As insurance policy premiums are normally paid in advance, if a buyer is assuming a policy in a real estate investment transaction, the policy premium must be prorated. The buyer will owe the seller the amount prepaid, but as yet unused, for the policy effective coverage period.
As in all real estate transfer pro-rations, we'll need to know whether we're prorating "through" or "to" the date of closing, as well as whether we're using a 360-day "banker's year" or a 365 day calendar year. The steps are:
- Determine the number of days from the closing to the day of policy expiration.
- Calculate the cost per day of the insurance.
- Multiply the number of days times the amount per day.
Let's do a sample insurance proration. A real estate investor is assuming the insurance policy on a rental property. The annual premium for the policy is $1350. The policy premium was paid in full on February 12, and the closing is on October 15 of the same year. We are using a calendar 365 day year and prorating "through" closing. This means the seller pays for the day of closing.
- # of days from Oct 16 through Feb 11 next year is: Oct 16 + Nov 30 + Dec 31 + Jan 31 + Feb 11 = 119 days
- $1350 divided by 365 days = daily cost of $3.70
- $3.70 cost/day X 119 days = prorated amount of $440.30.
This amount would be CREDITED to the Seller and DEBITED to the Buyer.
Pro-ration and the Closing Statement
Why are there items on a real estate transaction closing statement that must be pro-rated?
- Money in escrow - sometimes it is necessary to decide if some of the money held in escrow for expenses should be returned to the seller or stay in escrow for the buyer.
- Insurance - Insurance premiums are paid ahead, so the seller has paid for a full year of insurance. At closing, some of that premium money is returned to the seller for the rest of the year they will not own the property.
- Property taxes - Like insurance, but it works the other way. Let's say you're closing in June, and tax bills for this year come out in November for payment by January 1. The buyer will be the owner at tax time, but they weren't for the entire tax year. So, the seller will owe the amount due between closing and the tax due date. Usually, that amount is credited to the buyer's side of the statement at closing and the buyer pays the taxes when due.
- Rents - Rental properties will have rents paid for the month at the beginning of the month in most cases. So, if the deal is closing on the 15th of the month, the seller has been paid for the full month but only is due half of that. The buyer will be credited for the amount of rents for the last 15 or 16 days of the month.
- Commercial lease payments - There are several types of leases with different payment structures. It's complicated, but a closing will require pro-ration of what is due the seller for their period of ownership and the rest belongs to the new owner.
- Farm and Ranch Leases - Often farms and ranches may be leasing land from a neighbor or from the government for grazing. If so, any pre-payment that applies to the time after closing will need to go to the seller, as they're no longer owners. The buyer will be responsible for this.
It is important to know that these are accepted practices, but some of them can be negotiated as a part of the purchase agreement. They're not iron-clad. Particularly with commercial property, a sharp real estate professional can be valuable to their client by pointing out areas of the deal that could be negotiated if they've hit on a price stalemate.