With the upcoming limitation to $10,000 annually for any deduction for state and local taxes on Schedule A, questions arose about being able to prepay taxes before the end of 2017 to obtain the unlimited deduction rather than face the $10,000 cap beginning in 2018. Congress shut down any thought of prepaying 2018 income taxes, treating any payment of 2018 taxes made in 2017 as being paid in 2018 (IRC §164(b)(6) after revision by the Tax Cuts and Jobs Act).
With prepaying income tax shut down, taxpayers began to think about prepaying property taxes, with a number of localities providing methods to advance pay taxes for 2018. But if a tax has not yet been assessed or billed, can that tax be deemed “paid” under IRC §164(a)?
In response to these developments, the IRS issued News Release IR-2017-210, IRS Advisory: Prepaid Real Property Taxes May Be Deductible in 2017 if Assessed and Paid in 2017. The news release provides information on the types of payments made before the end of 2017 that can be deducted on the 2017 return.
The IRS provides the following statement regarding what is necessary for such payments of taxes to be properly deductible on 2017 income tax returns:
The IRS has received a number of questions from the tax community concerning the deductibility of prepaid real property taxes. 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.
IRC §167(a), which governs deductibility, provides the following:
(a) General rule.
Except as otherwise provided in this section, the following taxes shall be allowed as a deduction for the taxable year within which paid or accrued:
(1) State and local, and foreign, real property taxes.
A prepayment clearly is an amount paid for a cash basis taxpayer, but the question becomes whether what is paid is truly a tax before it is assessed—and what exactly would be the trigger that determines the date of assessment for federal tax purposes of these state and local level taxes.
The IRS gives the following examples of its position in the news release:
Example 1: Assume County A assesses property tax on July 1, 2017 for the period July 1, 2017 – June 30, 2018. On July 31, 2017, County A sends notices to residents notifying them of the assessment and billing the property tax in two installments with the first installment due Sept. 30, 2017 and the second installment due Jan. 31, 2018. Assuming taxpayer has paid the first installment in 2017, the taxpayer may choose to pay the second installment on Dec. 31, 2017, and may claim a deduction for this prepayment on the taxpayer’s 2017 return.
Example 2: County B also assesses and bills its residents for property taxes on July 1, 2017, for the period July 1, 2017 – June 30, 2018. County B intends to make the usual assessment in July 2018 for the period July 1, 2018 – June 30, 2019. However, because county residents wish to prepay their 2018-2019 property taxes in 2017, County B has revised its computer systems to accept prepayment of property taxes for the 2018-2019 property tax year. Taxpayers who prepay their 2018-2019 property taxes in 2017 will not be allowed to deduct the prepayment on their federal tax returns because the county will not assess the property tax for the 2018-2019 tax year until July 1, 2018.
Is the IRS correct in this position? That may need to ultimately be answered in court proceedings—although it would likely take a rather large property tax payment to make it economically viable for a taxpayer to take this matter to court.
As well, while the IRS treats the term “assessed” as if the meaning will be clear—but given the nature of state laws and the processes involved, it may not be immediately obvious when the tax is “assessed” for purposes of this rule.
As well, in income taxes the IRS was eventually forced to back off the view that no deduction could be allowed until the tax was first due. In the 1942 case of Estate of Lowenstein, 12 TC 694, the Tax Court held that so long as taxpayer paid an estimate of taxes due on a date in the following year that was reasonably expected to approximate the amount due and such a prepayment was authorized under state law, the deduction was allowed when paid even if later refunded.
But it’s very possible that the Courts could view property taxes as fundamentally different from income taxes, since in Lowenstein the events that would lead to the tax liability had already taken place (income earned) even if the balance was not yet due.
So what should advisers do? First, if a taxpayer did prepay property taxes before the end of 2017, the adviser needs to obtain information regarding what type of billing/assessment/other action had been taken by the taxing agency before payment was made. Obviously if the tax payment fits the criterial of the first IRS example then a deduction is allowed.
But what if the case looks more like the second example—or at least is not clearly within the limits of the first example? In that case the adviser will need to determine if he/she believes, given the facts and available authorities, that there is a reasonable basis for the deduction even if there is not substantial authority for the position.
At that point, the adviser would have to present the options to the taxpayer regarding the positions that can be taken, along with the warning that it appears taking the deduction would be contrary to the IRS’s stated position in the news release. If there is reasonable basis, the taxpayer should be told the deduction can be taken on the return but only if the position is adequately disclosed on a Form 8275.