© 2010 Rockwell Publishing Lesson 12: Closing Real Estate Transactions Principles of California Real Estate

© 2010 Rockwell Publishing Closing Closing: Final stage in real estate transaction. Also called settlement. Buyer pays seller purchase price. Seller transfers title to buyer.

© 2010 Rockwell Publishing Escrow In California, closing process is usually handled through escrow. Escrow: Arrangement in which neutral third party holds money and documents for buyer and seller until transaction closes.

© 2010 Rockwell Publishing Escrow 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, representing buyer and seller, until transaction is over.

© 2010 Rockwell Publishing Escrow Escrow instructions The parties usually give escrow agent written instructions for closing which: direct escrow agent to take necessary steps to close transaction specify conditions that must be met before escrow agent releases funds or documents reflect contingencies and other requirements in purchase agreement

© 2010 Rockwell Publishing Escrow Escrow instructions If there is any conflict between escrow instructions and purchase agreement, later contract (the escrow instructions) prevails.

© 2010 Rockwell Publishing Escrow Escrow services Escrow agent may provide many services, such as: ordering title report and inspections preparing documents paying off seller’s loan and other liens prorating and allocating expenses depositing and disbursing funds preparing Uniform Settlement Statements delivering and recording documents

© 2010 Rockwell Publishing Escrow Purpose and benefits Escrow’s main purpose is to ensure that: seller receives purchase price buyer receives clear title lender’s security interest is perfected Escrow’s main benefits are: convenience: neither party is required to attend closing in person protection: each party is protected from change of heart by other party

© 2010 Rockwell Publishing Escrow Purpose and benefits Deposit into escrow is essentially irrevocable; once party has placed sum of money or document into escrow, she can’t get it back except: according to conditions set forth in escrow instructions, or with other party’s consent.

© 2010 Rockwell Publishing Escrow Role of broker Real estate broker isn’t principal in escrow transaction and can’t direct escrow agent during closing process.

© 2010 Rockwell Publishing Escrow Agent’s scope of duties Escrow agent can call for funding of buyer’s loan but does not have authority to discuss inspection results or order repairs.

© 2010 Rockwell Publishing Termination of Escrow Escrow will terminate when: transaction closes escrow instructions aren’t fulfilled by closing date (or within reasonable time, if no closing date specified), or buyer and seller mutually agree to termination

© 2010 Rockwell Publishing Termination of Escrow Escrow does not terminate: unilaterally (action by only one party) by death or incapacity of either party

© 2010 Rockwell Publishing Termination of Escrow Interpleader Sometimes when transaction fails to close, disputes will arise between parties over funds or other items placed in escrow. If dispute arises, escrow agent should file interpleader action and let court decide who gets funds. Escrow agent should not try to decide dispute. (Not an arbitrator.)

© 2010 Rockwell Publishing Escrow Licensing Independent escrow companies must be licensed by California Department of Corporations. Only corporation may be licensed: not partnership not individual

© 2010 Rockwell Publishing Escrow Licensing Exemptions The following entities may provide escrow services without escrow license: bank or savings and loan insurance company title company attorney at law real estate broker handling escrow for client’s transaction

© 2010 Rockwell Publishing Licensing Exemptions Real estate brokers Broker may provide escrow services, and charge fees for those services, only in transactions in which they are also providing real estate services.

© 2010 Rockwell Publishing Summary Escrow Closing Escrow Escrow instructions Interpleader Independent escrow company Licensing requirements Exemptions

© 2010 Rockwell Publishing Closing Costs/Settlement Statements Closing costs: Fees and other charges related to real estate transaction that are typically paid at closing. Particular cost may be paid by buyer or by seller, or shared by both parties. Amounts may be paid to: other party, or third party.

© 2010 Rockwell Publishing Settlement Statements Settlement statement: Document that sets forth financial details of transaction. Also called a closing statement. Shows how much cash: buyer needs for closing seller will receive at closing

© 2010 Rockwell Publishing Settlement Statements Debits and credits Debit: An amount to be paid by a party. Credit: An amount to be paid to a party.

© 2010 Rockwell Publishing Settlement Statements Debits and credits Closing costs paid by one party to the other are a debit for one and a credit for the other. Debits and credits one party pays to or receives from a third party are a credit or debit to that party only.

© 2010 Rockwell Publishing Settlement Statements Debits and credits Purchase price: Buyer’s debit and seller’s credit. Assumed loan: Buyer’s assumption of seller’s loan is credit to buyer, and loan balance is a debit to the seller.

© 2010 Rockwell Publishing Settlement Statements Debits and credits Payoff of seller’s loan: Debit to seller. No entry made on buyer’s side of settlement statement. Escrow agent requests beneficiary’s statement from seller’s lender, which states loan’s remaining principal balance.

© 2010 Rockwell Publishing Settlement Statements Debits and credits Seller’s reserve account: Funds the seller’s lender required to be deposited to cover recurring costs. Also called impound or escrow accounts. Includes property taxes, insurance, assessments, and homeowners association fees. At closing unused balance is refunded, as credit to seller.

© 2010 Rockwell Publishing Summary Settlement Statements Settlement statement Credit Debit Purchase price Assumed loan Payoff of seller’s loan Seller’s reserve account

© 2010 Rockwell Publishing Prorations Prorate: To prorate an expense is to divide and allocate it proportionally between parties, according to time, interest, and benefit. Expenses commonly prorated include: property taxes mortgage interest payments hazard insurance premiums

© 2010 Rockwell Publishing Prorations Generally, seller is responsible for these expenses during period of ownership but not beyond; buyer becomes responsible for these expenses after taking title. Allocation of responsibility for these expenses must be detailed in settlement statement.

© 2010 Rockwell Publishing Settlement Statements Prorations To prorate an expense: calculate daily rate of expense (per diem rate) determine number of days party is responsible for expense multiply number of days by per diem rate to determine that party’s share of expense

© 2010 Rockwell Publishing Prorations Step 1: Per diem rate To find per diem rate: annual expense: divide by 365 days (366 days in a leap year) monthly expense: divide by number of days in month when closing occurs (28, 29, 30, or 31)

© 2010 Rockwell Publishing Prorations Formulas Although most closing agents use exact number of calendar days, state license exam may have questions that use simplified “banker’s year” of 360 days (30 days each month). To be completely accurate, per diem rates should be carried to at least 4 decimal points.

© 2010 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 (depending on whether expense is buyer’s or seller’s responsibility).

© 2010 Rockwell Publishing Prorations Step 3: Rate × Days Final step is to multiply per diem rate by number of days, to get that party’s prorated share.

© 2010 Rockwell Publishing Prorations Property taxes Property taxes are: seller’s responsibility up to closing date buyer’s responsibility from closing date and beyond

© 2010 Rockwell Publishing Prorations Property taxes If taxes have been paid in advance: buyer debited for closing date and days following that which are covered by advance payment seller credited for same amount

© 2010 Rockwell Publishing Prorations Property taxes If taxes are paid in arrears (not yet paid): seller debited for days before closing date that the (buyer’s) tax payment will cover buyer credited for same amount

© 2010 Rockwell Publishing Prorations Property taxes Property taxes are levied once a year. In California, property tax year runs from July 1 to June 30. Taxes are paid in two installments: first installment due November 1 (covers July through December) second installment due February 1 (covers January through June)

© 2010 Rockwell Publishing Prorating Property Taxes Example A transaction is closing January 20. The year’s property tax bill was $1,752 and the seller paid the entire amount on October 30. How much does the buyer owe? (Use a 360-day year.) $1,752 ÷ 360 = $4.87 Count days: 11 (Jan.) (Feb.–June, 30 × 5) = 161 $4.87 × 161 days = $784.07

© 2010 Rockwell Publishing Prorations Interest payments Mortgage interest is paid in arrears. Example: Payment made on April 1 includes interest that accrued in March. So seller’s last mortgage payment did not include interest for month in which closing will take place. Seller must pay this interest at closing.

© 2010 Rockwell Publishing In addition to prorating expenses, some transactions also require proration of income (in sale of rental property). Rent is usually paid in advance, so seller must give buyer prorated share of any advance rent (for time past closing). Security deposits are not prorated. (Seller must transfer entire security deposit to buyer at closing, as lease continues.) Prorations Rental income

© 2010 Rockwell Publishing Settlement Statements Cash at closing To determine balance due to seller (amount seller will take away from closing): add up all of seller’s credits add up all of seller’s debits subtract seller’s debits from seller’s credits

© 2010 Rockwell Publishing Settlement Statements Cash at closing To calculate balance due from buyer (cash needed for closing): add up all of buyer’s credits add up all of buyer’s debits subtract buyer’s credits from buyer’s debits Balance due from buyer is entered in buyer’s credit column.

© 2010 Rockwell Publishing Settlement Statements Final balances 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 his own checkbook, and each checkbook must be balanced separately.

© 2010 Rockwell Publishing Summary Prorations and Cash at Closing Proration Per diem rate Prepaid interest Balance due from buyer Balance due to seller

© 2010 Rockwell Publishing Tax Aspects of Closing Nearly all real estate transactions have tax implications for parties, but certain requirements must be taken care of at time transaction closes. Escrow agents must assure compliance with: 1099-S reporting rule FIRPTA California Withholding Law

© 2010 Rockwell Publishing Tax Aspects of Closing 1099-S reporting The closing agent has primary responsibility for reporting every sale of real property to Internal Revenue Service. Information is reported on Form 1099-S, which includes: seller’s name and social security number gross sale proceeds

© 2010 Rockwell Publishing Tax Aspects of Closing 1099-S reporting Although escrow agent has primary responsibility for 1099-S reporting, if escrow agent fails to report to IRS, mortgage lender is required to do so. If lender also fails to report sale, it becomes real estate broker’s duty to file 1099-S form.

© 2010 Rockwell Publishing Tax Aspects of Closing FIRPTA Foreign Investment in Real Property Tax Act: Federal law designed to prevent foreign investors from evading tax liability from sale of U.S. real estate. Buyer must determine if seller is “foreign person” (not U.S. citizen or resident alien). If “foreign” sale, buyer must withhold 10% of sales price and forward to IRS (escrow agent usually handles).

© 2010 Rockwell Publishing Tax Aspects of Closing California withholding law California also has law that requires buyers to withhold funds for tax purposes. To comply with this law, buyer or escrow agent must withhold 3.33% of total sales price and send funds to Franchise Tax Board. Some transactions are exempt.

© 2010 Rockwell Publishing RESPA Real Estate Settlement Procedures Act (RESPA): Federal law regulating closing process for most residential transactions. Law is intended to: give homebuyers information about closing costs that will help them compare costs and shop for settlement services eliminate kickbacks and unnecessary fees that increase costs for consumers

© 2010 Rockwell Publishing RESPA Federally related loans RESPA applies to any federally related loan transaction that is not exempt. Loan is “federally related” if it meets two requirements: secured by (certain) real property connected to federal government (federally regulated, insured, etc.)

© 2010 Rockwell Publishing RESPA Federally related loans The loan is secured by mortgage or deed of trust against: property on which there is (or which loan proceeds will build) a dwelling with four units or less, condominium unit or co-op apartment, or lot with mobile home, AND

© 2010 Rockwell Publishing RESPA Federally related loans The lender: is federally regulated, has federally insured accounts, is assisted by federal government, makes or sells loans in connection with federal program (Fannie Mae, Ginnie Mae, etc.), or makes real estate loans totaling more than $1,000,000 per year.

© 2010 Rockwell Publishing RESPA Federally related loans Most institutional home loans are covered by RESPA. RESPA doesn’t apply to seller-financed transactions.

© 2010 Rockwell Publishing RESPA Requirements Within 3 business days of loan application, lender must give loan applicant: HUD booklet that explains RESPA, closing costs, and settlement statements good faith estimate of closing costs (GFE) mortgage servicing disclosure statement

© 2010 Rockwell Publishing RESPA Requirements If lender or other settlement service provider requires borrower to use particular appraiser or other service provider, that must be disclosed to borrower when loan application is signed.

© 2010 Rockwell Publishing RESPA Requirements Any referral to affiliated service provider requires disclosure of the joint business relationship. Disclosure must include: fee estimate statement that the referral is optional

© 2010 Rockwell Publishing Closing agent must itemize all closing costs on Uniform Settlement Statement. Statement 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. RESPA Requirements

© 2010 Rockwell Publishing If lender requires borrower to make deposits into reserve (impound) account, RESPA prohibits requiring excessive amounts. RESPA Requirements

© 2010 Rockwell Publishing Lenders and all other settlement providers are prohibited from: Paying/receiving fees or kickbacks for customer referrals accepting unearned fees (for services not actually provided) charging fee for preparation of: Uniform Settlement Statement escrow account statement Truth in Lending Act disclosure form RESPA Prohibitions

© 2010 Rockwell Publishing Seller may not require buyer to use particular title company. RESPA Prohibitions

© 2010 Rockwell Publishing Summary Legal and Tax Aspects of Closing 1099-S reporting FIRPTA California withholding law RESPA Federally related loan RESPA requirements and prohibitions