Understanding Tax Prorations

Tax Prorations can be confusing if you are not a seasoned veteran of real estate closings.

Most real estate contracts will contain a section dealing with tax prorations. In Texas most residential transaction use the Texas Real Estate Commission (“TREC”) contracts. Section 13 of the TREC One to Four Family Residential Contract deals with prorations. When you close the purchase or sale, the prorated items will also show up as a charge or a credit on your closing statement.

The entire process of prorating taxes can be difficult to understand because prorations are accomplished with debits and credits on the closing statement. No cash actually changes hands. To prorate simply means to allocate. Since we are discussing taxes, in this context to prorate taxes means to allocate taxes which have accrued (meaning the expense is actually chargeable to a party but cannot be paid yet) but have not been paid.

Property taxes, for instance, cannot be paid for the current tax year until statements are provided by the taxing entities (city, county, school districts, etc). Taxes accrue from January 1st through December 31st of each year. However, they cannot be paid until near the end of the year, usually October or November, when tax statements are sent to property owners.

If a transaction closes at a time during the year when tax statements are not available, the taxes are prorated or allocated to the buyer and seller with a debit and credit entry on the closing statement. Typically, the seller gets a debit (a charge) and the buyer gets a credit. This proration or allocation of taxes is almost always an estimate because the actual taxes for the year are unknown until the statement is received. Usually, tax prorations are based on the previous year’s taxes. If taxes go up or down, the proration will be inaccurate; however, the estimate is based on the best information available.

The easiest way to illustrate tax prorations is with a hypothetical. Suppose the taxes for the last year before the year of sale were $12,000, and suppose the closing of the sale of the property occurred on June 30th of this year, exactly half way through the year. The seller would be responsible for the taxes which accrued from January 1st to July 1st. One half of last year’s taxes would be $6,000. The buyer will be responsible for the taxes for the remainder of the year after purchase. Since the buyer will own the property at the end of the year, the buyer will receive a tax statement for $12,000 at the end of the year of purchase, assuming taxes remain the same as last year. The buyer will pay the entire $12,000 tax statement.

However, at closing on June 30th, the buyer will receive a credit for $6,000 from the seller which is the seller’s share of the taxes for the year of closing. This credit will reduce the cash the buyer has to bring to closing.

On the seller’s statement, there will be a charge of $6,000 which reduces the cash the seller receives from the sale. When the buyer pays the tax bill at the end of the year, his or her net cost is $6,000 ($12,000 less the credit of $6,000).

But assume that the actual taxes on the property increase by $100 per month for the year of sale from $12,000 per year to $13,200. The buyer received a $6,000 credit because that credit was based on last year’s tax bill. The credit should have been one-half of $13,200 or $6,600. Now when the buyer pays the entire tax bill of $13,200 he or she is paying more than one half of the tax bill.

This is a common situation. Buyer and seller have agreed in Section 13 of the TREC contract to adjust the prorations when tax statements for the current year are available and both buyer and seller will be asked to sign an agreement at closing stating that when the actual taxes for the year of closing are known, they will adjust the prorations in cash between themselves.

Since taxes go up a lot more often than the come down, the buyer usually gets less than the credit deserved at closing. If you are a buyer, compare the actual tax invoice you receive at the end of the year with the credit you received at closing to determine whether you received the proper credit from the seller.

Often the difference between the estimated tax proration and the actual taxes is not significant enough to concern either party. But if it is significant, the aggrieved party should contact the other party and request an adjustment.

To make matters even more confusing, most buyers escrow taxes with their lender so taxes at the end of the year are paid from the buyer’s escrow account. However, this does not change prorations or the need to adjust with the seller at the end of the year of purchase.

Unfortunately, you cannot go back to the title company or closing agency for help with this. Most tax proration agreements signed at closing obligate the buyer and seller to make this adjustment between themselves.