience – neither party has to attend closing in person. Protection against other party’s change of heart. © 2011 Rockwell Publishing

Escrow Purpose and benefits Deposit into escrow is essentially irrevocable. After delivering funds or documents to escrow agent, can’t get them back except: according to conditions set forth in escrow instructions, or with other party’s consent. © 2011 Rockwell Publishing

Escrow Escrow agent’s services Escrow agent may provide many services: ordering title report and inspections paying off seller’s loan and other liens preparing documents prorating and allocating expenses depositing and disbursing funds preparing settlement statement delivering and recording documents © 2011 Rockwell Publishing

Escrow Escrow Agent Registration Act Washington statute requires escrow agents to be licensed and registered with Department of Financial Institutions. © 2011 Rockwell Publishing

Escrow Agent Registration Act Licensed escrow agent Licensed escrow agent: Company licensed to engage in escrow business in Washington under Escrow Agent Registration Act. © 2011 Rockwell Publishing

Escrow Agent Registration Act Licensed escrow agent Licensed escrow agent (company) must: comply with bonding requirements have errors and omissions insurance keep transaction records maintain a client trust account employ only licensed escrow officers to handle transactions © 2011 Rockwell Publishing

Escrow Agent Registration Act Licensed escrow officer Licensed escrow officer: Individual licensed to handle transactions as representative of licensed escrow agent (company). Licensed escrow officer must: pass state exam and meet other requirements be supervised by company’s designated escrow officer © 2011 Rockwell Publishing

Escrow Agent Registration Act Licensing exemptions Exempt from escrow licensing requirements: attorneys title companies banks, savings and loans, and credit unions insurance companies federally approved lenders parties acting under court supervision © 2011 Rockwell Publishing

Escrow Agent Registration Act Licensing exemptions Real estate agent exempt: when handling escrow for transaction in which he is providing brokerage services as long as he doesn’t charge additional fee for escrow services © 2011 Rockwell Publishing

Summary Escrow Closing or settlement Escrow Escrow agent or closing agent Escrow instructions Escrow Agent Registration Act Licensed escrow agent Licensed escrow officer Designated escrow officer Exemptions © 2011 Rockwell Publishing

Closing Costs Closing costs: Fees, charges, and expenses related to a real estate transaction that are typically paid at closing. Particular cost may be paid by buyer or by seller, or shared by both. Either party may have to pay: the other party a third party © 2011 Rockwell Publishing

Closing Costs Allocation Purchase agreement form and/or escrow instructions often state which party is responsible for certain closing costs. Buyer and seller may agree to different allocation and modify contract form. Costs not addressed in contract allocated by escrow agent according to custom. © 2011 Rockwell Publishing

Settlement Statements Settlement statement: Document that sets out financial details of transaction, providing an accounting for buyer and seller. Also called a closing statement. Lists closing costs, all other payments into and out of escrow. Shows how much cash: buyer will need for closing seller will receive at closing © 2011 Rockwell Publishing

Settlement Statements Escrow agent prepares settlement statement for each party when sale ready to close. For most home sales, uniform settlement statement form (HUD-1) must be used. We’ll describe simplified format, to make settlement statements easy to understand. © 2011 Rockwell Publishing

Settlement Statements Four-column format Simplified settlement statement has four columns: buyer’s debits buyer’s credits seller’s debits seller’s credits © 2011 Rockwell Publishing

Settlement Statements Debits and credits Debit: An amount to be paid by one of the parties. Credit: An amount to be paid to one of the parties. © 2011 Rockwell Publishing

Settlement Statements Amounts one party pays the other Amounts paid by one party to the other party are a debit for one and a credit for the other. These are listed in two columns. Example: Purchase price Listed in buyer’s debit column. Also listed in seller’s credit column. © 2011 Rockwell Publishing

Settlement Statements Amounts paid to or by third party Amounts one party pays to or receives from a third party are listed in only one column. Example: Loan origination fee Buyer owes fee to lender. Listed only in buyer’s debit column. Does not appear in seller’s columns. © 2011 Rockwell Publishing

Settlement Statements Total credits match total debits In four-column format, each party’s total credits should equal his or her own total debits. Settlement statement like check register for bank account. At closing, after all deposits (credits) and withdrawals (debits) made, each party’s balance should be zero. © 2011 Rockwell Publishing

Settlement Statements Allocation of credits and debits Purchase price Buyer’s debit Seller’s credit Earnest money deposit Buyer’s credit Sales commission Seller’s debit © 2011 Rockwell Publishing

Allocation of Credits and Debits Buyer’s financing Buyer’s new loan Buyer’s credit Assumed loan Buyer’s credit Seller’s debit Seller financing Buyer’s credit Seller’s debit © 2011 Rockwell Publishing

Allocation of Credits and Debits Seller’s loan payoff Seller’s loan payoff Seller’s debit Prepayment penalty Seller’s debit Reserve account refund Seller’s credit © 2011 Rockwell Publishing

Allocation of Credits and Debits Charges connected with buyer’s loan Appraisal fee Buyer’s debit Credit report fee Buyer’s debit Survey fee Buyer’s debit Loan origination fee Buyer’s debit Discount points Buyer’s debit Seller-paid points Seller’s debit Assumption fee Buyer’s debit © 2011 Rockwell Publishing

Allocation of Credits and Debits Title insurance premiums Owner’s title insurance Seller’s debit Lender’s title insurance Buyer’s debit © 2011 Rockwell Publishing

Allocation of Credits and Debits Other items Personal property Buyer’s debit Seller’s credit Inspection fee Debit to party ordering inspection Hazard insurance Buyer’s debit Excise tax Seller’s debit Attorney’s fees Debit for each party Recording fee Debit for each party Escrow fee Debit for each party © 2011 Rockwell Publishing

Summary Settlement Statements Closing cost Settlement statement Debit Credit Amounts paid by one party to the other Amounts paid to or by a third party Total credits and total debits © 2011 Rockwell Publishing

Settlement Statements Prorations Prorate: To divide and allocate an expense proportionately, according to time, interest, or benefit. Expense must be prorated if a party is responsible for only part of it. Escrow agent calculates share that must be paid by or refunded to that party. © 2011 Rockwell Publishing

Prorations As of closing date Responsibility for property expenses generally begins and ends with period of ownership. Also true of entitlement to financial benefits. Items commonly prorated as of closing date: property taxes mortgage interest insurance premiums rents (from income-producing property) © 2011 Rockwell Publishing

Prorations 3 steps Calculate daily rate of an expense, called the per diem rate. Determine number of days one party is responsible for the expense. Multiply number of days by per diem rate to determine that party’s share. © 2011 Rockwell Publishing

Prorations Step 1: Per diem rate To calculate per diem rate: Annual expense: divide by 365 days 366 days in leap year Monthly expense: divide by number of days in month when closing occurs (28, 29, 30, or 31) © 2011 Rockwell Publishing

Prorations Step 1: Per diem rate Occasionally an exam question may instruct you to use a 360-day year in order to simplify calculations. If you see a question with those instructions, assume that all months have 30 days. © 2011 Rockwell Publishing

Prorations Step 2: Number of days Count number of days between closing date and beginning or end of month in which closing will occur. Beginning of month for seller’s share. End of month for buyer’s share. Proration questions should tell you: whether to count the day of closing whether to use 360-day year and 30-day months © 2011 Rockwell Publishing

Prorations Step 3: Rate × Days Final step: multiply per diem rate by number of days. Result is the party’s prorated share. © 2011 Rockwell Publishing

Prorations Prorating property taxes Property taxes are: seller’s responsibility up to closing date buyer’s responsibility from closing date forward © 2011 Rockwell Publishing

Prorating Property Taxes Paid in advance or in arrears buyer debited for days following closing date that advance payment covers seller credited for same amount Taxes in arrears (not yet paid): seller debited for days before closing date that eventual tax payment will cover buyer credited for same amount © 2011 Rockwell Publishing

Prorating Property Taxes Example Closing date: July 14. Annual property tax bill: $1,200.85. Seller already paid entire amount. How much does buyer owe? Step 1: $1,200.85 ÷ 365 days = $3.29 per diem Step 2: 18 days (July) + 31 (Aug.) + 30 (Sept.) + 31 (Oct.) + 30 (Nov.) + 31 (Dec.) = 171 days Step 3: $3.29 per diem × 171 days = $562.59 © 2011 Rockwell Publishing

Prorations Prorating hazard insurance Hazard insurance is paid for in advance. At closing, seller entitled to prorated refund of part of premium. Refund is credit for seller. Buyer not debited for prorated share unless buyer assuming seller’s policy. © 2011 Rockwell Publishing

Prorating Hazard Insurance Example Closing date: Nov. 22. Annual premium ($310.25) paid in advance, on March 1 of this year, for coverage through Feb. 28 of next year. How much will be refunded to seller? $310.25 ÷ 365 = $0.85 per diem Count days: 9 (Nov.) + 31 (Dec.) + 31 (Jan.) + 28 (Feb.) = 99 days $0.85 per diem × 99 days = $84.15 © 2011 Rockwell Publishing

Prorations Mortgage interest Two types of mortgage interest usually must be prorated at closing: final interest payment on seller’s loan (debit for seller) prepaid interest for buyer’s loan (debit for buyer) © 2011 Rockwell Publishing

Prorating Interest Seller’s final interest payment Mortgage interest is paid in arrears. Example: Payment made April 1 includes interest that accrued in March. So seller’s final mortgage payment did not include interest for month in which closing takes place. Seller must pay this interest at closing. © 2011 Rockwell Publishing

Seller’s Final Interest Payment Example Closing date: May 7. Seller already made her May 1 mortgage payment. Loan balance is $98,550, interest rate is 10%. How much interest will seller owe at closing? $98,550 × .10 = $9,855 annual interest $9,855 ÷ 365 = $27 per diem May 1 through May 7 = 7 days $27 × 7 days = $189 debit for seller © 2011 Rockwell Publishing

Prorating Interest Buyer’s prepaid interest Prepaid interest: Mortgage interest buyer pays at closing to cover period from closing date until end of month in which closing occurs. Necessary because buyer not required to make loan payment the month following the closing month. If closing date Aug. 12, first loan payment due Oct. 1. First payment includes interest for September, but not interest for August. © 2011 Rockwell Publishing

Buyer’s Prepaid Interest Example Closing date: Sept. 9. First loan payment due Nov. 1. Loan amount $156,000, interest rate 9%. How much prepaid interest will buyer owe at closing? $156,000 × .09 = $14,040 $14,040 ÷ 365 = $38.47 Sept. 9 through Sept. 30 = 22 days $38.47 × 22 days = $846.34 © 2011 Rockwell Publishing

Prorations Rent from income property When income-producing property sold, may be necessary to prorate rent. Rent usually paid in advance. At closing, seller pays buyer prorated share of rent already collected for month in which closing occurs. Note that security deposits are not prorated. © 2011 Rockwell Publishing

Settlement Statements Cash at closing To determine balance due to seller (amount seller will take away from closing): add up seller’s credits add up seller’s debits subtract seller’s debits from seller’s credits © 2011 Rockwell Publishing

Cash at Closing Balance due to seller On simplified settlement statement, balance due to seller listed in seller’s debit column. That way, total in seller’s debit column equals total in seller’s credit column. © 2011 Rockwell Publishing

Cash at Closing Balance due from buyer To calculate balance due from buyer (amount buyer needs to bring to closing): add up buyer’s credits add up buyer’s debits subtract buyer’s credits from buyer’s debits Balance due from buyer entered in buyer’s credit column. © 2011 Rockwell Publishing

Settlement Statements Column totals Remember that buyer’s column totals don’t have to match seller’s column totals; in fact, they virtually never will. It’s as if each party has own checkbook, and each checkbook must be balanced separately. © 2011 Rockwell Publishing

Summary Prorations and Cash at Closing Per diem rate Prepaid interest Balance due from buyer Balance due to seller © 2011 Rockwell Publishing

Income Tax Aspects of Closing Federal income tax laws that apply to real estate closings: Form 1099-S reporting Form 8300 reporting FIRPTA © 2011 Rockwell Publishing

Income Tax Aspects of Closing Form 1099-S reporting Escrow agent or other closing agent required to report sale of real property to IRS. Sale reported on form 1099-S, with: seller’s name seller’s social security number gross sale proceeds Agent can’t charge separate fee for filing 1099-S. © 2011 Rockwell Publishing

Income Tax Aspects of Closing Form 1099-S reporting Sale of principal residence exempt from 1099-S reporting requirement if: seller certifies that none of the gain is taxable property sold for $250,000 or less ($500,000 or less if seller married) Certain other transactions also exempt from requirement. © 2011 Rockwell Publishing

Income Tax Aspects of Closing Form 8300 reporting Escrow agent who receives more than $10,000 in cash must report payment to IRS using form 8300. Form must be filed within 15 days of receiving cash. Copy should be kept for 5 years. © 2011 Rockwell Publishing

Income Tax Aspects of Closing FIRPTA Foreign Investment in Real Property Tax Act: Federal law designed to prevent foreign investors from evading tax liability on income generated from sale of U.S. real estate. Requires real estate buyer to determine whether seller is “foreign person.” Not U.S. citizen, not resident alien. © 2011 Rockwell Publishing

Income Tax Aspects of Closing FIRPTA If seller is foreign person, buyer must: withhold 10% of amount realized (sales price) send money to IRS within 20 days of closing date In most cases, escrow agent handles FIRPTA compliance for buyer. Many residential transactions exempt from FIRPTA. © 2011 Rockwell Publishing

RESPA Real Estate Settlement Procedures Act: Federal law regulating closing process for most residential transactions. Goals of law: provide borrowers with closing cost information to help them shop for settlement services eliminate kickbacks and unnecessary fees that increase closing costs © 2011 Rockwell Publishing

Transactions Subject to RESPA Federally related loans RESPA applies to any federally related loan transaction that is not exempt. Transaction federally related if: 1. loan is secured by residential property; and 2. lender has a connection with the federal government. © 2011 Rockwell Publishing

Transactions Subject to RESPA Federally related loans Specifically, federally related loan secured by: property on which there is (or on which loan proceeds will be used to build) a dwelling with four units or less condominium unit or co-op apartment lot on which there is (or on which loan proceeds will be used to place) a mobile home © 2011 Rockwell Publishing

Transactions Subject to RESPA Federally related loans In addition, lender: is federally regulated, has federally insured accounts, is assisted by federal government, makes loans through federal program, sells loans to Fannie Mae, Ginnie Mae, or Freddie Mac, or makes real estate loans totaling more than $1,000,000 per year. © 2011 Rockwell Publishing

RESPA Exemptions RESPA does not apply to: purchase of 25 acres or more business, commercial, or agricultural loan vacant land (unless dwelling to be put on it) temporary financing (construction loan) assumption, if lender’s approval not required or obtained seller-financed transaction © 2011 Rockwell Publishing

RESPA Requirements Within 3 business days of loan application, lender must give applicant: HUD booklet that explains RESPA, closing costs, and settlement statements Mortgage servicing disclosure statement Good faith estimate of closing costs (GFE) Applicant can’t be charged fees other than credit report fee until GFE given. © 2011 Rockwell Publishing

RESPA Requirements Service provider disclosures Special disclosures required if lender or other settlement service provider: requires borrower to use specific service provider (title company, appraiser, etc.), or refers borrower to affiliated provider. Use of affiliated service provider must be optional, and fee estimates must be given. Also, seller can’t require buyer to use particular title company. © 2011 Rockwell Publishing

RESPA Requirements Uniform settlement statement Closing agent must itemize closing costs on uniform settlement statement (HUD-1 form). Must be given to buyer, seller, and lender on or before closing date. Buyer (borrower) must be allowed to inspect statement at least one business day before closing, if requested. © 2011 Rockwell Publishing

RESPA Requirements Limit on reserve deposits Lender can’t require excessive deposits into reserve account for taxes, insurance, other recurring costs. No more than necessary to cover expenses when due, plus two-month cushion. © 2011 Rockwell Publishing

RESPA Requirements Kickbacks and unearned fees Lenders and other settlement service providers (including real estate agents) can’t: pay or receive fees or kickbacks for referring customers pay or receive unearned fees for services not actually provided charge a fee for preparation of uniform settlement statement, reserve account statement, or TILA disclosures © 2011 Rockwell Publishing

RESPA Requirements Estimated vs. actual costs Actual closing costs don’t necessarily match good faith estimate. RESPA has rules regarding which charges may increase at closing. Can’t increase: lender’s points and fees; transfer (excise) taxes. Total can increase by no more than 10%: charges for required services if lender chose or recommended service provider. © 2011 Rockwell Publishing

Summary Federal Laws and Closing Form 1099-S reporting Form 8300 reporting FIRPTA RESPA Federally related loan Good faith estimate of closing costs Settlement service provider Uniform settlement statement (HUD-1) Kickback © 2011 Rockwell Publishing