IRS Reiterates Its Position on Deducting Prepaid Property Taxes

The battle lines are being drawn between the IRS and various states upset about the $10,000 limit on state and local taxes.  The most recent evidence of this is found in an IRS Information Letter to New Jersey’s Attorney General (INFO 2018-009). 

This letter deals with a planning option pushed by some states for their residents at the end of 2017, allowing for the prepayment of 2018 property taxes before the new $10,000 deduction limit came into the law for 2018 returns.  The IRS issued a news release (IR 2017-20) on December 27, 2017 that indicated the IRS’s position, limiting any deduction only to taxes actually assessed before that date.

The IRS in this letter was addressing whether it was the agency’s position that New Jersey taxpayers in the following situation could claim a deduction on their 2017 income tax returns:

Specifically, you request clarification on whether cash-basis New Jersey residents who paid 2018 local property taxes in 2017 are entitled to a deduction in 2017 for federal income tax purposes.

The IRS begins their response as follows:

Prior to passage of the TCJA, the IRS has consistently taken the position during examinations that the deduction for state and local real property taxes is allowable as long as the tax is both paid and imposed (or assessed) in the tax year. Taxpayers have generally accepted this position.

In support of this position the IRS cites the 4th Circuit’s affirmation of the Tax Court’s ruling in the Estate of Hoffman v. Commissioner, TC Memo 1999-395.  The Fifth Circuit affirmation (albeit in a per curium decision) provided:

Petitioners’ also challenge the Tax Court’s ruling as to the prepayment of real estate taxes for the farm. In December 1996, Mrs. Hoffman paid a portion of the 1997 real property taxes. Real property taxes are allowed as a deduction “for the taxable year within which paid or accrued.” 26 U.S.C. section 164(a). The Tax Court disallowed a deduction for the tax year 1996 because the 1997 property taxes had not yet been assessed. Taxes which have not been actually assessed have not accrued. Lewis v. Commissioner, 47 T.C.M. (CCH) 605, 1983 WL 14730 (1983); Hradesky v. Commissioner, 540 F.2d 821 (5th Cir. 1976). Thus, any partial payment in 1996 was not deductible in that tax year. Id.

The case was not a published case because the Circuit was apparently relying on the Fifth Circuit’s ruling in the Hradesky case (540 F.2d 821 (5th Cir. 1976)). 

The Hradesky case was somewhat interesting in many respects.  In that particular case the taxpayer had paid the taxes to the impound account held by the holder of the mortgage prior to year end, designated to pay the next year’s property tax.  The Tax Court denied the deduction not because it was paid before the tax was assessed, but simply because it wasn’t paid to the taxing authority.

The Fifth Circuit did not want to decide whether a deduction could ever be allowed if amounts were paid to the mortgage company but not forwarded to the taxing authority, so it used a number of other criteria to deny the deduction.  As the panel held in that case:

Addressing Taxpayer’s remaining and only serious point of error, this Court does not undertake consideration of and does not pass on the question of whether a deduction for real estate taxes under 26 U.S.C.A. § 164(a) (1) must be allowed a cash basis taxpayer in the year irrevocable mortgage payments which include real estate taxes are made to a mortgagee, non-taxing party despite the mortgagee’s payment to the appropriate taxing authority in a subsequent tax year.  Instead, the absence of any indication in the record by Taxpayer that his prepayment of taxes to the mortgagee represented actually assessed rather than estimated taxes, that such taxes were actually due in the tax year in question, or that a firm commitment on the part of the mortgagee to pay the taxing unit within 1966 existed, the Tax Court’s finding under the clearly erroneous rule is adequately supported by the evidence. More simply, Taxpayer has failed to meet his burden of incorporating into the record facts which demonstrate this finding was without adequate evidentiary support or the result of an incorrect perspective of the law. Klamath Medical Service Bureau v. Comm., 9 Cir., 1958, 261 F.2d 842; Estate of Spicknall v. Comm., 8 Cir., 1961, 285 F.2d 561; 9 Mertens, Law of Federal Taxation, § 51.23, (1976 ed.); see generally W. F. Chaney v. City of Galveston, 5 Cir., 1966, 368 F.2d 774, 776; Cedillo v. Standard Oil Co., 5 Cir., 1961, 291 F.2d 246, 248. Consequently, the denial of a deduction for Florida property taxes in 1966 is affirmed.

As the IRS admits in its letter, this matter has not been litigated often in the past (which, given the amounts normally involved, would not be terribly surprising), so based on the case law the agency does have it believes its position is the proper one.  Even in the Hradesky and Hoffman cases, the real estate tax issue was a minor issue in the case, with the majority of each opinion devoted to resolving much larger issues that were in dispute.  The real estate matter ended up in court most likely only because other, bigger issues were going before the courts anyway.

The IRS letter concludes:

The TCJA did not change Section 164 of the Internal Revenue Code relating to property tax prepayment. As such, the IRS’s longstanding position remains the same and is reflected in the advisory. Thus, if a state or local taxing jurisdiction imposed tax on real property by the end of 2017, the amounts paid in 2017 are deductible on a taxpayer’s 2017 tax return. If the tax was not imposed by a state or local taxing jurisdiction by the end of 2017, the requirements for the deduction under Section 164 are not satisfied in that year, and the deduction is therefore not allowable in 2017.

But a question will remain—is there a justification for claiming the deduction despite the IRS position?  The answer, like much in tax, is a definite maybe.

First, an adviser must make clear to the client that claiming these deductions on the 2017 return is contrary to the very clearly stated position of the IRS.  There’s a reasonably possibility, assuming the deduction on the 2017 return is substantially greater than in 2016, that the IRS could identify the return as containing this position, select it for exam and then attempt to deny the deduction.  Absent adequate disclosure (that is, via a Form 8275), the IRS would also be very likely to assess penalties, interest and deductions.  As well, as long as the IRS is looking at the taxpayers’ returns for this reason, they might decide to look into other items on the return.  For many taxpayers, the increased examination risk alone would eliminate any desire on their part to claim the deduction.

Second, the position is going to be contrary to what little authority we have.  In the view of this author, the fact that the Tax Court in Estate of Hoffman accepted the view that the tax must be assessed, and the Fourth Circuit did not object to that position on appeal, are the most “on point” authority we have.  The Hradesky decision, while relied upon by the Tax Court in Hoffman, only offered the “assessed” option as one possible reason for disallowance without any real analysis of how that was required by the law.  But in Hoffman the lack of assessment was the sole reason the deduction was disallowed.  This suggests that the position should be disclosed on a Form 8275 attached to the return, something else the taxpayers may not wish to do.

With those caveats, the opinion has one rather glaring flaw in its analysis.  As the paragraph cited above notes above, a deduction for the taxes is allowed in the year the tax is paid or accrued under IRC §164(a).  The analysis next concludes that a tax is not accrued unit it is assessed (understandable), but ignores the “or paid” language.

The IRS would likely argue that what that “or” clause means is that a cash basis taxpayer can’t take a deduction for taxes until they are both accrued and paid, while an accrual basis taxpayer could take a deduction for taxes accrued even though not yet paid.  But that seems to be at odds with the fact that “or” in common usage provides for alternative conditions (If “A or B” is true if A is true and B is false, A is false and B is true or both A and B are true).  

The IRS reading would have the clause read that taxes are deductible if accrued and, if the taxpayer is on the cash basis of accounting, paid by year end.  It seems if Congress really meant that, the provision should have stated the taxpayer may deduct certain taxes, but only if such taxes are accrued before the end of the tax year when they are otherwise deductible.

Thus, those arguing for allowing some amount of prepayment would argue that Congress clearly intended there be a condition under which taxes not yet accrued could be deducted.  In their view, to argue otherwise would render the “or paid” clause meaningless as a secondary condition under which the tax could be deducted.

Will the argument for deduction ultimately prevail?  That is far from clear and certainly would require the taxpayer be willing to either litigate the position or hope someone else manages to win that case.