Analyzing Settlement Sheets in Real Estate Transactions
January 17, 2022
By Ralph Estel
Purchasing a building for business purposes or for renting is a complicated endeavor. A simple transaction can take weeks to consummate and requires the buyer to negotiate the base purchase price of the building; reimbursement or prepayments of real estate taxes and other expenses; who pays the various local and/or state fees and taxes; and potentially a loan. The negotiated price or reimbursement of all these items are memorialized on a settlement sheet at the purchase date. When the transaction is complete, the buyer then needs to record the transition into their accounting system. The buyer may want to simply record the total cash spent and loans incurred as a building asset on their balance sheet. Unfortunately, it is not that simple.
Every item on the settlement sheet needs to be analyzed separately to determine the appropriate accounting presentation. Most of these items can be grouped into the following categories: purchase price, purchase costs, prorations of expenses, escrows, and loan costs. Once the items on the settlement sheet are categorized into the various categories it will be easier to account for them appropriately.
1. Purchase price: This amount is usually listed as the “selling price” or “consideration” and represents the amount negotiated with the seller less any “seller assist” or price reduction(s) associated with the transaction. Each adjustment should be listed on the settlement sheet as separate lines.
2. Purchase costs: This category represents all the costs the buyer must incur to purchase the building and generally includes the following:
- Title insurance: Buyer purchases this insurance to protect himself against the risk the seller does not have the represented ownership (fee simple, etc.)
- Commissions: Any fees paid by the buyer to brokers or consultants
- Local/State fees or taxes: Transfer taxes and fees paid to local and state governments
- Negotiation costs: Fees paid to attorneys to negotiate the purchase of the building
Purchase price and purchase costs are combined and allocated between land and building. The allocation is determined either with management’s best estimate or a cost segregation study. A cost segregation study is a study done by engineers and allocates the purchase price in extreme detail (i.e., the cost allocated to the electrical panel or lights in the parking lot). In certain circumstances it can substantially accelerate the depreciation deduction.
3. Proration of expenses/revenue: This category represents the allocation of expenses to the seller’s or buyer’s holding period. Here’s an example: A seller prepays $12,000 in annual real estate taxes on January 1. If the sale of the building occurs on October 1, the buyer would have to reimburse the seller $3,000 for real estate taxes the seller paid for the period October 1 to December 31. While “real estate tax” is frequently a prorated item, there can be several others, including a tenant’s prepaid rent; monthly maintenance contracts or prepaid expenses; and/or a litany of other items.
Proration of expenses and revenue should be booked to the appropriate revenue or expense account. In the above example, the $3,000 that were reimbursed to the seller for real estate taxes would be booked to real estate expense.
4. Escrows: This category represents cash the bank, seller, or third party has required the buyer to put into a separate account for a future expense or event.
Escrows that the buyer expects to receive or use are recorded as a separate cash account.
5. Loan costs: This category includes any fees charged by the bank or third party to enter into the loan. These costs include the following:
- Origination or Loan Fees: Fees the bank charges to enter into the loan
- Appraisal Fees: Fees paid to any appraiser to determine the value of the property
- Document processing fees: Fees charged by the bank or municipal government to enter into the loan and include mortgage recording fees, notary fees, and other items
- Negotiation fees: Fees paid to attorneys or consultants to negotiate the loan
Loan costs are recorded as another asset on the balance sheet and amortized over the life of the loan.
The recording of the settlement sheet discussed above assumes the financial records are maintained under the income tax basis of accounting. Although GAAP follows many of the same general principles, there are additional steps and requirements that need to be considered as well as some differences in the accounting for certain items.