I received a telephone call from an accountant in Florida last night raising an important question: Is it permissible to deduct the real estate taxes that you prepay when the local jurisdiction’s tax year does not align with the calendar year? The answer highlights that prepayment may be less attractive than you think.
In many jurisdictions—like in Montgomery County, Maryland—the fiscal year does not align with the calendar year. The tax year runs from July 1 through the following June 30. Ordinarily, property owners prepay half of the tax on September 30 and the other half on December 31. Thus, the payment that a property owner makes on or before December 31, 2017 covers taxes due for the 2018-2019 fiscal year.
The problem is that the Treasury Regulations generally restrict deductions to money spent during the current tax year for the current tax year. In other words, if you spend money in June 2017 for something that you use in June 2017, it is deductible on your 2017 tax returns. However, if you prepay an expense, the expenditure is not deductible until the year during which you use the purchased item. The IRS illustrates this point with an example: A small business owner pays $3,000 in 2017 to purchase a business insurance policy that will be effective for three years, commencing July 1, 2017. The insurance policy lasts for 36 months but only six of those months occur in this calendar year. Thus, the only part deductible in 2017 is 6/36 of the premium payment. Twelve thirty-sixths will be deductible on the taxpayer’s 2018 return, 12/36ths will be deductible on the taxpayer’s 2019 return, and the remaining 6/36ths will be deductible on the taxpayer’s 2020 return.
There is, however, a small exception to this rule. While it is correct to state the general rule as requiring that the deduction be spread out over the lifetime of the thing purchased when it is not used during the current calendar year, in fact the language of Treasury Regulations is more nuanced than that. The Regulations provide that an expense must be deducted over the lifetime of the item purchased unless the expense was made to acquire a benefit that does not extend beyond the earlier of “12 months after the first date on which the taxpayer realizes the right or benefit; or the end of the taxable year following the taxable year in which the payment is made.” Tr. Reg. 1-263(a)-4(f).
That language is a bit technical, but its meaning can be made clear by an illustration of its application. Here, we are discussing a tax payment made in December 2017 for a tax year that runs from July 1, 2018 through June 30, 2019. The rule has us compare two dates. First, there is the date that comes 12 months after the first date on which the taxpayer realizes the benefit. Here, that first date on which the taxpayer realizes the benefit is July 1, 2018; twelve months after that date would be June 30, 2019. Thus, the first date is June 30, 2019. Second, there is the end of the taxable year following the taxable year in which the payment is made. The taxable year in which the payment is made is 2017; the end of the following taxable year is 2018. Hence, the second date is December 31, 2018. And the rule provides that we must use the earlier of those dates—or December 31, 2018. In other words, the expenditure must be deducted over the lifetime of the item purchased if it was made to acquire a benefit that does extend beyond December 31, 2018.
Here, the expenditure to prepay real property taxes will cover a period that runs from July 2018 through June 2019. Thus, the expenditure acquired a benefit that goes past December 31, 2018, and so it must be deducted over time. It cannot be deducted in full on your 2017 tax return; only the portion applicable to 2018 can be deducted on the 2017 tax return.
What happens with the rest? Is the portion of the prepayment applicable to 2019 lost? As a practical matter, it probably is, even though technically it is not. The prepaid expenses for the time outside of the “12-month rule” is still deductible but it cannot be deducted until the tax year for which the payment applied. Thus, technically, the deduction is not lost: The deduction can be taken on your 2019 return. However, as a practical matter, you probably will be unable to take that deduction because of the Tax Act’s new $10,000 limit to deductible state and local taxes. In other words, you are permitted to deduct that expense in the applicable year but you cannot do so beyond the $10,000 aggregate limit for state and local income and property taxes. Many people will find that the deduction is therefore foreclosed.
And remember, if you are subject to the Alternative Minimum Tax, you will get no real benefit from prepaying your property taxes because when doing the AMT calculation, you have to add back major deductions like state income taxes and property taxes and multiply them against the AMT tax rate. While technically this does not entirely eliminate the benefit of prepayment, it makes prepayment worth less than the trouble it takes.