Wondering about proration in real estate? You're in the right place! This guide will teach you what it means, how it applies to buying and selling a home, and how to ensure you're paying a fair rate.
What is Proration in Real Estate?
Prorate comes from the Latin phrase “pro rata” which roughly translates to “proportionally.” When it comes to real estate, you'll likely hear the term used to talk about the breakdown and division of expenses based on the proportion of the year that a certain party owned or rented a property.
Let's look at an example. Basically, if a person sells his home on May 25th, then he only owned the home for the first 146 days of the year, while the new owner is in possession of the property for the remaining 219 days. To discover the prorated ownership of the property, we just have to do some simple math.
The number of days a certain party owned the home/number of days in a year.
So in this case, he owned the home for 146 / 365, which is roughly 40% of the year, while the new buyer can stake a claim for the other 60%.
Why is Proration in Real Estate Important?
It's important to understand how proration works for many reasons. The most common of which are listed below:
Settling Up between the Buyer and the Seller
When you close on a home in the middle of a month or billing cycle, expenses will usually be prorated to ensure fairness. While the specific details of each sale should be included in the purchase contract, the following examples are the most common:
Real estate proration is most often used when discussing howannual taxes will be divided between the new homeowner and the seller. Usually, these taxes will be broken down by month (or prorated) and included in the closing costs.
For example, property taxes, while they vary from state to state, are usually paid only once a year, typically at the beginning of the year. Using the example above, the seller would expect the buyer to reimburse him for 59% of what he paid, given that he will not occupy the property during that time.
School taxes are usually also paid annually at the beginning of the fall term, so depending on how many days the buyer will reside in the home during the school year, he could be responsible for some of the costs.
If the taxes have not been paid at the time of closing, then the seller will receive what is known as a “debit proration” and the buyer will get a “credit proration.”
Sometimes utility bills like water, gas, and electricity will be prorated during the sale of a home. While this situation is slightly less common than prorating taxes, it could come up at closing, so you should be ready to discuss it with your representation.
For example, if the seller of a home doesn't pay the county or city utilities, then the bills will roll over to tax assessments. They will then be deducted from the tax bill for proration and the person purchasing the home will receive a credit for future tax bills.
Typically, this happens during a short sale or a bank foreclosure because if the person selling the house hasn't been paying his mortgage, then he is likely not paying his other bills either.
Paying a Fair Mortgage to the Bank
While it technically depends on the terms of a particular mortgage, banks might prorate interest to the start of the loan. That is, when a seller sells a home, the bank requires the new buyer to make the first mortgage payment on the first day of the second month after the sale.
So, keeping with our original example, if the new buyer purchased his home on May 25th, then his first mortgage payment would be due on July 1st; however, included in this mortgage would be interest on the loan for the month of June AND prorated interest for the month of May, as he technically owned the home for seven days of the month.
One Last Thing: Commercial Property
If you are interested in real estate proration in relation to commercial property, it's important to know that developers and commercial property owners typically rent or sell space by the square foot – however, most buildings also have areas that cannot be done away with or rented separately (think hallways and bathrooms).
How can this be solved?
Typically, the owner of the building will take the annual expenses for each of the common areas and divide it by the amount of rental-eligible square footage in the building. She will then prorate these expenses to each renter based on the amount of space they are renting.
Whether you are a landlord or tenant, you can use this proration formula to ensure things are financially fair.
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