It’s not uncommon for real estate contracts to include prorations for both buyers and sellers. Prorations exist to reasonably divide any expenses related to the property, including property taxes, HOA dues, mortgage interest, utilities, and so forth so that both parties are not stuck paying for more than their fair portion.
Many times buyers are charged for the prorations in a real estate contract, but sellers can often be on the hook for these expenses too. The cost associated with these fees will be included as a debit to one party and a credit to the other on the respective closing statements.
So, how exactly do prorations work in real estate contracts? To get a better idea, it’s helpful to look at each type of proration individually, as each is calculated in its own way.
Property Tax Prorations
If you own property, you’ll be on the hook to pay property taxes. The amount you have to pay will depend on a number of factors, including your exact location. Each state calculates its property taxes based on its own unique calendar year. In California, the calendar year for the purpose of calculating property taxes is from July 1st to June 30th.
Taxes are typically paid in two installments rather than in one lump sum at the end of the calendar year. In California, these dates are November 1st and February 1st. A 10% penalty is charged for delinquent payments.
You will need to determine whether the taxes have been prepaid or are not yet due and are to be paid at a later date. If the taxes have already been prepaid, sellers will receive a credit proration and buyers will receive a debit proration. On the other hand, if the taxes haven’t been paid yet, sellers will receive a debit and buyers will receive a credit proration.
If the seller’s last payment towards property taxes covered a time period after the closing date, the proration will be made from the date of closing to the date that the taxes are paid up to. In this case, the proration will be a credit to the seller and a debit to the buyer.
For instance, if the closing date on the deal is October 20th, 2017 and the seller paid the first installment that covers up to February 1st, 2018, the seller will be credited and the buyer will be debited between these two dates. The purpose of this proration is to reimburse the seller for this time period that the property no longer has the seller’s name on title.
If the closing date arrives after the date that the property taxes are due, the proration is calculated from the first day of the tax installment to the closing date.
For example, if the closing date is February 15th, 2018, and the seller has not yet paid the second installment that was due February 1st, the seller will be debited and the buyer will be credited from February 1st, 2018 to February 15th, 2018. This will reimburse the buyer for the time period that the seller owned the property within that tax period.
Sometimes property tax prorations are paid out from the seller’s proceeds, and the unused portion will be credited to the seller and charged to the buyer if the closing date is nearing the due date for property taxes to be paid. Make sure you read your contract closely to find out whether or not you will be credited or debited for any property taxes associated with the property in question.
Mortgage Insurance Prorations
Every mortgage payment made covers the interest paid the month before. For example, a mortgage payment that’s made on June 1st pays the interest from May. Lenders typically collect mortgage interest up to 30 days before the first mortgage payment needs to be made when a new home loan is taken out. Sellers will owe interest to buyers up to or through the closing date. The buyer will then be responsible for paying the interest on the following mortgage payment after closing of escrow.
For instance, if a deal closes on April 15th, the first mortgage payment will be due June 1st which will cover the interest for May. Buyers will be charged interest from April 15th to May 1st on their closing statement.
In order to calculate the interest proration, the number of days of interest that the seller owes to the buyer will need to be established. The amount of interest per day is then multiplied by the number of days of owed interest in order to come up with the total amount owed.
HOA Fee Prorations
If the subject property is governed by a homeowner’s association (HOA), then monthly dues will be charged to cover expenses related to maintenance and management of the overall property. Buyers and sellers must divide this fee by the amount of time each party will be in the home for the current month.
Let’s say closing is on May 15th and the HOA fees are $200 per month. If the seller has not yet paid the dues for May, they will be paid from the seller’s proceeds for the time period between May 1st and 15th. If the seller has already paid for May’s HOA fees, the buyer will be responsible for covering this time period.
Utilities aren’t often the subject of prorations on real estate contracts, but they are sometimes applicable in some jurisdictions. For instance, in certain municipalities, if the seller does not pay the city or county utilities, then they’ll be rolled over to the tax assessments and deducted from the tax bill for prorations.
The Bottom Line
No one wants to have to pay any more than they have to in a real estate deal, regardless of how little the amount may be. Proration calculations make everything fair and square in terms of paying for only what each party is responsible for. These can be intricate calculations, which should be carefully looked over when both buyers and sellers receive a copy of their closing statements in order to ensure the divisions have been calculated fairly and accurately.