How Does Property Tax Proration Work at Closing?

When do you start paying property taxes on a new home? Are property taxes due at closing? How do prorations work in real estate transactions? If you have any of these questions, you are not alone. For many first-time homebuyers or real estate investors, hearing words like "tax proration" can be a little intimidating. Fortunately, prorations aren't too difficult to understand or calculate once you understand what they are and how they work.

In this article we will learn the ins and outs of real estate prorations at closing including how property tax prorations are calculated, why prorations are used, and how to tell when the buyer gets a prorated credit vs when the seller gets a prorated credit. Once we've covered these topics, we'll look at an example to help us get a more hands-on understanding.

A tax proration is a way of making sure both parties in a real estate transaction only pay property taxes for the time they owned the property. Property taxes are typically paid in arrears, which means they are due at the end of the calendar year. So when an investor or new home owner buys a house in the middle of the year they will have to pay the full year's worth of property taxes at the end of the year. That's a little unfair to the buyer since they didn't own the property or live there for the first half of the year. As a result, a buyer wants the seller to give them a credit that covers the property taxes for the first half of the year when the seller owned the property.

Having the seller give a credit for property taxes is not required, but it is customary and most sellers are very willing to prorate the property taxes due.

Property taxes are not the only things that may get prorated in a real estate transaction. Often property insurance, HOA fees, and other items can be prorated as well. In contrast to property taxes where the seller gives the buyer a credit, in some cases the buyer may give the seller a credit. Let's look at property insurance for an example. Property insurance is typically a prepaid item, which means it is paid at the beginning of the calendar year. This means if a property transaction is taking place in the middle of the year, the seller has already paid property insurance for the entire year. To compensate for this, the buyer will give the seller a credit. This helps ensure that both the buyer and the seller are only responsible for paying property insurance for the portion of the year in which they owned the property.

To put it another way, for prorated items that are paid in arrears (due at the end of the year) such as property tax, the seller will give the buyer a credit. And for prorated items that are prepaid (due at the beginning of the year) such as property insurance, the buyer owes the seller a credit. These prorated credits divide the full year's expense appropriately so that each party only pays expenses for the portion of the year when they own the property.

To more fully illustrate how prorating works, lets walk through an example. To make it simple and easy to understand we will just assume there are 30 days in each month and 365 days in a year and we won't attempt to factor in leap years or any other date complications.

Let's say you are buying a property and your closing date is July 4th, Happy Independence Day! Also, assume the property taxes for this transaction are $2,500 for the year. The first step is to calculate how many days the seller is responsible for and how many days the buyer is responsible for. In this scenario the seller is responsible for Jan 1 through July 3 while the buyer is responsible for July 4 through the end of the year. This means the seller is responsible for 183 days (assuming 30-day months for simplicity).



The next step is to calculate the cost per day. To do this you simply divide the annual property tax amount ($2,500) by the number of days in a year (365). Doing this tells us that property taxes for this property cost $6.85 per day.



Now that we know how many days the seller is responsible for and how much property tax costs per day, we can calculate the total credit the seller will give the buyer. In this case the total prorated credit will be $1,254.

Congratulations! You now understand the basics of real estate prorations which means when your lender or realtor starts talking about them you can be conversant and knowledgeable on the subject. Additionally, you now know how prorations are calculated and can do the math on your own to figure out what the prorated amounts will be before you show up at closing. Perhaps most importantly, you now see that tax proration calculations aren't scary or overly tricky. Real estate transactions can be complicated and the more you know the more the better you will be able to make good purchasing decisions.