Are 2018 State and Local Real Property Taxes Paid in 2017 deductible or not? The Answer’s in the Statute.
By: John L. Marien
On December 22, 2017, President Trump signed into law the Tax Cuts and Jobs Act. In light of the various tax cuts contained in the revisions to the Internal Revenue Code, Congress was compelled to formulate legislation that would recover some of the lost revenue. One provision aimed at recovering a portion of this revenue loss was the addition of a $10,000 limit to an individual’s itemized deductions for state and local taxes. This limitation precludes individual taxpayers from deducting more than $10,000 in certain state and local taxes on Form 1040, Schedule A. The limitation applies for tax years 2018 through 2025.
Upon learning of a possible limitation on deductibility of state and local taxes, tax practitioners began advising clients to prepay their 2018 state and local income taxes before the end of 2017. In New York, Governor Andrew Cuomo issued Executive Order 2017-172 on December 22, 2017, allowing New York real property owners to prepay a portion of their 2018 real property taxes in 2017. This portion was generally only the real property taxes that were set to be billed in January 2018. It did not include school taxes which are generally determined and billed later in the year.
In response to questions on this topic, and facing the likelihood of a tidal wave of prepayments on real property taxes, the IRS on December 27, 2017, issued IR-2017-210. The published guidance advised taxpayers that: “In general, whether a taxpayer is allowed a deduction for the prepayment of state or local real property taxes in 2017 depends on whether the taxpayer makes the payment in 2017 and the real property taxes are assessed prior to 2018… A prepayment of anticipated real property taxes that have not been assessed prior to 2018 are not deductible in 2017. State or local law determines whether and when a property tax is assessed, which is generally when the taxpayer becomes liable for the property tax imposed.”
The IRS advisory notice, however, may well be contrary to the law. Real property taxes are allowable as a deduction under I.R.C. section 164(a)(1) “in the taxable year which paid or accrued.” (Emphasis supplied). This basic provision of the law was not changed under the Tax Cuts and Jobs Act. There is no requirement under the statute, either before or after the new law, that any such taxes must also be “assessed” during such taxable year in which it was paid in order to be deductible for cash method taxpayers. Indeed, state and local income taxes are not actually assessed until the following year when the state tax returns are filed. Yet the IRS and the Internal Revenue Code have always allowed deductions for the prepayment of these liabilities through wage withholding or estimated payments in the year they are made – i.e., the year they are “paid.” Any overpayment of these estimated income tax liabilities by a cash-basis taxpayer is includible as income in the year in which the return is filed and the refund is received, to the extent the prepayments were deducted.
A key provision in Gov. Cuomo’s Executive Order is that it authorized the state and local taxing agencies to determine and to accept prepayments made in 2017 for certain 2018 real property taxes. Under the authority of this Executive Order, many New York counties and municipalities established the necessary procedures to determine the overall amount of these liabilities and physically accept the prepayment of these 2018 real property taxes before the end of 2017. School taxes, which would generally not be determined and billed until later in 2018, could not physically be accepted by the taxing authorities in December of 2017. The local taxing authorities generally limited the amount of any prepayments to the amounts that approximated the 2017 real property taxes. It’s important to remember that if a real property tax cannot physically be “paid” to and accepted by the state and local authorities, then it cannot be deducted under section 164(a) in any event. So, any IRS concerns that taxpayers would prepay excessive and exorbitant amounts of real property taxes are actually unfounded.
It may be helpful to practitioners to analyze the new restriction in the context of the Internal Revenue Code provision itself. The change made to Section 164 under the new law was the addition of subsection 164(b)(6), which places the maximum $10,000 limitation ($5,000 for married individuals filing separately) on an individual’s itemized deduction for the 2018 through 2025 tax years. Specifically, subsection 164(b)(6)(B) places a $10,000 limitation on the aggregate amount of the following state and local taxes: subsection 164(a)(1) [real property taxes]; subsection 164(a)(2) [personal property taxes]; subsection 164(a)(3) [income taxes]; and subsection 164(b)(5) [general sales taxes].
Subsection 164(b)(6)(B) places one further restriction – for purposes of the $10,000 limitation, “an amount paid in a taxable year beginning before January 1, 2018, with respect to a State and local income tax imposed for a taxable year beginning after December 31, 2017, shall be treated as paid on the last day of the taxable year for which such tax is so imposed.” In other words, any 2018 state or local income tax paid in 2017 would be deemed as being paid in 2018 for purposes of determining the new $10,000 limit. This last sentence has been the subject of much discussion and misinterpretation.
By its very terms, this sentence does not apply to state and local real property taxes. It applies only to state or local income taxes. So, any 2018 real property taxes prepaid in 2017 are generally fully deductible in 2017 for cash method taxpayers as long as they are properly paid in 2017. Keep in mind that the otherwise normal restrictions on the deductibility of any prepaid expense must still be satisfied. For example, all prepaid expenses must satisfy the so-called 12-month rule imposed under Treas. Reg. section 1.263(a)-4(f)(1). This capitalization rule generally allows a deduction for a prepaid expense only if its benefit does not extend beyond the earlier of either 12 months after the date the taxpayer realizes the right or benefit, or the end of the taxable year following the taxable year in which the prepayment is made. Furthermore, taxpayers must always establish that the prepayment was made in good-faith and that they have a reasonable expectation that they have a 2018 real property tax liability in the first place. In other words, taxpayers are not allowed to take a deduction for the prepayment of state and local real property taxes unless they are able to establish that their actual liability exists and the prepayment reasonably approximates the amount of this liability. Again, this has always been the case, it has nothing to do with the new tax law.
To summarize, under the relevant statutory provisions, there appears to be no basis for the IRS to challenge Schedule A itemized deductions by taxpayers who prepaid their 2018 state and local real property taxes in December of 2017. Despite the IRS statement in the advisory notice, taxpayers may well be able to claim a Schedule A itemized deduction for prepayment of their 2018 real property taxes as long as the payments were actually made and as long as they had a good-faith reasonable basis that these prepayments represented a liability they expected to owe. Individuals should consult with their tax advisor on this issue.
The attorneys at Andreozzi Bluestein are well versed in all areas of tax law. Should you have a question related to the deductibility of the prepayment of state and local real property taxes in 2017, please call us today with no obligation.
 See, Estate of Lowenstein v. Commissioner, 12 T.C. 694 (1949). acq., 1949-2 C.B. 2, aff’d on other issues sub. nom. First National Bank of Mobile v. Commissioner, 183 F. 2d 172 (5th Cir. 1950). Cert. denied, 340 U.S. 911, 95 L. Ed. 658, 71 S. Ct. 290 (1951); Estate of Cohen v. Commissioner. T.C.M. 1970-272; Rev. Rul. 71-190, 1971-1 C.B. 70. See, also, Rev, Rul. 82-208, 1982-2, C.B. 58.
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