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Prorations are credits between the buyer and seller at closing. They ensure each party is only paying these costs for the time that they owned the home.
There are a variety of costs involved in owning a home, and the homeowner typically pays for these at various intervals throughout the year. Because a sale usually takes place sometime during the year and even in the middle of a month, the seller and buyer have to work out how to share those costs for that specific month and year.
Prorations are credits between the buyer and seller at closing. They ensure that each party is only paying these costs for the time that they owned the home. They will show up as debits or credits on each party's closing statement.
Prorations can be for costs such as:
Before signing a purchase contract, you should read it to find out how prorations are handled. You want to make sure they are assigned fairly. Otherwise, you and your real estate agent should discuss whether to make changes to the language about them.
In most cases, buyers are charged for prorations. They then show up as a debit on the buyer's closing statement and as a credit on the seller's closing statement. This is because the seller has already paid many of the relevant costs. The credits increase the seller's net profits and reimburse the seller for items they have prepaid for the period the seller will not own the property.
For instance, in many cases, a seller will already have paid property taxes in advance for the year. But after the sale, the buyer will be the one responsible for those taxes. At closing, the buyer will need to credit a prorated portion of those taxes back to the seller for the remaining days of the year in which the seller will no longer own the home. This prorated amount will show up as a credit on the seller's closing statement and a debit on the buyer's closing statement.
Ultimately, the direction of the credit and debit will depend on when each specific type of cost is paid in your area.
There are various fees and expenses that might be prorated at a real estate closing. Here are some of the most common ones.
Unlike rent, which is paid in advance, mortgage interest is paid in arrears. When you pay a mortgage payment on January 1, for example, it pays the interest for December. On a new mortgage loan, lenders want to collect interest up to 30 days before the first mortgage payment is due. If you close on, for example, November 15, your first mortgage payment will be due January 1. If you are the borrower, you will be charged 15 days of interest on your closing statement, from November 15 through 30.
To figure out your interest proration in this scenario, divide the annual interest by 12 months to find the monthly interest, and then divide that by the number of days in the month (30, in the case of November) to find the daily interest. Multiply the daily interest by the number of days remaining in the month (in this case, 15 days) to find the interest proration that will be debited from your account.
The same principle applies to sellers who must pay interest in conjunction with a loan payoff. The seller in the above scenario would owe interest for November 1 through 15. In this case, both seller and buyer have a prorated debit charged to their account.
Property tax calendars vary by state and municipality. Some states collect property taxes in advance, some collect in arrears, and some collections depend on the time of year. What's most important at this juncture is whether your closing period involves prepaid taxes.
If the taxes are prepaid, and you are the seller, you will receive a credit. If the taxes are prepaid, and you are the buyer, you will be charged. The opposite is true if taxes are not yet due and payable—sellers will receive a debit proration, and buyers a credit proration.
In some situations, even if the taxes are not yet due and payable, your taxes will be due if your closing date is near the normal date for collecting taxes. In that case, the closer will pay the taxes from the seller's proceeds, credit the unused portion to the seller, and charge the buyer accordingly. Some calculating buyers will ask for no tax prorations in the purchase contract if it is apparent that the buyer will be expected to reimburse the seller for a portion of prepaid taxes.
If you are a seller and accept the buyer's terms for no tax prorations, you will pay taxes for a period during which you do not occupy the property.
If you itemize deductions on your federal tax return, you can deduct the prorated property tax you paid. The federal government considers property taxes the seller's responsibility up to, but not including, the date of sale. Property taxes are the buyer's responsibility from the date of sale onward.
If a seller has not yet paid homeowner association dues, they will be paid from the seller's proceeds, and the seller will receive a credit for the unused portion. For example, if the dues are $300 a month, the daily proration is $10. When a transaction closes on the 10th of the month, the seller will be charged 10 days of HOA dues ($100). The buyer will pay $200 for the remaining 20 days of HOA dues.
Rent is generally paid in advance. Buyers who purchase an investment property expect to receive a credit for that portion of the rent, which covers the period the buyer will own the property. A sale that closes on November 15, involving a tenant-occupied property that rents for $1,000 a month, would result in the buyer receiving credit for 15 days of prepaid rent ($500). The seller would receive a debit of $500. Security deposits held by the seller are also transferred to the buyer as a credit to the buyer and a debit to the seller.
Insurance premiums are paid in advance, and buyers typically take out a new hazard insurance policy when buying a home. However, if the buyer is assuming the seller's existing loan or buying on a land contract, they might ask the seller to transfer the existing insurance policy.
Fire insurance policies generally transfer with or without consideration. "With consideration" means the seller will be reimbursed for the period they will not own the property, and "without consideration" means there will be no prorations. Most buyers obtain a new policy.
It is not often that utilities are prorated at closing, but prorations do apply to certain municipalities. In most cases, the utilities roll over to the tax assessments and are deducted from the tax bill for prorations. The buyer is then credited against future tax bills. You will see this situation happen in short sales and foreclosures, because if the seller isn't making the mortgage payments, they are probably not paying the utility bills.
