Prorating the 1031 Exchange Transaction

The closing of escrow in any commercial real estate transaction, whether it be a 1031 Tax Exchange or not, incorporates the prorating of certain payables and receivables. For example, lets say that the transaction closes sale in mid May. Who is responsible for the real estate taxes in the year of sale? What about insurance premiums and overdue rent?

The escrow officer typically handles the calculation of prorations, but it is important to know how and what you are entitled to receive as a buyer or seller of real estate. The first step in figuring out prorations is to determine the date of the close of escrow. This will tell you how many days during the year that you owned the property. If you are selling your relinquished property in a 1031 Tax Exchange, and you close escrow on March 30^th, you owned the property for 88 days out of the year and the new buyer will own the property for 276 days (the day escrow closes is not included).

Real estate taxes are technically a lien on real property by the local taxing authority. This lien gets attached to the property as of noon on January 1^st for the upcoming year. Although each taxing jurisdiction is a little bit different, the assessed value of property is usually disclosed to the owner on July 1^st. The actual tax bill and dollar amount are usually not available until November 1^st, and are delinquent after April 10^th of the following year. The seller of the real property usually owes their pro rata share of the years property taxes (number of days they owned the property/ tax bill for the year).

Insurance is another expense for which buyers of real estate and lenders on real estate typically escrow funds. Both parties are interested in insuring the real property that they are about to invest in. Coverage can include fire protection, general liability, earthquake, flood, and many others. The prorated amount is usually a requirement made by the lender to insure that they have several months worth of insurance premiums should something go wrong with the property or the transaction.

Rents are always prorated in a commercial real estate transaction. The proration is typically calculated based upon a 30 day month (leaving the day of escrow close out of the calculation). The thing that makes rents easy to prorate is the fact that they are paid in advance at the beginning of the month. If your transaction closes on the 15^th of the month, the seller is entitled to half of the rent collected for the month (15/30), and the amount collected has already been confirmed by both parties.

Past due rent that gets collected in the future is usually property of the seller, even though they do not own the real estate at the time of collection. If a tenant owes back rent, their payments are first credited to the buyer until their current months rent is paid, any extra is then applied to the balance that they owed the seller. Prepaid rent is usually property of the buyer. If a tenant has prepaid rent for several months, and the sale transaction takes place sometime in between, the prepaid rent gets prorated between the buyer and seller of the real estate. Security deposits are property of the buyer. These deposits get transferred over to the buyer at close of escrow.

Loan assumptions or payoffs are also matters that are handled through prorations in the escrow account. If the buyer is assuming the sellers loan on the property, the interest payments due in the month of close should be prorated accordingly. It is very important that the buyer make sure that the seller is current with their payments to the lender. The lender is also likely to charge a loan assumption fee to the buyer. If seller is paying off their existing loan with the buyers proceeds, it is necessary for prorations to be made. The lender is also likely to charge the seller a fee for paying off the loan early.

There are various other matters that can be easily handled through the use of prorations in the escrow account. These can include, but are not limited to, home owners association, personal property taxes, special assessment districts, Qualified Intermediary fees in a 1031 Tax Exchange, etc. It is important for a buyer or seller of real property to discuss the prorations with the escrow officer and make sure that they understand the calculations that are being made and that they are comfortable with them. Escrow officers can be a great help in any transaction and should be utilized to the benefit of both parties.