What Are Prepaids in Real Estate & How Do They Work?

Prepaid expenses in real estate are amounts paid at closing that cover property-related costs for a period extending beyond the closing date. They ensure that ongoing expenses are appropriately allocated between the buyer and seller.

Understanding Prepaid Expenses

Prepaid expenses in real estate represent costs paid in advance for future services or obligations. Their purpose is to ensure ongoing property-related costs are covered by the correct party for the accurate period, especially when property ownership changes hands mid-period. This arrangement is necessary because many property expenses, such as taxes and insurance, are billed annually or semi-annually.

When a home sale closes, these future expenses need to be accounted for daily. For example, if a seller has already paid property taxes for an entire year, but the sale occurs halfway through that year, the buyer will reimburse the seller for the portion covering the period after closing. This mechanism prevents either party from disproportionately bearing the cost for a time they do not own the property. These prepaid amounts are distinct from other closing costs, which are fees for services rendered during the transaction itself.

Common Types of Real Estate Prepaids

Common types of prepaid expenses address specific ongoing costs associated with property ownership:

Property taxes: These are frequently prepaid at closing. If the seller has paid taxes for a period extending beyond the closing date, the buyer often prepays their share to the seller for the remaining portion.
Homeowner’s insurance premiums: Lenders generally require the first year’s premium to be paid at closing to ensure continuous coverage from the day the buyer takes ownership. This payment secures the property against potential damage, protecting both the homeowner’s and the lender’s investment.
Homeowners Association (HOA) dues: If applicable, these are recurring fees collected by a homeowners association to maintain common areas and provide services within a community. Buyers typically prepay these monthly or quarterly fees for the period immediately following the closing.
Mortgage interest: Buyers usually prepay interest from the closing date through the end of the month in which the closing occurs. This is because the first full mortgage payment is typically due on the first day of the second month after closing, covering the interest for the prior full month.

Accounting for Prepaids at Closing

The handling of prepaid expenses at closing involves specific accounting procedures to ensure fairness. The concept governing these adjustments is proration, which is the process of dividing expenses proportionally between the buyer and seller based on the exact closing date. This ensures that each party pays only for the days they own the property.

Prepaid amounts appear on the Closing Disclosure (CD), a five-page form detailing the financial aspects of the mortgage loan. On the CD, prepaids are typically shown as a credit to the seller, who has often paid for services or taxes beyond their ownership period, and a corresponding debit to the buyer. This adjustment directly impacts the final cash-to-close amount for both parties.

Escrow accounts, also known as impound accounts, play a significant role in managing future recurring prepaids like property taxes and homeowner’s insurance. At closing, buyers often fund an initial reserve into this account. Lenders establish these accounts to collect a portion of these expenses with each monthly mortgage payment, ensuring funds are available when the larger annual or semi-annual bills become due.