What is proration in real estate: A comprehensive guide

In real estate transactions, proration is crucial in ensuring fair distribution of certain expenses between the buyer and the seller. You need to know what is proration in real estate, and how it divides and adjusts expenses or income on a property proportionally based on time. How it helps calculate important parameters such as property taxes, homeowners association fees (HOA), and mortgage interest. 

This article explores the concept of proration, focusing on key concepts such as the proration amount, tax prorations, and how these are handled during the day of closing.

So, what is proration in real estate?

Proration is the allocation of expenses or income for a property between the buyer and seller. It is based on the period each party owns the property within a specific time frame. It ensures that each party only pays for the expenses or receives income for the period they own the property. Prorations are typically calculated during real estate transactions and settled at the closing of the sale. Before we understand how to calculate proration, we need to know a few important terms and concepts. 

• Proration amount: This represents the portion of an expense or income attributable to the buyer or seller.
• Paid in advance: Certain expenses like property taxes, HOA fees, and some insurance premiums, are often paid in advance. Proration ensures that the buyer reimburses the seller for any pre-paid expenses that apply to the period after the property transfer.
• Tax prorations: This refers to the adjustment of property taxes between the buyer and seller. Since property taxes are usually billed annually, proration is necessary to allocate the tax burden fairly based on the number of days each party owns the property during the tax year.

Why is proration important?

Proration ensures fairness in financial responsibilities, preventing disputes between buyers and sellers. It guarantees that each party only pays for the expenses for the period they owned the property. It makes the real estate transaction equitable. Whether dealing with property taxes, HOA fees, or mortgage interest, proper proration ensures that each party fulfills their financial obligations accurately and fairly.

What are the common prorated expenses to consider?

• Property taxes proration: These are usually paid annually or semi-annually and often prorated at closing. These vary by location. If taxes are prepaid, sellers get a credit and buyers pay; if not, it’s reversed. When the closing is near tax due dates, adjustments are made accordingly.
• HOA fees proration: Homeowners Association fees are typically paid monthly or quarterly and need to be prorated based on the ownership period. If dues are unpaid, they’re deducted from the seller’s proceeds. The buyer then covers the rest of the month.
• Mortgage interest proration: For properties with existing home mortgages, the interest accrued up to the day of closing is prorated. 

• Rent proration: If the property is rented, rent is prorated so that the buyer gets credit for any rent covering the time they own the property.
• Insurance proration: Typically, buyers get a new policy, but sometimes existing policies can transfer, with or without prorations.
• Utilities proration: Rarely prorated, but if unpaid, they may be deducted from the seller’s proceeds and credited to the buyer.

How is proration calculated?

To calculate prorations, you first determine the annual expense or income associated with the property. For instance, if property taxes for the year are $3,650, and the property is being sold, these costs need to be prorated based on the time of ownership. 

Here’s a step-by-step guide to proration calculation:

1. Identify the total annual cost (e.g., property taxes, HOA fees).
2. Divide the annual amount by the number of days in the year to get the daily rate. For example, $3,650 divided by 365 days equals $10 per day.
3. Multiply the daily rate by the number of days in the year the property was owned by either party.

Keep in mind that the day of closing is a significant factor in proration calculations. The buyer and seller need to agree on who is responsible for the expenses on the day of closing. This decision affects the final proration amount.

How does the closing day affect the proration amount?

Let’s do some math to understand this. Let’s say the closing occurs on August 15 and the property has been owned by the seller for 227 days (from January 1 to August 15). 

If the buyer is responsible for the day of closing, then the buyer will owe the seller for 138 days (from August 15 to December 31).

Suppose the property taxes are $3,650 annually, and the closing date is August 15. The annual amount would be $3,650 and the daily rate will be $3,650 / 365 days = $10 per day

The proration amount will be different based on the day of the closing. 

• If the seller is responsible for the day of closing: 227 days x $10/day = $2,270 owed by the seller.
• If the buyer is responsible for the day of closing: 138 days x $10/day = $1,380 owed by the buyer.

In this case, if the buyer pays for the day of closing, they would reimburse the seller $1,380 for the prepaid taxes.

Key takeaway

Proration is an essential aspect of real estate transactions. It ensures a fair distribution of expenses and income between the seller and buyer. The exact proration amount is determined by dividing the total expenses between the number of days in the year (typically 365 days) and then multiplying by the number of days the property is owned by each party.

By understanding what is proration in real estate, and its calculation, both parties can complete the transaction smoothly and avoid potential conflicts. 

Written by Ramona Sinha. October 24, 2024

Ramona is the Senior Content Writer for Kukun. This experienced blogger uses simple and succinct words to decipher the complex phenomenon called life. She has written articles covering a broad range of topics, such as real estate, lending and mortgage, finance, business, taxation, home designs, home improvement projects, decor concepts, and more. An avid traveler, she’s a digital nomad at heart and an animal lover from the depth of her soul.