Most closings involve the division of financial responsibility between the buyer and seller for such items as loan interest, taxes, rents, fuel, and utility bills. These allowances are called prorations. Prorations are necessary to ensure that expenses are divided fairly between the seller and the buyer.
Accrued items such as water bills, Illinois real estate taxes, and interest on an assumed mortgage that is paid in arrears are expenses to be prorated that are owed by the seller but later will be paid by the buyer. The seller therefore pays for these items by giving the buyer credits for them at closing.
Prepaid items, such as fuel oil in a tank, are expenses to be prorated that have been prepaid by the seller but not fully used up. They are therefore credits to the seller.
The Arithmetic of Prorating
Accurate prorating involves four considerations:
- Nature of the item being prorated
- Whether it is an accrued item that requires the determination of an earned amount
- Whether it is a prepaid item that requires the determination of an unearned amount (that is, a refund to the seller)
- What arithmetic processes must be used
Accrued items = buyer credits
Prepaid items = seller credits
Using this general principle, there are two methods of calculating prorations:
- The yearly charge is divided by a 360-day year (commonly called a statutory, or banking, year), or 12 months of 30 days each.
- The yearly charge is divided by 365 (366 in a leap year) to determine the daily charge. Then the actual number of days in the proration period is determined, and this number is multiplied by the daily charge.
The statutory month variation, is also acceptable in Illinois. In this method,
- The yearly charge is divided by 12 to determine a monthly amount.
- The monthly charge then is divided by the actual number of days in the month in which the closing occurs. This final number is the daily charge for that month.
In Illinois we use the following to calculate prorations
- Standard year of 360 days
- Standard month of 30 days
When the real estate tax is levied for the calendar year and is payable during that year or in the following year, the accrued portion is for the period from January 1 through and including the date of closing. If the current tax bill has not yet been issued, the parties must agree on an estimated amount based on the previous year’s bill and any known changes in assessment or tax levy for the current year.
Sample proration calculation Assume a sale is to be closed on September 17. Current real estate taxes of $1,200 are to be prorated. A 360-day year is used. The accrued period, then, is 8 months and 17 days. First determine the prorated cost of the real estate tax per month and day:
$1,200/12 = Monthly Taxes of $100
8 x $100 = $800
$100/30 = Daily Taxes = $3.33
17 x $3.33 = $56.67
Total Taxes owed for 8 months and 17 days
$800 + $56.67 = $856.67
This amount represents the seller’s accrued earned tax. It will be a credit to the buyer and a debit to the seller on the closing statement.
A prepaid cost is usually associated with the seller. The seller has paid a cost, but some of the benefits of the cost will be enjoyed by the buyer. The buyer then has to pay the seller at closing for the buyer’s portion of the cost attributed to the buyer’s use.
One example of a prepaid item is a water bill. Assume that the water is billed in advance by the city without using a meter. The six months’ billing is $60 for the period ending October 31. The sale is to be closed on August 3. Because the water bill is paid to October 31, the prepaid time must be computed. Using a 30-day basis, the time period is the 27 days left in August plus 2 full months.
Monthly water cost
$60/6 months = $10 per month
Daily water cost
$10/30 days = $0.33 per day
Buyer use of Prepaid Water Cost 2 months and 27 days
Total Cost Attributed to Buyer Use 2 x 10 – $20.00
27 x $0.33 = $9.00
This is a prepaid item; it is credited to the seller and debited to the buyer on the closing statement.
General Rules for Prorating
The rules or customs governing the computation of prorations for the closing of a real estate sale vary greatly from state to state. The following are some general guidelines for preparing the closing statement:
- In Illinois, the seller owns the property on the day of closing, and prorations or apportionments usually are made to and including the day of closing.
- Mortgage interest, general real estate taxes, water taxes, insurance premiums, and similar
expenses usually are computed by using 360 days in a year and 30 days in a month..
- Accrued general real estate taxes are prorated at the closing. When the amount of the current real estate tax cannot be determined definitely, the proration is usually based on the last obtainable tax bill.
- Special assessments for municipal improvements such as sewers, water mains, or streets usually are paid in annual installments over several years, with annual interest charged on the outstanding balance of future installments. The seller normally pays the current installment, and the buyer assumes all future installments.
- Rents are usually adjusted on the basis of the actual number of days in the month of closing. It is customary for the seller to receive the rents for the day of closing and to pay all expenses for that day. If any rents for the current month are uncollected when the sale is closed, the buyer often agrees by a separate letter to collect the rents if possible and remit the pro rata share to the seller.
- Security deposits made by tenants to cover the last month’s rent of the lease or to cover the cost of repairing damage caused by the tenant generally are transferred by the seller to the buyer.
Real estate taxes In Illinois real estate taxes are paid in arrears. The buyer must be credited for any taxes that still will be paid in the future for time in the “past’ (i.e., up until dosing) when the seller occupied the property. If an unpaid installment based on last year has been billed, this specific amount is credited to the buyer and debited to the seller. The buyer must be credited with the current year’s taxes to time of dosing because those taxes will not be paid until next year (again by the buyer/new owner). Consequently, the seller is debited accordingly, through the date of close, and a proration (and often a tax estimate based on last year’s tax) is necessary for this latter figure.
Mortgage loan interest On almost every mortgage loan the interest is paid in arrears, so buyer and seller must understand that the mortgage payment due on June 1, for example, includes interest due for the month of May. Thus, the buyer who assumes a mortgage on May 31 and makes the June payment pays for the time the seller occupied the property and should be credited with a month’s interest.