Year-end planning: IRS weighs in on prepaying state and local real estate taxes

Authored by Paul Dillon

The recently enacted Tax Cuts and Jobs Act (the Act) limits the state and local tax deduction (including real estate and income taxes) to $10,000 for years beginning in 2018. Since the Act was passed, many state and local officials, as well as commentators, have suggested prepaying such taxes by year-end to obtain a federal deduction prior to the limitation becoming effective. 

In guidance just released on Dec. 27, 2017, the IRS said the prepayment of 2018 state and local real property taxes will be deductible on a taxpayer’s 2017 tax return if those taxes were assessed before 2018. State and local law will determine whether and when property tax is assessed, the IRS said, adding that assessment is “generally when the taxpayer becomes liable for the property tax imposed.” 

Two examples included in the IRS guidance illustrate whether prepayment of a taxpayer’s real property tax is deductible in the 2017 tax year.

  • In the first example, a local jurisdiction assesses its property tax on July 1, 2017, for the period of July 1, 2017, to June 30, 2018.  An installment payment due in 2018 may be prepaid in 2017 and deducted on the taxpayer’s 2017 return.
  • In the second example, property taxes assessed on July 1, 2018, for the period of July 1, 2018, to June 30, 2019, may be prepaid in 2017 but will not be deductible on the taxpayer’s 2017 tax return because the property tax is not assessed until 2018.

We believe the IRS position is consistent with existing case law that involves prepayments of tax. Basically, a voluntary prepayment only creates a prepaid asset. For example, cash basis taxpayers cannot prepay 12 months of rent and obtain a current year deduction. While several cases hold that tax prepayments may be deducted in the year paid, those situations involve an existing tax liability. That is, tax prepayments were made for the taxable year, which was almost concluded, and were not an advance payment of taxes for the subsequent tax year. In regard to real estate taxes, if the property tax year has not commenced and the tax assessed, any prepayment, even if willingly accepted by the local authority, would not be deductible. A number of court cases confirm this position as it relates to real estate taxes.

Even in situations where you can make a payment by year-end and obtain a deduction, you should be mindful of the alternative minimum tax (AMT). Large state income and real estate taxes are the most likely reason individual taxpayers become subject to the AMT. Grouping such payments into a single year increases the likelihood of AMT. If you will be subject to the AMT in 2017, you will not receive a benefit from making the early payment.

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The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely.  The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.