Deduction of prepayment of real or personal property tax

No question the 2017 prepayment of the second installment of a cash basis taxpayer's 2017/18 real or personal prop taxes would be an allowable. But what about prepayment of the 2018/19 taxes for which the bill won't arrive until calendar year 2018?

Based on a Google search for "prepayment of real property tax" seems to be a standing practice in some midwest counties to provide vouchers for prepayments and accounting firms to advise their individual clients to deduct. That's not authority for anything, but an interesting footnote. Any of you Illinois people comment on that?

Letter Ruling 209303003 does describe an intangible property tax prepayment deduction that was ruled to be deductible in year paid even though it was not required to be paid until subsequent year. No mention of lien dates but the tax bill had not been issued.

https://www.taxnotes.com/irs-letter-rul ... %209303003

Requirements were listed including good faith, reasonable effort to determine the amount of tax, and very importantly that the payment was not a mere deposit.

(This when I regret not subscribing to a citator service. Any suggestions for the internet equivalent?)

The letter ruling addresses the timing of the deduction without any reference to case law on prepaid expenses or the probably inapplicable 1-263(a)(4): "the facts indicate that on the date of payment the taxpayers had a reasonable basis to believe that they would owe state intangible tax in the approximate amount of the payment they made."

Real estate values might drop in the Bay Area because of the new tax act, but if a taxpayer only prepaid the first installment of the 2018/19 tax based on what their 2017/18 tax bill was, they would be very close to what the actual assessment would be.

How the letter ruling decided this was not a "tax motivated transaction" is a mystery. But the ruling declares "One of the characteristics of the cash method is that, unless there is a specific provision to the contrary, a taxpayer may generally control the tax year in which an allowable current expense may be deducted by paying the expense in the year for which the taxpayer seeks to take the deduction. Thus, under the cash method, a deviation from the time a taxpayer normally pays an expense will usually represent a change in the facts underlying the timing of a deduction, not a change in the standards a taxpayer uses to determine the proper time for taking the deduction."

Len Raphael
Oakland CA

In Ohio, and many other states, real property taxes are always in arrears as they say. The tax for 2017 is not billed until late December 2017 in Franklin County with due dates in January (1/2) and June (1/2) Many Ohio Counties that do not bill until early 2018 will have an amount that you can pay before 12/31/17. Many of my clients used this to bunch their payments in alternate years, e.g. paying the 2016 r.e. tax in Jan and June 2017, and then the 2017 r.e. tax in Dec. 2017. They would also not pay their Ohio estimated tax in certain years until Jan. Ohio rarely assesses any penalty for late payment, and even if they did there was net benefit in bunching deductions. In the alternate years they would take the standard deduction.

Jake, thank you for the quick reply.

Our local tax collector/treasurer was considering setting up a trust account, but that Private Letter Ruling I thought described a situation where the prepayment goes directly into the county's general fund. Important that IRS doesn't consider it to be a mere "deposit" but a "payment."

I believe this is correct. WA is a calendar year property tax system. I am in Oregon. It is my belief that the tax becomes a lien on the property on 1/1/18. I suggested to the client that they put the check in the mail on 12/30, county will receive the check in 2018 and apply it to the account of the taxpayer.

Thurston county assessors office said we will not even accept the payment and apply it to the account since the millage rate is not even known until at least 1/15 and have no liability to apply it to. I told the client to mail the check anyway.

fyi, this was the reply by Kip D who co-authored a Dec 15th 2017 article on prepayment of state income tax online TaxAdvisors.

"Len, a payment of a 2018/2019 is not a subsequent year payment, it’s a second subsequent year and thus would also be considered a tax motivation by any IRS interpretation."

I don't follow that reasoning especially because the private letter ruling, even though no weight, uses a reasonableness rule.

He also mentioned, and I agree, that the 253 reg on prepaid expenses is N/A because it concerns intangibles.

Len Raphael
Oakland CA

Prepayment provision. For tax years beginning after Dec. 31, 2016, in the case of an amount paid in a tax year beginning before Jan. 1, 2018 with respect to a State or local income tax imposed for a tax year beginning after Dec. 31, 2017, the payment will be treated as paid on the last day of the tax year for which such tax is so imposed for purposes of applying the above limits. (Code Sec. 164(b)(6), as amended by Act Sec. 11042) In order words, a taxpayer who, in 2017, pays an income tax that is imposed for a tax year after 2017, can’t claim an itemized deduction in 2017 for that prepaid income tax.

I imagine property tax is along those same lines.

Really wish they would have taken the word "income" out of that guidance, unless they really meant it to only be "income" -- which I doubt was the intention.

If there's anything clear in this new tax act, is that prohibition only applies to state income tax. So that leaves us looking at code, regs, rulings, cases etc. on cash basis deductions of real and personal prop tax. Wish we could rely on private letter rulings because that one I cited is right on point and favorable.

Does anyone know if the 1980 Zaninovich v. Commissioner case is still followed? That case involved farmer who prepaid 12 months of rent per a lease on Dec 1. That's different from paying an estimated prepayment of property taxes that in CA would be due November of 2018, but with cash basis taxpayers the rules for certainty when accruing an expense don't apply.
As the letter ruling described, it's a reasonableness test.

This is from BNA courtesy of the local tax attorney who so far agrees with me: (out of two asked)

U.S. Income Portfolios: Income Tax Accounting
Portfolio 570-3rd: Accounting Methods—General Principles
Detailed Analysis
V. Deductions and Credits
B. Cash Method Taxpayers
2. Prepayments


b. The One-Year Rule for Period Costs

Prepaid period costs — such as insurance, taxes, interest, and rent — are treated differently. The rule requiring capitalization of expenditures with useful lives extending substantially beyond the close of the taxable year applies to period costs and, independently of any business purpose analysis, prohibits taxpayers from deducting payments of such costs related to multiple years. 1564
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1564 See Regs. § 1.263(a)-4(d)(3), (f) (T.D. 9107, 69 Fed. Reg. 435 (1/5/04)). Note that § 461(g) requires cash basis taxpayers to capitalize and amortize prepaid interest, except for “points” on certain residential mortgages. See V, B, 2, c, below.

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The litigation surrounding prepaid expenses reflects a history of uncertainty as to whether such expenses were deductible or capitalized.

There was initially some dispute over whether prepaid expenses were even capital assets. In Comr. v. Boylston Market Ass'n, 1565 the First Circuit held that prepaid premiums on an insurance policy covering several years should be pro-rated, overruling its earlier holding to the contrary in Welch v. De Blois. 1566 The IRS took the same position. 1567 The Eighth Circuit chose to follow De Blois rather than Boylston Market in Waldheim Realty & Investment Co. v. Comr., 1568 however, holding that such payments were immediately deductible. The Court noted that it was common practice to obtain insurance policies covering a number of years to obtain favorable rates and that the taxpayer had consistently deducted premiums in the year of payment. 1569 The IRS's position has been accepted by most courts, however, at least if the prepayment relates to a period greater than one year. 1570
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1565 131 F.2d 966 (1st Cir. 1942).

1566 94 F.2d 842 (1st Cir. 1938).

1567 It initially took the position that such expenses were capitalizable, GCM 13148, XIII-1 C.B. 67 (1934), reversed its position following De Blois in GCM 20307, 1938-1 C.B. 157, and then returned its to its original holding after Boylston Market. See GCM 23587, 1943 C.B. 213, superseded by Rev. Rul. 70-413, 1970-2 C.B. 103.

1568 245 F.2d 823 (8th Cir. 1957).

1569 Waldheim was followed in Morton v. U.S., 258 F. Supp. 922, 930 (W.D. Mo. 1966), aff'd, rev'd, and rem'd on other issues, 387 F.2d 441 (8th Cir. 1968), in which the court permitted a current deduction for various small premiums covering periods of up to three years.

1570 See, e.g., Jephson v. Comr., 37 B.T.A. 1117 (1938) (discussed below).

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With the issuance of Rev. Rul. 68-643, 1571 the battleground shifted to prepaid interest. In that ruling, the IRS asserted that prepayments for periods extending more than 12 months beyond the end of the year of the prepayment distort income. 1572 This represented a reversal of its earlier policy permitting a current deduction for interest paid up to five years in advance. 1573 The courts have consistently upheld the IRS's position, 1574 although the Tax Court has hinted that in some circumstances a current deduction for payments more than a year in advance might be allowable. 1575
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1571 1968-2 C.B. 76, modified by Rev. Rul. 69-582, 1969-2 C.B. 29 (exception for mortgage “points”).

1572 This position was reaffirmed in Rev. Rul. 77-304, 1977-2 C.B. 59.

1573 See Anderson v. Comr., 568 F.2d 386 (5th Cir. 1978).

1574 E.g., Anderson v. Comr., 568 F.2d 386 (5th Cir. 1978); Resnik v. Comr., 66 T.C. 74 (1976), aff'd per curiam, 555 F.2d 634 (7th Cir. 1977); Cole v. Comr., 64 T.C. 1091 (1975), aff'd, 586 F.2d 747 (9th Cir. 1978); Sandor v. Comr., 62 T.C. 469 (1974), aff'd, 536 F.2d 874 (9th Cir. 1976); (all holding taxpayers not entitled to current deductions for prepayments of over one year's interest).

1575 Cole v. Comr., 64 T.C. 1091, 1104 (1975) (“We again decline to place a stamp of approval on everything said in [Rev. Rul. 68-643] or on the application of that ruling to all cases”), aff'd, 586 F.2d 747 (9th Cir. 1978); Sandor v. Comr., 62 T.C. 469, 482 (1974) (“[w]e are not prepared to say that a deduction of any prepaid interest extending beyond a period of 12 months following the year of payment would distort income under all circumstances”), aff'd, 536 F.2d 874 (9th Cir. 1976). See also Coit v. Comr., 54 T.C.M. 816, 822 (1987) (appearing to allow current deduction for “commitment fee” (held to be interest) on construction loan; rejecting Commissioner's “mere assertion that current deduction would distort income, noting the disallowance of other claimed interest deductions in greater amounts”).

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These authorities did not address the issue of the treatment of prepayments relating to shorter periods. The IRS's early general counsel memoranda on prepaid insurance referred to premiums “paid in advance for a period of more than one year,” 1576 although it was unclear whether this language was also intended to refer to one-year premiums for periods that straddled two taxable years. Several Tax Court decisions recognized an exception for premiums relating to periods of one year or less. In Kauai Terminal, Ltd. v. Comr., 1577 the Board of Tax Appeals refused to require capitalization of a premium on a one-year fire insurance policy, stating:
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1576 GCM 20307, 1938-1 C.B. 157; GCM 13148, XIII-1 C.B. 67, 68 (1934). Rev. Rul. 70-413, 1970-2 C.B. 103, which concludes that prepaid premiums on a three-year policy must be prorated, does not include this language.

1577 36 B.T.A. 893 (1937), acq., 1939-2 C.B. 18.

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[W]hile it can not be said that an insurance premium which covers a period of more than one year may, as a general rule, be deducted in its entirety in the year of advance payment, the present case deals only with a one-year premium such as has habitually, in accordance with an approved and regularly adopted accounting method, been charged off and deducted each year in the year of payment. 1578

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1578 36 B.T.A. at 898–99 (cite omitted).

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In Jephson v. Comr., 1579 the Board permitted the current deduction of premiums on one-year policies, citing Kauai, but required capitalization of premiums paid on three-year policies, declining to follow De Blois. 1580
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1579 37 B.T.A. 1117 (1938).

1580 Id. at 1120. Accord Bell v. Comr., 13 T.C. 344, 348 (1949) (deduction for premium on one-year policy spanning two years allowed, citing Kauai and Jephson).

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The IRS acknowledged a one-year rule of sorts in Rev. Rul. 68-643, in which it stated that it would consider prepaid interest covering a period extending more than 12 months beyond the end of the year of the prepayment as distorting income, but that it would evaluate prepayments for shorter periods on a case-by-case basis. 1581
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1581 In Rev. Rul. 69-582, 1969-2 C.B. 29, the IRS modified Rev. Rul. 68-643 to provide that prepayment of “points” equal to 6% of the face amount of a residential mortgage did not produce a material distortion of income.

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In Zaninovich v. Comr., 1582 the Ninth Circuit permitted a calendar year taxpayer a deduction for a payment of rent for the period from December 1 to the following November 30, stating that it is permissible to deduct an expenditure that is not “allocable” to a period extending more than 12 months beyond the end of the year of the expenditure. The court distinguished earlier cases involving payments covering either longer periods or periods beginning after the close of the year of payment, or involving expenditures that were capital for other reasons (such as payments on frontloaded leases treated as amortizable lease acquisition expenses). 1583
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1582 616 F.2d 429 (9th Cir. 1980). But see Lattice Semiconductor Corp. v. Comr., T.C. Memo 2011–100 (IRS denied taxpayer's change without prior consent to 12-month rule for prepaid expenses; taxpayer must continue computing taxable income under old accounting method if IRS denies request to change method).

1583 It later extended the “one-year rule” to prepaid feed cases in Comr. v. Van Raden, 650 F.2d 1046, 1050–51 (9th Cir. 1981), aff'g 71 T.C. 1083 (1979), holding that the payment was deductible because substantially all (98% by value) of the feed was consumed within one year.

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In Hillsboro National Bank v. Comr., 1584 the Supreme Court used as one of its examples a payment made on a 30-day lease straddling two taxable years, citing Zaninovich, and stated in a footnote: “It is clear that § 162(a)(3) permits the deduction of prepaid expenses that will benefit the taxpayer for a short time into the next taxable year.” It attributed the rule to “the desire to save taxpayers the burden of careful allocation of relatively small expenditures.” 1585 Although the court in Zaninovich did not approach the question under the three-prong test, it apparently regarded the one-year rule as conclusive on the clear reflection of income issue. 1586
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1584 460 U.S. 370, 384–85 (1983).

1585 Id. at 384 n.17.

1586 See also Van Raden, 650 F.2d at 1050 (stating that material distortion issue did not need to be reached because matter could be resolved under one-year rule).

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Thus, a prevailing view emerged that the one-year rule was a capitalization rule, derived from Regs. § § 1.263(a)-2(a) and 1.461-1(a), prohibiting current deductions for expenditures that created assets with useful lives extending substantially beyond the taxable year. 1587 The courts also upheld the case-by-case application of the “material distortion” test to prepayments within the Rev. Rul. 68-643 version of the 12-month rule, disallowing deductions in abusive cases. 1588
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1587 See, e.g., Sorrell v. Comr., 53 T.C.M. 1362 (1987) (one-year rule was means of determining whether to capitalize what would otherwise be deductible expense and did not apply to “rent-up” fees on short-term leases, some of which ended within 12 months of payment); Waldheim Realty & Inv. Co. v. Comr., 245 F.2d 823 (8th Cir. 1957) (current deduction allowed for multi-year premiums; taxpayer had consistently deducted premiums currently); Kauai Terminal, Ltd. v. Comr., 36 B.T.A. 893 (1937) (insurance premiums were recurring expense that had been consistently accounted for on that basis), acq., 1939-2 C.B. 18.

1588 See, e.g., McMullan v. U.S., 686 F.2d 915 (Ct. Cl. 1982) (interest deduction should be prorated when calendar year taxpayer paid interest due through Dec. 1973 on Dec. 29, 1972); Burck v. Comr., 63 T.C. 556 (1975), aff'd, 533 F.2d 768 (2d Cir. 1976) (Tax Court refused to let taxpayer take full deduction for prepayment of one year's interest on Dec. 29; Second Circuit agreed). Accord, e.g., Ferrill v. Comr., 684 F.2d 261 (3d Cir. 1982) (prepayment of interest through Dec. 21, 1973, on Dec. 27, 1972). See also Pope v. Comr., 43 T.C.M. 234 (1981) (prepayment of one year's interest on Dec. 29 had no business purpose and materially distorted income, without reference to Rev. Rul. 68-643).

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In 2004, the IRS removed any remaining uncertainty regarding capitalization of prepaid expenses when it issued final regulations governing the capitalization of amounts paid to acquire or create intangible assets and certain other transaction costs. 1589 With respect to prepaid expenses, the capitalization regulations state simply: “A taxpayer must capitalize prepaid expenses.” 1590
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1589 T.D. 9107, 69 Fed. Reg. 435 (1/5/04), applicable to amounts paid or incurred after Dec. 30, 2003.

1590 Regs. § 1.263(a)-4(d)(3)(i).

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Example: Corporation N, an accrual method taxpayer, pays $10,000 to an insurer to obtain three years of coverage under a property and casualty policy. The $10,000 is a prepaid expense, and N must capitalize it. 1591

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1591 Regs. § 1.263(a)-4(d)(3)(ii) Ex. 1.

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The capitalization regulations also incorporate the 12-month rule. With certain exceptions, an amount that a taxpayer would otherwise be required to capitalize under the regulations (including prepaid expenses) need not be capitalized if the taxpayer pays the amount to create a right or benefit that does not extend beyond the earlier of (i) the date 12 months after the first date on which the taxpayer realizes the right or benefit and (ii) the end of the taxable year following the taxable year in which the taxpayer pays the amount. 1592
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1592 Regs. § 1.263(a)-4(f).

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Example: On Dec. 1, Year 1, corporation N pays a $10,000 insurance premium to obtain a property policy with no cash value. The policy has a one-year term beginning on Dec. 15, Year 1. The 12-month rule applies to the $10,000 payment because the right or benefit attributable to the payment extends neither beyond the date that is 12 months after Dec. 15, Year 1 (which is the first date on which N realizes a benefit from the payment) nor beyond the end of the taxable year following the taxable year in which N makes the payment. N, therefore, is not required to capitalize the $10,000 payment. 1593

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1593 Regs. § 1.263(a)-4(f)(8) Ex. 2.

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Note: The 12-month rule in the capitalization regulations applies generally to amounts paid to create intangible assets, not just prepaid expenses. The rule, however, does not apply to amounts paid to create financial interests or to amounts paid to create amortizable § 197 intangibles. 1594 It also does not apply to amounts paid to create intangibles of indefinite duration. 1595
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1594 Regs. § 1.263(a)-4(f)(3).

1595 Regs. § 1.263(a)-4(f)(4).

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The only and possibly fatal part of Zaninovich is the reference to "advance payments" in this first sentence: "The cases involving substantially shorter terms in which taxpayers have been required to amortize have, unlike the case before us, involved advance payments, see, e. g., Williamson v. Commissioner, 37 T.C. 941 (1962) (payment on December 27, 1956 for a lease running for one year from March 1, 1957 where payment was not due until beginning of lease); cf. D.K. McColl v. Commissioner, P 41,050 P-H Memo B.T.A. (Vol. 10, 1941) (deduction disallowed where rent paid on December 31 for following year because transaction was a sham but dicta indicated advance payment was deductible in year to which it applied), or accrual basis taxpayers, see, e. g., Bloedel's Jewelry, Inc. v. Commissioner, 2 B.T.A. 611 (1925) (payment in May, 1920 of rental due for a lease term running from September 1, 1920 to August 31, 1921).5

The Dec 2018 installment payment is an advance of the due date and the lien date.

But the second installment of 2017/18 property tax that is not due until spring of 2018 is also an "advance payment" even though in property tax sense it's a payment in arrears.

Just read an article on Forbes that said property taxes are not included with the 'income' taxes provision. Its Forbes...take it as you will.

Thanks. I'll read it. The biggest obstacle is that some of the other California county treasurers/tax collectors are telling Alameda County treasurer that CA state law would require the county to return any payment before the lien date. But the treasurer would be willing to talk to a county treasurer/collector in some of the other states where such payments are accepted before the lien date is key. Any names and phone numbers since time is running out.

Checked our county's real estate web site, and they posted: "If you are interested in prepaying your 2018 taxes, we will accept tax deposits on active Real Estate accounts. Although our office does accept tax deposits, we are not experts in federal tax law and are not able to offer any advice, or opinion on whether or not your deposit will be deductible on your 2017 federal tax returns." Calling it a deposit makes me suspect that it would not be deductible for 2017. (In our county, real estate tax is not paid in arrears.)

IPB has a summary of this issue. Guess they got bored of sending the same answer to all their ultra high net Worth clients.

Riki_EA, one of those citiations i gave, expressly distinguished between deposits and prepayments, with deposits not being deductible. So despite the IPB blurb saying VA tax collectors are allowed to accept prepayments, the quote on your VA tax collector site torpedoes the deduction by calling them "deposits'

Len Raphael
Oakland CA

The link by Brian in post #13 specifically mentions VA as a state you can prepay!

Riki_EA, one of those citiations i gave, expressly distinguished between deposits and prepayments, with deposits not being deductible. So despite the IPB blurb saying VA tax collectors are allowed to accept prepayments, the quote on your VA tax collector site torpedoes the deduction by calling them "deposits'

Len Raphael
Oakland CA

Len, if IPB says it is so, it is probably so. There is an old Tax Court case from the 1940s that allowed a tax prepayment deduction where the payments were deposits. It is the rev rulings that are more stringent.

IPB has a summary of this issue. Guess they got bored of sending the same answer to all their ultra high net Worth clients.

For what its worth, Maryland does allow prepayments - well, Baltimore county does ( taxes are collected at county level here) - They have a special form developed for that that this year.

I am more concerned withe the prepayment issue -in Maryland you prepay your taxes on 7/1-6/30 fiscal year. Therefore, if you pay 12/31/17 for the next fiscal year beginning July 1, 2018; you are reaping a benefit of that payment 18 months out - that seems to violate the 12 month rule for prepayments, no ?

FYI, many California counties have informed homeowners that they may NOT prepay 2018/2019 real property taxes.

that seems to violate the 12 month rule for prepayments, no ?. Didn't a bunch of posts say rather firmly that the 12-month rule is not applicable to purely personal-use real property taxes? Or was it not applicable because the tax prepayment, even for a business, is not within "creation of an intangible asset"?

one of the people who posts on the CALTAX yahoo site was saying that the code section that codifies the 12 month rule was n/a because it was limited to the intangible asset creation context. he was miffed somehow when i posted excepts the cites i posted here, because he thought I was somehow insulting his intelligence. Actually I was just trying to get my head straight on it, and ask others for critiquing it. This site is much more user dumb question friendly but people dig into the technical aspects too without hitting you over the head with it.

which is why i smiled when someone just emailed me to say they used to post here, but felt it was dominated by a few people. Compared to CalTax, this is open and supportive.

but i fail to see why the 1980 Z 9th Circuit Caso can be ignored. Sure,private letter ruling can't be relied on by other taxpayers, but the reasoning seemed sound to me.

the killer fact remains that CA county tax collectors consensus (no legal citation) is they cannot accept prepayments of the 1st installment of 2018/19.

Len Raphael
Oakland