To prepay or not to prepay state and local taxes? That’s been the burning question over the past week. With tax reform now law, taxpayers are anxious to take advantage of certain tax planning strategies. But will they work? The Internal Revenue Service (IRS) now has an answer as to whether it might accept prepayment as a tax strategy – and not surprisingly, it’s maybe.
Here’s what you need to know about the prepayment of state and local taxes. Typically, those taxes are deducted on a Schedule A. Beginning in 2018, deductions for state and local sales, income, and property taxes remain deductible but are limited: The amount that you can deduct for all state and local sales, income, and property taxes may not exceed $10,000 ($5,000 for married taxpayers filing separately).
One of the ways to “beat” the cap in 2018 is to prepay your taxes in 2017. With that in mind, under the new law, Congress specifically prohibited pre-payments for income tax to be used as state and local tax deductions for the current year. Amounts paid in 2017 for 2018 state or local income taxes will be treated as paid in 2018.
But Congress did not impose a similar restriction on property taxes. Many tax professionals, including yours truly, have suggested that prepaying real estate taxes should be allowed in some circumstances. The IRS, in response to “a number of questions from the tax community concerning the deductibility of prepaid real property taxes” agrees and has finally issued some official guidance.
As part of IR-2017-210: IRS Advisory: Prepaid Real Property Taxes May Be Deductible in 2017 if Assessed and Paid in 2017, the IRS declared that whether the deduction is allowed “depends on whether the taxpayer makes the payment in 2017 and the real property taxes are assessed prior to 2018.” That’s consistent with their prior treatment of prepayments. By way of additional clarification, a prepayment of “anticipated real property taxes that have not been assessed prior to 2018” would not be deductible in 2017. That is also consistent with their prior treatment of prepayments.
So, you might ask, who decides whether those taxes will be assessed prior to 2018? The respective state or local authorities.
On December 22, 2017, New York State Governor Andrew Cuomo signed an Executive Order authorizing local governments “to immediately issue warrants to levy property taxes by the end of the year.” Assuming those bills go out as intended, they should be deductible in 2017 if paid in 2017.
Also, the City of Philadelphia typically issues assessments for the new year in December of the prior year. So, 2018 bills should be in mailboxes now. Under the IRS guidance, those should also be deductible in 2017 if paid in 2017.
The IRS offers the following as an example of a deductible prepayment:
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.
However, there are limitations. The IRS also offered the following as an example of a nondeductible prepayment:
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.
So, can you see the difference? A prepayment on its own isn’t enough: Taxes must be assessed in order to claim the deduction for the prepayment.
Even if you can deduct the prepayment, you may want to ask your tax professional whether it makes good tax sense to do so. But keep in mind that there may not be a clear advantage to prepayment – and if you prepay in 2017 for 2018, you can’t claim the deduction in 2018 unless you pre-pay the next year.
And don’t forget about the dreaded Alternative Minimum Tax, or AMT. The AMT was NOT repealed under tax reform for 2018 . And, more importantly, it remains “as is” for 2017.
The AMT is a secondary tax put in place in the 1960s to prevent the wealthy from artificially reducing their tax bill through the use of tax preference items. If you’re subject to the AMT, you have to calculate your taxes a second time, adding back in some of those tax-preference items. For example, normally, if you live in a high-tax state like New York, you can deduct your state and local taxes on your Schedule A if you itemize. For AMT purposes, however, you could lose the deduction. For more on the AMT, check out this prior blog post here.
In addition to the IRS guidance above, you should also make sure any required estimated state income tax payments have been made for your 2017 tax return. In most states the last estimated payment for 2017 is due January 15, 2018, but can be paid earlier. Technically, any amount overpaid is not deductible, in 2017. Therefore, if you estimate you’ll owe (in addition to withholdings) $3,000 for your state income taxes for 2017, pay them now and they’ll be deductible in 2017. However, if you pay $15,000 under the same circumstances because you know you’ll have to pay $12,000 in 2018, the additional $12,000 would not be deductible.
Remember: No two taxpayers are alike. Give Solid Tax Solutions (SolidTaxSolutions.com) a call at (845) 344-1040 if you have questions about whether prepaying your property tax or other year-end tax strategies can work for you.
Bruce – Your Host at The Tax Nook
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