CHAPTER 9

PRORATED VALUES IN FINANCE AND TAXES

Important Guidelines

Prorating transactions is a constant necessity in real estate. This need recurs in so many different aspects of the investing process that every real estate investor needs to acquire two skills: the ability to make prorations accurately and a rationale for making prorations that can be documented and supported.

This chapter provides detailed explanations of the various forms of proration and explores methods for making a proration decision. Some of the decisions you make regarding proration may have ramifications for years to come. For example, the method you use to divide a property’s value between land and improvements directly determines how much depreciation you are allowed to claim each year. There are several ways to make the proration decision, and for most people, several concerns arise when making such decisions. These include:

1.Picking the most advantageous method for making a proration

2.Documenting the rationale for the decision itself

3.Identifying alternative proration methods that may be preferable

WHY YOU NEED TO PRORATE VALUES

If you operate a business that is open to the public, you may run into proration only rarely, if ever. For example, operating a retail boutique or a consulting company involves selling goods or services, keeping track of costs and expenses, and managing a bank account. While bookkeeping for most small business operations requires skill, it is not as complex as investment accounting.

Even a generalized investing record-keeping system is often fairly straightforward. For example, stock market investors need to track different types of income sources: capital gains and losses, dividends, and interest. They may wish to compare gains and losses on an annualized basis, and they need to account for their expenses, including trading fees, sales commissions, and subscriptions.

Real estate investors face a far more complex task in keeping track of revenue and expenses. There are numerous additional, often complex record-keeping demands related to figuring out depreciation, reporting taxes, and even calculating capital gains (which may include bringing forward unclaimed losses from previous years, recapturing depreciation, and even calculating the tax basis in property when previous gains have been deferred—see Chapter 11).

Among the complexities that real estate investors face is the proration of various expenses and, in some cases, even revenue. Some examples:

When a tenant begins paying rent during the month, you need to prorate the first month’s expenses to cover the period before the rent due date (usually the first).

If two or more tenants share rent, you need to calculate how much each one owes in total rent. This may involve calculations that have to include not only the space each tenant occupies but common areas as well.

When you claim depreciation for items that are not specific to any one property (for example, autos and trucks or landscaping equipment), you need to decide how to prorate that expense among the properties.

Operating expenses are not always specific to one property, and these also have to be prorated among properties on some basis.

In charging tenants for a portion of your increased property taxes, insurance, or utility costs (as may be specified in a lease or rental contract), you need to prorate by the days affected by the increased rates. You also need to prorate among tenants in any multiunit building.

Property taxes are often due twice a year, but expenses apply to specific months. In some instances, the expense needs to be set up to reflect the applicable month of the expense rather than the timing of the payment. The same calculation requirement is often seen in insurance; payments may be due for 3, 6, or 12 months in advance, but it is desirable to report each month’s expense in the appropriate time slot.

When you purchase properties, you are allowed to depreciate the improvements, but not the land. The method you use to break down your basis between these two will determine the amount of depreciation you are allowed to claim.

USEFUL PRORATION METHODS

The specific types of transactions that require proration should each be handled on the basis that makes the most sense, given the nature of the transaction. For example, in dealing with tenant-related matters, proration probably will involve prorating on the basis of a number of days or square feet of rental space. When dividing up expenses, this would most logically be done on the basis of rental income. No one method will work for every proration requirement. For this reason, you will need to study each specific area and identify the most useful method of proration.

PARTIAL MONTH RENT

One of the most frequent times proration is required is when someone moves into or out of a rental midway through the month. This affects both the calculation of rent—either the first or the last month—and the cost of utilities. For example, if rent is due on July 1 and a tenant gives notice that she is moving out on July 12, how do you prorate rent and utilities? Some rental agreements require that notice be given through to the first of the following month, but that is inflexible, and at times people need to vacate on a date other than the end of the monthly rental period.

The applicable period for which rent is charged or credited can be calculated using one of two methods: the actual number of days or a 30-day month method. Whichever method you employ, it is wise to include the method of calculation in the rental agreement. The difference the choice of method makes depends on the month (28, 29, 30, or 31 days) involved; however, the dollar amount will not be significant. As a matter of policy, it is reasonable to suggest that you decide on a method and use it consistently.

In the actual-days method, you count the number of days in the period and calculate those days as a percentage of the total month. If rent will be charged through July 12 and the month has 31 days, the formula would be to figure twelve thirty-firsts of the full month’s liability.

•Formula: Partial Month’s Rent Liability

D ÷ M = P

where:

D	= days in period to be counted
M	= full month
P	= partial month liability

•Excel Program: Partial Month’s Rent Liability

A1:	number of days
B1:	full month
C1:	=SUM(A1/B1)

The same formula applies if you use the second calculation method, assuming that all months have 30 days and the year consists of 360 days. This so-called banker’s year is commonly used in the lending and real estate industries. In that case, the month (M) will always have the value 30.

The example in which a tenant gives notice through July 12 would involve dividing 12 by the full month’s count. Using the 30 day-month method:

12 ÷ 30 = 0.40

If you use the alternative method, the proration in a 31-day month would be:

12 ÷ 31 = 0.39

There is little difference between these two methods. For example, based on rent of $700 per month, the difference in liability is only $7.

The procedure works on the other end of the rental period as well. For example, let’s say your property is vacated on July 12 and a new tenant takes up residence on July 16. How much rent is due for the short month from July 16 through the end of the month? To apply the formula using both methods, you begin by counting the days. In a 30-day month, the period from the 16th through the 30th is 15 days. In a 31-day month, you would use 16 days:

15 ÷ 30	= 0.50
15 ÷ 31	= 0.48

If the rent were $700 per month, the difference here is $14.

SHARED RENT AMONG TENANTS

A second tenant-related proration is required whenever one of two situations arises. The first is the case where two or more tenants cohabit and are responsible separately for part of the rent. The second is the case where rent applies for only part of the year, and the property is used as a second home or vacation home for the balance.

Tenants’ share of property can be complex when common areas are involved. Consider this situation: You have a 2,200-square-foot house and three tenants, Bob, Josh, and Andy. Total rent is $1,100 per month. Each tenant has his own bedroom:

Bob	375 square feet
John	400 square feet
Andy	260 square feet

The rest of the house is shared by the three tenants, and they have agreed to pay for the entire house on a “shared” basis. But what does that mean? The solution is not as straightforward as it may seem. In some shared agreements, three tenants will simply agree to split the rent one-third each. But in this example, Andy could make a case that because his bedroom is the smallest, he should not have to pay a full one-third of the rent. Bob and Josh could argue in response that the bedroom size is not the most important aspect, but that the common areas (living room, kitchen, and so on) make the deal more equal than mere bedroom size. Some accommodation might have to be made to adjust for these arguments.

On a strictly prorated basis, the total rent would be divided using square feet. This means Andy would pay the least amount of rent.

•Formula: Prorated Rent, Tenant Share

T ÷ F = P

where:

T	= tenant’s square-foot share
F	= total square feet
P	= prorated rent

•Excel Program: Prorated Rent, Tenant Share

A1:	tenant’s square-foot share
B1:	total square feet
C1:	=SUM(A1/B1)

In the example, each tenant’s total rent would be calculated by first adding up the square feet of the bedrooms alone. This comes to 1,035 feet. Next, apply the formula:

Bob	375 square feet ÷ 1,035 = 36%
John	400 square feet ÷ 1,035 = 39%
Andy	260 square feet ÷ 1,035 = 25%

Applying these prorations to the total rent, $1,100, gives:

Bob	36% * $1,100	= $   396
John	39% * $1,100	= $   429
Andy	25% * $1,100	= $   275
Total	100%	$1,100

If you are to make any adjustments to these breakdowns based on emphasis on common areas and in consideration of varying bedroom sizes, the deal can be brokered using any method that makes everyone happy. If the tenants agree to round out to rents of $400, $400, and $300, or $375, $375, $350, it does not matter to you, as long as everyone is in agreement.

The multitenant situation can be quite complex. For this reason, it makes sense for a landlord to insist on working with one primary tenant who signs the agreement and is responsible for the entire rent. That tenant can then make a deal with the others according to whatever works out, allowing the landlord the simplicity of working with only one person.

PARTIAL-YEAR RENTALS

Partial-year rentals are somewhat easier to deal with than shared rent proration. In the typical partial-year rental situation, you will plan to use a property for certain months and rent it out for the rest of the year. For example, you and your family may want to use the property during July and August, and for the remainder of the year it is rented out as an income property. The basis for prorating the use of the house is normally going to be the number of days the property is identified for each use, whether it is actually occupied or not. It is the availability that determines how much you are allowed to deduct as rental expense for tax purposes. For example, the property may be available for rent for 10 months. Even if you collect rents for only seven months, you are still allowed to claim expenses for the portion of the year the property is available.

There are three methods for calculating the proration of expenses: actual days based on the number of days in the year (365 or 366), number of days based on 30-day months and a 360-day year, and a simple division of months.

For example, suppose you rent out a property for 10 months. You are allowed to claim deductions for depreciation, interest, property taxes, insurance, utilities, and other expenses for ten-twelfths of the year, calculated using one of the prorated methods. For the remaining two months, you can claim interest and property taxes as itemized deductions on a second home, but other expenses cannot be deducted.

If you use the days method, the formula is based on the actual number-of-days count or on 360. For example, if your property is available for two months, the 360-day-year method would count that as 60 days. Under the actual days method, you count July and August, which both have 31 days, so that would be 62 out of 365 days.

•Formula: Prorated Rent, Partial-Year Use

R ÷ F = P

where:

R	= rental period
F	= full year
P	= prorated rent

•Excel Program: Prorated Rent, Partial-Year Use

A1:	rental period (days)
B1:	full year (365 or 360)
C1:	=SUM(A1/B1)

Using either the 360-day or 365-day method produces the prorated answer:

60 ÷ 360	16.67%
62 ÷ 365	16.99%

The outcome for the two cases is very close. The decision to use the 360-day year often comes down to a matter of convenience rather than a significantly greater amount of deductions.

DEPRECIATION FOR NONPROPERTY ITEMS

In Chapter 11, depreciation calculations are provided and explained. For the purposes of proration, real estate investors need to decide how to handle nonspecific property depreciation. For example, you know that claiming depreciation for a building and other improvements is specific to one property. However, if you own two or more rental properties, how do you break down depreciation on a truck?

In reporting revenue and expenses for rental properties, you are required to break down deductions among properties. So the most obvious way to assign or allocate depreciation for nonproperty items is on the basis of revenue (see the next section, “Nonspecific Expense Proration”). This is logical and fairly easy to calculate, and it solves the problem. However, it also makes tracking expenses more difficult. If you prorate depreciation and other expenses, you should prepare a worksheet showing all of your calculations—not only to prepare for the possibility of a tax audit but also so you will know how you broke down the numbers from one year to the next. This year’s worksheet makes next year’s tax calculation far easier.

An alternative is to report specific expenses for each property and then include a nonspecific expense column as well. In this column, there would be no revenue, but expenses such as depreciation, office supplies, auto and truck expenses, and professional fees are listed. This keeps reporting simple, but it may also complicate your tax reporting, especially if you are not allowed to claim a full deduction each year for reported losses. In that case, losses are carried forward and claimed against other investment income, or taken when properties are sold. So if you have unassigned expense losses carried over, how do you assign them to individual properties when those properties are sold? Using unassigned categories works only if and when you are able to claim a deduction for your real estate losses in the current year.

NONSPECIFIC EXPENSE PRORATION

The most complex tax calculation you will need to make is dividing expenses among properties. Some expenses, including mortgage loan interest, property taxes, utilities, and property-specific depreciation, are easily assigned to the subject property. However, some other expenses are not specific to one property, and these have to be assigned on some basis when you own two or more rentals.

One method would be to simply divide expenses evenly. If you own three properties, one-third of your nonspecific expenses go to each property. If you owned one property for only part of the year, it may be necessary to calculate a proportionate reduction for the year’s expenses.

•Formula: Expense Allocation (Even Distribution)

E ÷ P = A

where:

E	= nonspecific expenses
P	= number of properties
A	= allocation percentage

•Excel Program: Expense Allocation (Even Distribution)

A1:	nonspecific expenses
B1:	number of properties
C1:	=SUM(A1/B1)

As noted, if you own three properties, unallocated expenses would be prorated one-third to each. However, what if one of your properties was owned for only part of the year? Suppose you own three properties, but you acquired one of those properties at the beginning of the fourth month. This means that on the even-distribution basis, the third property should be prorated a lower portion of the total.

In this case, you would need to break down the proportionate level of proration for the property you owned for a shorter period. This can be done on the basis of the number of months involved. You owned properties 1 and 2 for 12 months each, and property 3 for only 8 months. The total number of months is 32 (12 + 12 + 8).

•Formula: Expense Allocation (Months Owned)

M ÷ T = A

where:

M	= months of ownership during the year
T	= total months of ownership, all properties
A	= allocation percentage

•Excel Program: Expense Allocation (Months Owned)

A1:	months of ownership during the year
B1:	total months of ownership, all properties
C1:	=SUM(A1/B1)

Using the previous example, properties 1 and 2 would each be prorated 37.5 percent (12 ÷ 32), and property 3 would be prorated the remaining 25 percent of unallocated expenses (8 ÷ 32).

Another method is to break down the expenses based on a proportionate share of rental income. This is a reasonable method even when you own properties only part of the year. A shorter period would translate into lower revenues, so this formula can be used consistently no matter when properties were acquired. Under this method, you add the rental income for all properties owned during the year, then each property receives a share of prorated expenses based on its percentage of the total.

•Formula: Expense Allocation (Revenue Share)

R ÷ T = A

where:

R	= revenue received for the property
T	= total revenue, all properties
A	= allocation percentage

•Excel Program: Expense Allocation (Revenue Share)

A1:	revenue received for the property
B1:	total revenue, all properties
C1:	=SUM(A1/B1)

For example, if you own three properties during the year, the first step is to add up rental revenues for all three:

Property 1	$10,800
Property 2	12,600
Property 3	+  7,200
Total	$30,600

Applying the formula, 35 percent of expenses would be prorated to:

Property 1	$10,800 ÷ $30,600 = 35%
Property 2	$12,600 ÷ $30,600 = 41%
Property 3	$ 7,200 ÷ $30,600 = 24%

INCREASED EXPENSES CHARGED TO TENANTS

Another proration situation arises when lease or rental terms include a provision for passing on increases in certain expenses, such as property taxes, utilities, or insurance. For example, you may own a three-unit building, and each tenant has agreed to accept rent increases if and when the building’s property taxes are increased. The contract’s terms should define exactly how the increase is to be prorated among the three units, to avoid possible arguments in the future. Two logical methods of calculating the breakdown are on the basis of revenue (see the previous discussion) or on the basis of square feet for each unit.

Using a square-foot breakdown may be easier to support than a breakdown based on rental income. As the rent you charge may vary between units and not track square footage exactly, it may be more reliable to use square feet consistently, regardless of how much rent is charged. A tenant may rightly protest, for example, if one unit is vacant when the property tax increase comes through, and the landlord attempts to divide the expense among two tenants. It is not the tenant’s fault that the third unit is unoccupied, and it would be more equitable to use square feet. Thus, in the event that a unit is vacant, a higher rent would apply to a new tenant.

To calculate a proration based on square feet, it makes sense to ignore gross building area and concentrate on rentable square feet only. The proration would apply to the increase in the specific expense (in this case, property tax) only, and each tenant would be required to pay a higher rent based on that allocation.

•Formula: Expense Allocation (Square Feet)

F ÷ T = A

where:

F	= rentable square feet, each unit
T	= total square feet, all units
A	= allocation percentage

•Excel Program: Expense Allocation (Square Feet)

A1:	rentable square feet, each unit
B1:	total square feet, all units
C1:	=SUM(A1/B1)

For example, your rental property contains three units. They measure:

Unit 1	550 square feet
Unit 2	475 square feet
Unit 3	+   440 square feet
Total	1,465 square feet

Applying the formula, unit 1 is responsible for 38 percent of the increase (550 ÷ 1,465), unit 2 gets 32 percent (475 ÷ 1,465), and unit 3 is prorated 30 percent (440 ÷ 1,465).

PROPERTY TAXES AND INSURANCE CALCULATIONS

In recording transactions in your books and records, you can use several different methods. The easiest is to record expenses as they occur, even when the applicable period extends beyond the month in which payment is made. The second method involves prorating the expense over the period.

For example, you may pay an insurance premium every March and September. The March payment covers your property from April through September, and the September payment relates to the period from October until the following March. Under the cash accounting basis, you would simply record the insurance payments in March and in September. But if you would like to track your insurance expense from month to month, you need to prorate it. This allows you to review revenue, expenses, and profit (or loss) from one month to the next with accuracy. When you record a six-month payment in a single month, the true outcome is obscured. It may simplify your bookkeeping to use the cash basis and then make adjustments when you review monthly results, or it may be preferable to adopt a methodical system for handling prepayments for insurance, property taxes, and any other prepaid expense.

•Formula: Expense Allocation (Prepayments)

E ÷ M = A

where:

E	= total prepaid expense
M	= number of months the expense relates to
A	= allocation amount

•Excel Program: Expense Allocation (Prepayments)

A1:	total prepaid expense
B1:	number of months the expense relates to
C1:	=SUM(A1/B1)

For example, your March prepayment for insurance on a rental property is $288. The period covered is six months, so each month is assigned $48, or one-sixth of the total payment ($288 ÷ 6). In this calculation, you use an amount rather than a percentage because the prepaid expense (E) is expressed in dollars.

LAND/BUILDING PRORATION METHODS

Investors struggle with the question of how to divide the total basis in their property investment between land and improvements. This breakdown is not provided automatically in real estate listings, and there are at least three methods for calculating the breakdown. It is necessary to make the division because the value of land cannot be depreciated. So in selecting one method over another, it is important to remember that higher improvement percentages translate into a higher depreciation deduction.

If you need and want a higher deduction, it would make sense to pick a method based on this desire. However, if you cannot deduct all of your net tax-based losses each year (see Chapter 11), a more conservative system is advisable. Because all depreciation is recaptured (eventually taxed) upon sale of the property, a lower deduction could be preferable. Choosing one method over another is a decision you should make with your tax adviser’s help. Once a method is picked, it has to be used for the property consistently. It may also be wise to use the same method for all of your investment properties; in the event of an audit, using the same method for all properties supports your decision and adds credibility.

The first method is to base your allocation of total value between land and improvements on the assessed value at the time you buy a property. The depreciable portion (improvements) is expressed as a percentage of the total assessed value, and that percentage is applied against your total basis.

•Formula: Depreciation Basis (Assessed Value)

I ÷ V = A

where:

I	= improvement value per assessment
V	= total assessed value
A	= allocated basis, improvements

•Excel Program: Depreciation Basis (Assessed Value)

A1:	improvement value per assessment
B1:	total assessed value
C1:	=SUM(A1/B1)

For example, you purchase a property for $162,800. According to the assessor’s office, the total assessed value of the property is $140,000: $90,000 in improvements and $50,000 for land. The depreciable basis of improvements is 64 percent ($90,000 ÷ $140,000). Applied against your total basis, this means that you can base annual depreciation on $104,200, rounded up ($162,800 * 0.64).

A second basis for depreciation is the value used by your insurance carrier. Every policy identifies what the insurer is covering. Land is excluded, since even in the case of a total loss of the building, the land would remain. The dwelling protection amount is expressed in terms of “limits of liability.” So a partial loss would involve reimbursement for a calculated value that was not necessarily equal to the full limit. The full limit would be the basis only in the event of a total loss. This number may also serve as the basis for depreciation.

•Formula: Depreciation Basis (Insured Value)

L ÷ V = A

where:

L	= insurance limits of liability, dwelling
V	= total basis in the property
A	= allocated basis, improvements

•Excel Program: Depreciation Basis (Insured Value)

A1:	insurance limits of liability, dwelling
B1:	total basis in the property
C1:	=SUM(A1/B1)

For example, you purchase a property, and your total basis is $162,800. Your insurance agent calculates the dwelling’s limit of liability (based on age, size, and features) as $153,000. Applying the formula, your depreciable basis is 94 percent (rounded up) ($153,000 ÷ $162,800), or insured value equal to 94 percent of the price.

The third method is to base your proration on the appraiser’s report. This report breaks out the value of improvements and land based on the cost approach, the sales comparison approach, or a combination of the two.

•Formula: Depreciation Basis (Appraised Value)

I ÷ V = A

where:

I	= improvement value per appraisal
V	= total appraised value
A	= allocated basis, improvements

•Excel Program: Depreciation Basis (Appraised Value)

A1:	improvement value per appraisal
B1:	total appraised value
C1:	=SUM(A1/B1)

For example, you purchased a property, and your total basis is $162,800. The appraisal estimated the market value of the property at $165,000, and identified land value as $40,000 and improvements as $125,000. Thus, improvements are valued at 76 percent of the total market value, rounded up ($125,000 ÷ $165,000). The basis for depreciation of improvements using this method is $123,700 (rounded down) ($162,800 * 0.76).

CONSISTENCY IN METHOD

Three final notes are worth remembering for any and all prorations you make. The first is the need to show your work and keep worksheets as part of your property records. The second is to use a method consistently, and the third is, keep it simple.

Documentation is crucial in order for you to go back in subsequent years or for subsequent properties and apply the same formulas. Your rationale for making a particular proration should be explained on the worksheet as well. For example, if you decide to break out nonspecific expenses on the basis of rental income proration, include a footnote to the calculation explaining that you consider this to be the most reliable and consistent method for allocating expenses. And if you decide to use appraised value as the basis for identifying depreciable improvements, refer back to the appraiser’s report and attach a photocopy of the sheet from the appraisal showing the value of land, improvements, and the total.

Consistency is also important in the types of subjective calculations you make in your books. Because virtually every proration is an estimate, your assumptions are strengthened when you use the same method every year and for every property. If you use different methods, the decision about how you prorate expenses or identify the basis of improvements is more difficult to support or explain.

Finally, complex formulas or rationales are difficult to work with and may also be difficult to explain. Avoid obscuring your rationale by picking a simple proration method whenever possible. This simplifies your record keeping and enables you to make your calculations with less effort.

Chapter 10 expands upon the rules of proration to show how the principles are applied in one very important way: in the escrow and closing process. This is a process in which all transactions are documented for buyer and seller, and invariably, you will have to split expenses or liabilities between the two sides.