Expertise Beyond the Numbers

Deductions for Prepayment of State and Local Taxes under the New Tax Bill

The Passage of the Tax Cuts and Jobs Act just before the end of 2018 has created a frenzy of planning activity by taxpayers looking to minimize tax liabilities under the bill.

For individuals who currently itemize their deductions, one of the most common planning strategies to consider is the timing of payment of their state and local tax (SALT) payments.  Appropriate planning for these deductions can be tricky in a normal year.  For 2017, it is even more complicated.  Below is a summary of the various considerations in making the appropriate decisions on these matters.

State and local taxes, including income and real and personal property taxes, imposed on individuals are generally allowed as an itemized deduction in the year that they are paid.  For taxpayers who pay little or no state income taxes, an election is available to deduct state sales taxes, rather than income taxes, on their return.  Through 2017, these taxes are deductible without limitation.  However, under the new bill, the deduction for these taxes will be limited to a total of $10,000 for tax years 2018 through 2025.

Due to the $10,000 limitation that will apply beginning in 2018, many taxpayers are looking for ways to accelerate payment of these taxes.

However, for taxpayers who are subject to the alternative minimum tax (AMT), there is no federal tax benefit to accelerate payments of SALT.

Based on these considerations, below is a suggested framework for determining what additional SALT payments might be beneficial, if made by December 31, 2017:

2017 State and Local Income Taxes

  • For taxpayers who expect to be subject to AMT in 2017, there is no benefit to accelerating these payments.
  • For taxpayers who do not expect to be subject to AMT for 2017:
    • If you expect to have available SALT deductions of more than $10,000 in 2018, you should make an estimated payment by December 31, 2017 to cover any unpaid balance of your 2017 state and local income tax. Note that there is generally little or no benefit to substantially overpaying these taxes, as any overpayments will be taxable in the following year.
    • If you expect to have available SALT deductions of less than $10,000 in 2018:
      • If you expect to be in a similar or lower marginal tax bracket in 2018, you should make an estimated payment by December 31, 2017 to cover any unpaid balance of your 2017 state and local income tax. Note that there is generally little or no benefit to substantially overpaying these taxes, as any overpayments will be taxable in the following year.
      • If you expect to be in a higher marginal tax bracket in 2018, you will benefit more from these deductions in 2018. No prepayment of SALT in 2017 is advisable.

2018 State and Local Income Taxes

Upon hearing of the limitations that will apply to SALT deductions in the future, many taxpayers wondered whether they could prepay their 2018 tax liabilities by December 31, 2017, and receive the benefit for those payments on their 2017 federal tax return.  Some states, including Maryland, indicated a willingness to accept prepayments of 2018 income tax liabilities.  However, in the final bill, Congress precluded any benefit from this strategy.  Any 2017 prepayments of tax liabilities related to tax years after 2017 are not deductible.  Interestingly, the bill specifically references income taxes as subject to this prohibition against prepayment…it is silent with respect to real property tax prepayments.  More on that below.

2017 Real Property Taxes

State and local real property taxes are subject to varying tax years and payment due dates.  Some jurisdictions will accept prepayments, and some will not.  To the extent that you have control over the timing of payment of these taxes, the strategy here is similar to the strategy for 2017 state and local income taxes:

  • For taxpayers who expect to be subject to AMT in 2017, there is no benefit to accelerating these payments.
  • For taxpayers who do not expect to be subject to AMT for 2017:
    • If you expect to have available SALT deductions of more than $10,000 in 2018, you should pay the balance due on your 2017 real property tax bill by December 31, 2017.
    • If you expect to have available SALT deductions of less than $10,000 in 2018:
      • If you expect to be in a similar or lower marginal tax bracket in 2018, you should pay the balance due on your 2017 real property tax bill by December 31, 2017.
      • If you expect to be in a higher marginal tax bracket in 2018, you will benefit more from these deductions in 2018. No acceleration of real property tax payments is advisable.

2018 Real Property Taxes

This is where it get interesting.  We are hearing stories from across the nation about county assessment offices receiving numerous inquiries from homeowners who are hoping to pay their 2018 real property tax bills by December 31.  The responses from the jurisdictions are all over the board.  Some are not allowing taxpayers to make prepayments, either due to systems limitations or to the lack of enabling legislation.

In Maryland, as of this writing, we have heard that Baltimore County and Howard County are accepting prepayments.  Montgomery County and Prince George’s County have specifically indicated that they are not accepting prepayments.  A cursory search of other counties’ sites turned up nothing.  The District of Columbia and Virginia jurisdictions appear to allow for prepayments.

But, regardless of whether a jurisdiction is willing to accept your prepayment, would that payment, if made in 2017, be deductible on your 2017 income tax return?

The answer is a bit unclear.  Tax law allows for the deduction of SALT by a cash basis taxpayer (which includes almost all individuals) in the year of payment.  However, case law indicates that, in order to be deductible, the payment must be made by a taxpayer in good faith, based on a reasonable expectation that a liability exists as of the date the tax is paid.  Most of the case law in this area is focused on prepayments of income taxes.

So, there seems to be at least a position that prepayment of 2018 real property taxes by an individual would be deductible in the year that they are paid.  However, we are confident that the IRS’ position on this would be that the payment was not made based on a good faith expectation that a bona fide liability existed at the time of payment.

Based on the sheer number of taxpayers who are focused on this issue, we would not be surprised if Congress and/or the IRS were to provide additional guidance in this area in the near future.  There are likely to be additional technical corrections bills from Congress, and regulations issued by the IRS in the coming months and years.  Unfortunately, we cannot wait for that guidance in order to decide how to proceed by December 31, 2017.

One path that you might consider, if you do not expect to be subject to AMT in 2017, and you do not expect to benefit from the deduction of the real property tax payment if made in 2018, would be to check with your jurisdiction to see if they will accept a prepayment of your 2018 real property tax liability, and apply the payment to your account without refunding.  If they will, then you can make the payment by December 31, 2017, and determine whether the deduction is valid at the time of preparation of your return, based on the guidance available at that time.

If you choose to make this prepayment, we recommend that you consult with your tax advisor prior to making a final decision as to whether to actually claim the deduction on your 2017 federal tax return.

Special Note Regarding 2018 SALT Deductions

As we plan for 2018 and beyond, the deduction for SALT is limited to an aggregate of $10,000 of state and local income, property and/or sales taxes.  Under current law, refunds of state income taxes are generally taxable to the extent that the payment of those taxes in the prior year was deductible.

It is unclear in the new bill how we will determine the amount of any state income tax refunds that are taxable in future years.  Will any income tax refunds be presumed to come first from deductible income taxes, or from income taxes which were not deductible?  Or, is there some pro rata calculation that will be required?  How do property taxes factor into the equation?  The answers to these questions are presently unknown.

Until we receive further guidance on these questions, some taxpayers may benefit by electing to deduct sales taxes in reaching the $10,000 deduction limit, thereby avoiding the potential need to include future state income tax refunds in federal taxable income.

 

The above discussion is intended as a broad overview of the factors that need to be considered in planning for deductions of SALT under the new bill.  Before making any final decisions, we recommend that you consult with your tax advisor. Contact us if you have any questions as you are navigating your 2018 tax plans.