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Tax Adjustments During the Closing Process

by Brandon Cornett

Tax adjustments at a closing can mystify some homebuyers, even though they are fairly straightforward. The part that is often confusing is the terminology used and the way it is explained.

There are several adjustments that take place during the real estate closing, but in this article we will focus on the ones that affect the home buyer.

Property taxes in virtually every county in the United States are paid at specific intervals. In many counties, you pay your property taxes twice per year, or every six months. They are paid in advance, meaning that you are paying for the next six months, rather than the six months that just past.

Because property taxes are paid in advance, the existing owner of a home will have paid a certain portion of them when you agree to buy the home. Because of this, a tax adjustment is usually made. Basically, you are paying the seller back for the taxes they paid on (what will be) your behalf after the closing.

To keep it simple, let's assume that taxes are paid in January of every year in the sum of $2,400. That bill of $2,400 covers the six-month period of January to June. On July 1 every year, a tax bill of $2,400 is owed, which covers the six-month period of July to December each year. The annual taxes therefore are $4,800.

The 6-month payment of $2,400.00 means that the monthly tax bill on the property is $400.00 per month, which is generally prorated to a daily fee based on 30 days per month (even though every month does not have 30 days, most real estate professionals use that as the basis for determining a per diem rate). In this scenario, the $400 per month bill is equivalent to a per diem rate of $13.33.

At the real estate closing, the adjustment will be based on how many months and days of taxes have been prepaid. For every month prepaid you will owe the seller $400. So for every day over the whole months you will owe $13.33 per day.

In some jurisdictions, you may have two or more property taxes and the adjustments will be calculated in the same way. Since property taxes in some places can be significant, it is a good idea to know ahead of time when the tax bills are paid and how substantial the adjustment will be so you are not caught off guard.

In addition to these taxes that you are paying the seller, the lender will likely be requiring you to put some money in escrow towards your next tax bill. Most lenders pay the property taxes on the owners' behalf in order to protect their interests in a home. Because of this they require money be placed in escrow (generally a portion of your monthly mortgage payment) towards your taxes, with a 2 - 3 month cushion in case you fall behind in your mortgage payments.

At the closing you will pay a sum of money into escrow equivalent to what should be in your escrow account at that time of the year. It is important to ask the lender in advance how much they will require being placed in escrow at the closing.

Tax adjustments are simple math but can be somewhat confusing, so ask questions before the closing and get a good understanding of what tax adjustments will be made at the closing and what your financial obligations are.

Related article: Closing Costs When Buying a Home

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Brandon Cornett is the editor of Home Buying Institute.