What is proration?
A proration is a form of monetary payment that buyers and sellers of real estate adjust for a specific time period. Businesses can use prorations to calculate tax liabilities, adjusted payments for shared spaces and other financial obligations. In other instances, a business accountant may use prorated salary adjustments to ensure employees receive their income for the specific time periods they work for.
How do you calculate prorations?
As you grow your business, you may need to expand to multiple locations or move to a larger space. If you purchase or lease a property, you can typically calculate any prorated taxes using the following method:
1. Calculate the daily tax rate
To find the daily tax rate, divide the yearly tax rate by the number of days in the year. For example, if the yearly tax rate is 2%, divide this number by 365 days (0.02 ÷ 365) to get 0.00005479452054, or 0.005749452054%, as the daily tax rate. If it’s a leap year, you would divide the annual tax rate by 366 days.
2. Find the exact day count for the closing date
You need to figure out your exact closing date, or the date that the sale of the property occurs. The closing date’s day count is important for calculating how much the tax obligations will be for both the buyer and the seller. For example, January 1 would be day one, as this is the first day of the calendar year, and a closing date of December 31 would give you a day count of 365 (within a non-leap year) since it’s the last day of the calendar year.
3. Calculate the seller’s day count
Calculate the seller’s total number of days by subtracting one from the closing day number. For instance, a closing date of June 1 would be a day count of 152, since from the first day of the year up to June 1 is equal to 152 days. Then you need to subtract by one because the closing date is the day that the property switches owners and the seller stops owning the property. Therefore, 151 is the number of days the seller actually owned the property.
4. Calculate the buyer’s day count
To find the buyer’s day count, subtract the seller’s day count from the number of days in the year. Using the previous example, find the buyer’s number of days by subtracting 151 (the seller’s day count) from 365, assuming a non-leap year. In this case, the buyer’s number of days is 214.
5. Calculate the buyer’s and seller’s tax requirements
To calculate how much of the property taxes to prorate at closing, you need to know what the tax obligations are for both the buyer and seller. To find this amount, multiply each party’s number of days by the daily tax rate, and then multiply again by the property value.
Using the previous examples, the buyer should multiply the daily tax rate of 0.005479452054% by their day count of 214 and again by a $500,000 property value, which looks like this: 0.00005479452054 x 214 x 500,000. This makes the buyer’s total tax liabilities $5,863.01. Use the same method for the seller: 0.00005479452054 (daily tax rate) x 151 (seller day count) x 500,000 (property value). The seller’s total tax liabilities are $4,136.99.
Read more: How to Grow Your Business
Example of prorations
One example of proration occurs when purchasing or leasing an industrial property or office building. For example, if you lease a 4,000-square-foot office space and let another organization co-lease with your business, you’ll calculate how much of the space you share and how much you don’t. So if there are 2,500 square feet of the 4,000-square-foot building your business won’t occupy or use, you can prorate your monthly payments to reflect what the other business owes toward its share of the space based on this difference in square footage.