Pro-ration in a Real Estate Transaction

Real estate investors can rely on a real estate broker or title company to provide closing statement estimates. However, many times there is not a real estate agent involved, and it’s also prudent for the investor to know how item pro-rations are done.

First, there are three basic choices that will influence how an item will be prorated at closing:

Is it paid in advance or arrears? – Insurance premiums and maintenance fees are generally paid in advance, while taxes and interest are usually paid in arrears. If paid in advance, an item will result in a credit to the seller and a debit to the buyer, as there is money owed the seller for payments covering time after the closing date. Of course, items that haven’t yet been paid, with amounts owed up to closing day (in arrears), will be a debit to the seller and credit to the buyer.

Are we pro-rating “to” or “through” the closing date? – This will be in the contract of sale, and only amounts to the difference of one day of expense, but we should know if we’re paying for that day of interest or not, as it could be a few hundred dollars or a lot more.

Are we using a “banker’s” or a “calendar” year? – For items paid on an annual basis, a banker’s year uses 360 days as a 12 month year of 30 day months. A calendar year uses 365 or 366 days.

Once those questions are answered, here are how some items are handled in the pro-ration process:

Rent – First, this does not involve security deposits, which are passed over in total. As the seller has collected rents for the month, if our closing is on the 15th, and we’re pro-rating through the closing date, we’ll divide the month’s rent by the number of days in the month, then multiply that amount by the number of days remaining in the month after closing to get the amount owed by the seller to the buyer.

An assumed insurance policy – As insurance is normally paid in advance for the year, the buyer will owe the seller for the pre-paid time left on the policy after closing. If we’re using a calendar year, and prorating through closing day, we need to determine how many days after closing will remain on the policy. Divide the entire premium amount by 365 to get a per-day value, and multiply that amount by the number of days left in effect after closing through expiration. We would credit the seller this amount back, as the buyer will enjoy the protection.

Taxes – Paid in arrears, and depending on when they are due, the seller will owe the buyer some money to pay taxes when due for the time the seller owned the property. Again, using our variables for the type of year and whether “to” or “through” closing, the tax amount to credit to the buyer will be calculated, with an appropriate seller debit/buyer credit.

Assumed mortgage interest – Another “arrears” item, the buyer will be paying a mortgage payment on the assumed loan that will have interest owed for the time that month that the seller owned it. So, there will be a credit to the buyer for the amount of interest to or through closing owed by the seller.

None of these are difficult calculations, but an investor should know how to arrive at these amounts. All added together, it can make for a nasty surprise at the closing table for the unprepared investor.