By Andrea Mouw
December 20, 2017
Deducting State Tax Prepayments in 2017
Tax reform legislation has been signed into law by President Trump. The legislation will reduce tax rates as well as limit some tax deductions available under current law. One of the more popular deductions available for individual taxpayers that will be limited in future years is the deduction for state taxes paid. As a result, many taxpayers are looking to see what actions can be taken in 2017 to take advantage of the deductions that may be limited in future years.
State and Local Income Tax
Currently, a cash basis taxpayer is allowed a deduction for state and local income taxes for the tax year in which the tax is paid under Internal Revenue Code § 164. Historically, IRC §164 has not limited the amount of the deduction available and has allowed taxpayers to deduct the full amount of state income taxes paid. The proposed legislation, however, would limit taxpayers to deducting only $10,000 of combined state income (or sales) and property taxes for tax years beginning after January 1, 2018.
To maximize the amount of state income taxes that could be deducted, taxpayers have considered paying both their 2017 state income taxes and their estimated 2018 income taxes prior to the end of 2017. Taxpayers are entitled to a deduction for any income taxes paid during 2017 that relate to a liability imposed for the 2017 tax year. However, the proposed legislation specifically addresses the treatment of prepayments of 2018 taxes in 2017 and provides that the payments will be treated as made on the last day of the year for which the taxes are imposed. Therefore, a taxpayer making an income tax payment in December 2017 will be entitled to deduct the portion related to actual 2017 taxes owed on its 2017 tax return but will deduct any prepayments related to its 2018 tax liability on its 2018 tax return. As a result, taxpayers are advised to pay their entire 2017 state income tax liability prior to the end of 2017 but not to pay their 2018 estimated tax liability.
Under current law, a cash basis taxpayer is permitted a deduction for any property taxes for the tax year in which the tax is paid or accrued. As noted above, the proposed legislation places a $10,000 limitation on the combined state income and property taxes that may be deducted. Unlike state income taxes, the ability to prepay property taxes varies between jurisdictions based on the timing of the lien, assessment and payment dates. A property tax deduction is generally permitted where the lien date has passed and the amount of tax has been assessed or estimated. As property taxes are generally due in the following year, taxpayers have historically paid and deducted this tax in the following year.
To the extent the 2018 liability is fixed based on the lien and assessment dates, taxpayers may prepay this tax in 2017 so that they are able to deduct the taxes in 2017 when deduction limitations do not exist. Taxpayers will need to review the lien and assessment dates for each jurisdiction to determine if a prepayment opportunity exists. Taxpayers should also confirm the specific procedures for prepaying property tax payments early with the local tax authority to determine if the jurisdiction has the ability to apply this tax to this specific liability, and how prepaid taxes should be remitted.
Alternative Minimum Tax
Taxpayers must take into account the potential applicability of Alternative Minimum Tax (AMT) when doing tax planning. The prepayments of state and local taxes do not provide any tax benefit for AMT taxpayers as itemized deductions for state and local taxes are not deductible for AMT purposes. Therefore, taxpayers subject to AMT would not realize a benefit from prepaying their state taxes.
Other Itemized deductions considerations
Under the proposed legislation, the standard deduction will increase to $24,000 for joint filers ($12,000 for single filers). If this legislation is enacted, many taxpayers will not claim itemized deductions going forward, so it is important to consider the areas where itemized deductions can be accelerated into the 2017 tax year. For example, charitable contributions made in 2018 may not provide the same tax benefit as those made in 2017, so the taxpayers may wish to consider accelerating those donations into 2017.
Please contact your Eide Bailly professional or a member of our accounting methods team to learn more about year-end opportunities and planning.