This question gets more complex by the day. On Dec. 27, the IRS issued Announcement 2017-210, which can be found on their website. https://www.irs.gov/newsroom/irs-advisory-prepaid-real-property-taxes-may-be-deductible-in-2017-if-assessed-and-paid-in-2017 My first reaction to this was, good for the IRS for doing their job to provide guidance to taxpayers. But there is a caveat. The job of the IRS is not easy because it is subject to political constraints (the acting IRS Commissioner, David Kautter, also serves as Assistant Treasury Secretary for Tax Policy). It is unusual for the Assistant Secretary to also serve as acting IRS Commissioner – indeed this has never happened before, at least in recent memory – and it raises questions precisely about issues like the one about the state and local deduction – does the IRS announcement reflect a nonpolitical view or is it designed to serve the political purposes of the Trump administration?).
Those who are not aficionados of IRS documents may not focus on the fact that the IRS Announcement is not a Revenue Ruling, which would carry some legal status. An Announcement generally does not break new legal ground. The Accouncement states: “ A prepayment of anticipated real property taxes that have not been assessed prior to 2018 are not deductible in 2017.” (this is also ungrammatical, by the way). One would expect an Announcement that states a legal conclusion to provide a citation with legal authority, but the Announcement does not do so.
It turns out that the area is a bit murky. Perhaps one reason is that so far the question has not come up very often, if at all, and the IRS has not chosen to focus on it since it is not a problem area. (Note that an agency starved for funds, as the IRS is, due to Republican desires to defund the agency as much as possible even while giving it new mandates, cannot possibly do all the useful things it might be doing.) The usual way that taxpayers looking for a deduction for state tax enhance the deductible amount is by paying additional estimated state income tax. This works up to a point. Because estimated tax is just that – an estimate of a liability that cannot be determined until the close of the year — taxpayers have a lot of leeway in deciding how much to pay and the IRS tends to accept payments as deductible, even if they end up exceeding the tax due. But the IRS has set a limit. IRS Publication 17 says: “You can deduct estimated tax payments you made during the year to a state or local government. However, you must have a reasonable basis for making the estimated tax payments. Any estimated state or local tax payments that aren’t made in good faith at the time of payment aren’t deductible.” There is not much authority on this (beyond revenue rulings discussed below; the regulations are silent on the point), and there is no comparable discussion on property tax.
The words that the IRS uses in Publication 17 are “reasonable basis” and “good faith”. In other words, you must have a reasonable basis that the payment you are making is going to go towards satisfying a tax liability. One issue that is left undiscussed is how far away this tax liability can be? An estimated tax payment for state income tax that is made on Jan. 1 will be used to satisfy a tax liability that will not accrue until Dec. 1 of that year. In the case of a property tax prepayment made on Dec. 31, the property tax liability will be accruing in an even shorter time frame (i.e. before the close of the following calendar year). But there is no authority of which I am aware of how far out in time you can go. Probably this issue has not been addressed in Regulations because it was not considered a high priority, since the issue rarely if even came up. Perhaps now it will be but notice that the issuance of regulatory guidance is another one of those things that is hampered by serious IRS budget underfunding. Ths IRS and Treasury has a big backlog of Regulations to write and issue. These require time and care and professional staff dedicated to this. Publication 17 by the way is not a regulation, or even a ruling, it is in the nature of instructions, so the legal authority it has is minimal.
A couple of revenue rulings provide a legal underpinning for the statements in Publication 17. Rev. Rul 71-190 involved a corporation which filed a state tax return on Dec. 31 and paid tax of $6,000. It then filed an amended state tax return a few months later showing a lialibity that was half as large. The IRS ruled that the entire $6,000 was deductible because it was paid by Dec. 31. The ruling stated: “In the instant case, the taxpayer made an estimated payment of what purported to be his Kentucky State income tax liability for 1969. The payment was accepted by the Kentucky State tax authorities and credited to the taxpayers account prior to the close of its taxable year in such a manner to constitute a bona fide payment of taxes within the meaning of section 164(a) of the Code.” The word used was “bona fide”, similar to Publican 17’s statement that the payment must be made on a “reasonable basis” and in “good faith”. Rev. Rul. 82-208 applies this principle. In this case, a cash method individual taxpayer made a payment at the end of 1981 of state income tax and received the amount back as a refund from the state in 1982. “On the date of payment, A had no reasonable basis to believe that A had any additional state income taxes for the calendar year 1981. Therefore, the payment was not made in good faith and is not deductible under section 164(a)(3) of the Code.”
In general, deductions are not allowed for deposits. For example, Rev. Rul. 79-229 explains the rule in the business context: “Whether a particular expenditure is a deposit or a payment depends on the facts and circumstances of each case. When it can be shown that the expenditure is not refundable and is made pursuant to an enforceable sales contract, it will not be considered a deposit. “ This is not directly applicable to the question at hand (payments of taxes in respect of a future year) but one point stands out, namely whether the payment is refundable. If a taxpayer sends in a property tax payment and could get it refunded with no questions asked, as opposed to being credited against the property tax for 2018, then there would be a problem. I am assuming, though, that any property tax prepayments made for 2018 would not be refundable and would only be creditable against 2018 property tax (the recently enacted Montgomery County Maryland procedures specify this).
There is some sparse caselaw on this issue, but nothing that shows that courts have actually grappled with this question in a substantial way. One case on point where the court says that property tax must be assessed in order to be deductible is Hoffman v. Commissioner, 1999-395 (Dec. 6, 1999) (TC Memo cases have less precedential weight than regular opinions). Hoffman cites Hradesky v. Commissioner, 540 F.2d 821 (5th Cir. 1976), aff’g per curiam 65 T.C. 87 (1975). The problem is that Hradesky involves substantially different facts. In Hradesky the taxpayer was trying to get a deduction for an amount paid into an escrow account with a bank, rather than paid directly by the taxpayer to the taxing authority. So while the requirement of assessment makes sense in that context, extending it beyond the facts of Hradesky is questionable.
So there is murkiness, but in my view (1) the general language of the statute (section 164) allowing the deduction, and (2) the IRS rulings issued so far concerning state income tax, which talk about payments made in good faith and on a reasonable basis, provide ample authority to make the prepayments. The language of the conferees on 2017 budget reconciliation act (BRA) is also supportive. The deduction for income tax paid involves an estimate of tax that will be due. There is no requirement that the income tax be “assessed” at the time of making the payment. The specific question about prepayments for future years is not dealt with in regulations, rulings, or case law. But, it is not inconsistent with anything issued so far (except Announcement 2017-210), which makes up a rule that a prepayment of property taxes that have not been assessed prior to 2018 is not deductible. The Announcement does not cite any legal basis for this conclusion, and while it may lead to IRS rejections of deductions, I would predict that there is a pretty good chance that if it came to litigation the taxpayers would win. (There is also a question of when a property tax has been “assessed” which may be different in different jurisdictions.)
Litigation is not the only way to resolve the issue. Congress could deal with this issue in a technical corrections bill to 2017 BRA in 2018, but that is most likely going to require Democratic cooperation, and it is totally up in the air how Congress would deal with this.
Finally, while taxpayers making property tax payments should anticipate some hassles from the IRS, they are not taking a big risk. First, by making the prepayment they are not necessarily committing to what position to take on their 2017 returns. Depending on how things shake out, there may be further clarification between now and the time returns are due. Second, there is not much lost by making the prepayment. This money is not gone, it is just a 2018 bill that is being paid early, so taxpayers don’t have much to lose.
It is also important to keep in mind the larger context. The problem of taxpayers rushing to make prepayments was entirely predictable. In fact, the 2017 BRA did deal with it, but in a botched way. It said nothing about property tax, and the statutory language about income tax prepayments was written in a technically defective way, as I have explained elsewhere. The explanation of the conferees reads as follows: “The conference agreement also provides that, in the case of an amount paid in a taxable year beginning before January 1, 2018, with respect to a State or local income tax imposed for a taxable year beginning after December 31, 2017, the payment shall be treated as paid on the last day of the taxable year for which such tax is so imposed for purposes of applying the provision limiting the dollar amount of the deduction. Thus, under the provision, an individual may not claim an itemized deduction in 2017 on a pre-payment of income tax for a future taxable year in order to avoid the dollar limitation applicable for taxable years beginning after 2017.”
This says nothing about property tax and the implication is that, at least with respect to income tax, the conferees were under the impression that a deduction would be allowed for prepayments of 2018 tax made in 2017 (i.e. not just estimated tax for 2017). There was, of course, no thorough public discussion of this issue (or indeed any issue involved in the 2017 BRA) since no hearings were held. The kinds of problems we are seeing – and there will be many more of them, this one being salient because it literally has to be dealt with by taxpayers over the next couple of days – are attributable to the poor and undemocratic legislative process followed by the Republican majority.
So this is not just about taxpayers rushing to save some tax by year-end maneuvers. Whether it is the taxpayers who make the prepayments or the ones who see others making them and wondering whether they should have done this or why this was not handled in a better way, this issue should help cement in peoples’ minds that the 2017 tax act was not just bad policy (giveaways to the wealthy) but poorly made policy. The two are interconnected, because the secretive and rushed way that the policy was made facilitated making policy that benefited the wealthy campaign donors of Republican politicians, their wealthy friends, and the wealthy Republican politicians themselves. [revised Dec. 29, 2017]