The American Education Institute

USE SECURITY DEPOSITS, RENTS, AND TAX CREDITS DUE AT CLOSING.

Whenever you close on any property, there are always computations to be figured to assure that, for example, what ever real estate taxes are owed by the seller get paid by the seller and not by you.  On the seller’s side, of course, these computations also guarantee that he will pay only what he owes and not what afterwards is taxed to you.  This is only fair, after all.  But be assured of the following as well.

The most basic rule of transacting income-producing real estate that you need to remember is this:   Rents are paid in advance of the time they cover, and real estate taxes are paid in arrears. Hence, the seller will generally have all your applicable rents collected before the property sale closing, but you’re going to get stuck with his tax bill afterwards.  That’s why you as a buyer are entitled to credits, both for prepaid rents and post-levied taxes.

Your local property tax assessor will, by law of course, notify you in advance of any reassessments of your property’s value (and give you time to protest any increase if need be) but the taxing bodies that apply their levies to that value won’t tell you their increasing tax needs in advance unless you attend their individual public hearings.  In addition to other headaches, this can also produce computational errors at the time of closing.

The plain fact of the matter is this:  neither the seller, his attorney, nor anyone else connected with the sale and transfer of any property anywhere can possible know how much is going to be charged next year for taxes applicable to property this year.  Governments simply levy taxes afterwards, not beforehand, and thus no one can predict at closing how much exactly in tax is owed to that given point, nor how much the new owner is going to have to pay from that point onward.  And while it is probably at good thing that citizens are, in effect, billed for governmental “goods and services” only after they’ve received them, it can become somewhat of a pain whenever someone new takes over something already existing that the government hasn’t yet decided how much to “bill for.”

But as in all governmental things else, transferring property is not impossible.  Generally what happens is a kind of real estate tax averaging is done, and both parties simply agree to what amounts to a “best guess” of how much tax will later be owed, and work from there.  Quite ofter language is written into the closing contract to the effect that such-and-such amount is used as a basis for computing taxes now owed, but if that amount varies by so-and-so amount from the actual taxes charged at the time they become know, the seller will then pay such-and-such in addition to the buyer or the buyer will then be entitled to collect so-and-so additionally from the seller.  But in practical terms, if that language specifies an allowable variance from the guesswork of, say, no more than fifty dollars, no one gets too excited and nobody send anybody any bills afterwards.

However, you should also rest assured that, if you really do press this issue as a buyer, you can indeed be legally protected so as to recover any excess tax you are forced to pay on behalf of the seller — even to the exact penny — if you so insist.  But again, your attorney may charge you more to rewrite the language than you could ever hop to recover later from a seller who really isn’t at fault anyway for the backward way that governments work.

That’s taxation for you.  But most things, on the other hand, work much more precisely — rents, for example, and security deposits.  These are always paid in advance, and for good reason.  In practical terms, the only guarantee a landlord has that a tenant will stay where he says he will stay is the money the tenant has already paid to stay there.  Also, the only guarantee the landlord has that the tenant won’t likely destroy the place is whatever bond money the tenant has allowed the landlord to hold as non-refundable in case he does.

These things, of course, are paid in advance to the owner of the property from whom the tenants rent, and when that owner changes those advance payments much change as well.  Unlike with taxes, such payments to owners can be figured right to the penny for the precise duration of ownership.  If, for example, you buy an income property and close on the first of April, all March rents belong to the seller but all April rents now belong to you.  And, unless tenants move out as of that date, all moneys paid as security deposits to the previous owner much now be passed along to you to hold (until they later move an/or settle any applicable property damages incurred).

IT’S THE LAW!

Note too that sometimes you can legally demand more security deposit be paid by each tenant to you as the new property owner, but almost everywhere such things are covered by existing signed leases which, by the way, also transfer to the new owner.  But more to the point, this means you can’t raise tenants’ rents until their leases expire.  Some state laws may vary on this point, but as another practical hint:  It is always a good idea to check all the leases conveyed with any property before you buy that property.

In some instances, landlords also collect first and last months’ rents — in addition to security deposits — before any tenants move into their property.  In cases like these, not only are security deposits turned over to a buyer of the property but also all those last months’ rents as well.

All rents and security deposits to be turned over to a new owner are almost always handled  through credits made on behalf of the property buyer at the time of closing.  These credits can substantially reduce the amount of cash that may be required with such a transaction.  It is sometimes even possible to walk away from the closing with cash in you pocket, as the buyer, which had to be paid by the seller in transferring all such rents and deposits that are now due to you.

Suppose you are buying a 10-unit building.  The security deposits involved could easily amount to $4,500 (say $450 for each unit time 10 units).  These could also, quite easily, be a credit for yet-to-pay real estate taxes in an amount ranging from $3,000 to $5,000.  Then when you add credits due you for previously collected rents (including last months’) which will now apply to the time of your ownership, you can easily see how the total of all credits could reach $14,000 or more.  There’s an amount right there that could be utilized at closing to satisfy a down payment, couldn’t it?

Here’s something else to remember.  During the first 30 days of your new property ownership, you should have zero expenses.  This is because mortgage and other payments for such things as utilities are always billed and paid in arrears.  (You get the use first and pay afterward.)  Meanwhile, all your rents are collectible and paid in advance.  Therefore, you will have one “pure profit” month where everything comes in and nothing goes out.  You can always figure out how much that will be ahead of time and put that to good use, too.

Here’s a good example of how this method number 12 can give you very usable cash that you might not otherwise have thought you had.

Suppose you buy a 10-unit apartment building, and your closing date is set for February 21st.  Say in this case that February has its usual allocation of 28 days, so this means you will e closing three-fourths of the way through the month.  Total monthly rents come to $5,000 ($500 per apartment times 10) and at the time of closing all rents for March have been collected already.  In addition to the March rents, you are also entitled to rents for the rest of February (one-fourth the total) which, of course, have also been previously collected by the seller.  The total credit due you so far stands at $6,250 ($5,000 for March plus 1/4 of that for February, or $1,250).

Security deposits, already held by the seller, amount to an additional $3,500 ($350 per unit time 10 units).  Real estate taxes you both figure will amount to $9,000 for a full year, which for the sake of this example is a fiscal year ending some time after you acquire ownership.  Based on this best guess of $9,000, you and the seller agree that his portion will be $8,000 and your portion will be $1,000.  What this all means is that, at the time of closing, you combined credits from the seller amount to $17,750 ($6,250 rents + $3,500 security deposits + $8,000 unpaid real estate taxes).

Finally, for the sake of this example, the seller’s mortgage is paid off at closing and yours begins.  For arbitrary convenience, say that your new mortgage (which always begins as of the day of closing) requires your payment as of the 21st of each month.  But it also means that your first payments won’t be due till the 21st of March.  So now you can always count on using the rents you collect as of the first of the month to pay your mortgage 21 days later.  You already have March rents in you credits at closing, so your first mortgage payment is already in hand.

However, you could also do this:  ask your mortgage holder to change your payment due date to the first of the month, beginning the following full month as of April 1st.  Naturally, you will be charged additional interest for the ten-day extension (March 21st to 31st), but then you’ll have even more cash from the rents due to you on the first of April, and surely the full month’s rents will greatly exceed the expense of your ten-day interest extension; so this, too, can result in extra cash to cover a down payment, to make repairs or improvements, to put to use to buy yet another property!

Any way you look at it, this amounts to yet another method for buying property with none of your own money and financing it completely at 100%.  The chart, below,  illustrates this method in brief.

METHOD NUMBER 12 IN BRIEF

What it is designed to do:

• Use security deposits, rents, and tax credits due at closing

Example of typical transaction:

• You’re buying a 10-unit property
• You’ll close three-fourths of the way through the month
• Combined rents income is $5,000 per month ($500 x 10 units)
• Combined transferable security deposits equals $3,500 fixed ($350 x 10 units @ one-time charge)
• Rents are paid in advance; seller has already collected for next month $5,000 (totally due to you)
• Seller’s previously collected rent means one-fourth of the current month ($1,250) is also due to you
• Taxes are paid in arrears; those to be paid sometime after closing total $9,000 (your portion will be $1,000)

How you proceed:

Since there will be money owned to you because of this income-producing property, you may legally incorporate those funds into your closing settlement.  Most likely those funds will be figured at closing as credits due to you from the seller,.  Because these credits are so substantial, you may not need any closing cash at all.  In fact, you could easily emerge with cash in your pocket instead of the seller’s.

Example of what to expect:

1.  full credit of prepaid rents                           $5,000.00

2.  Proportional credit for current rents     $1,250.00

3.  Full credit of security deposits                 $3,500.00

4.  Proportional credit for taxes due            $8,000.00

5.  Total credit due to you, the buyer          $17,750.00

Dr. Eric T. Martin / 100% Financing When Buying Real Estate / 1-30-10