Deducting State, Local and Foreign Property Taxes - ABA YLD 101 Practice Series

By Heather Anson and Matthew P. McLaughlin
  1. General
    In addition to the deduction for mortgage interest, one of the more significant tax benefits of home ownership is the deductions available for property taxes, which in some geographic locations can be substantial. A taxpayer may deduct state, local, and foreign property taxes, whether or not they are incurred in the taxpayer's business or profit-oriented activities. I.R.C. § 164(a); however, like the mortgage interest deduction, property taxes are deductible only if the taxpayer elects to itemize deductions.
  2. What Constitutes a Tax?
    Before the deduction is allowed for state, local or foreign property taxes, the charge paid by the taxpayer must be considered a tax. A real property tax is a tax imposed on interests in real property and levied for the general welfare. Such does not include government user fees, regardless of the name given the payments. Treas. Reg. § 1.164-3(b). The internal revenue service has stated the following in distinguishing a tax from a governmental fee or charge:

    A tax is an enforced contribution, exacted pursuant to legislative authority in the exercise of taxing power, and imposed and collected for the purpose of raising revenue to be used for public or governmental purposes, and not as a payment for some special privilege granted or service rendered. Taxes are, therefore, distinguishable from various other contributions and charges imposed for particular purposes under particular powers or functions of the Government. In view of such distinctions, the question whether a particular contribution or charge is to be regarded as a tax depends upon its real nature. If it is in the nature of a tax, it is not material that it may be called by a different name; and, conversely, if it is not in the nature of a tax, it is not material that it may be so called.

    A charge primarily imposed for the purpose of regulation is not a tax, even though it produces revenue.

    Rev. Rul. 57-345, revoked on its facts by Rev. Rul. 60-366. Therefore, renters' taxes and taxes on the transfer of real property are not deductible under Section 164(a). See Rev. Rul. 75-558; Rev. Rul. 80-121.
  3. Who May Take the Deduction?
    1. General Rule
      In general, property taxes are only deductible under I.R.C. § 164(a) by the person on whom the tax is imposed. Treas. Reg. §1.164-1(a). Therefore, the owner of real property will usually be the party entitled to deduct the property taxes. Conversely, a tenant may not deduct local real property taxes imposed on the landlord, even though the tax burden is passed on to the tenant through a tax surcharge or higher rent. Rev. Rul. 75-301.

      The general rule that the person subject to the property tax may take the deduction is complicated when property is owned jointly. Special rules apply in such cases to allocate the tax deduction among the joint owners. Further, Section 164(a) requires an allocation of the tax imposed when property is sold during the tax year.
    2. Jointly Held Property
      Tenancy by the Entirety. If a married couple holds property as tenants by the entirety and they file separate returns, each person can only deduct the taxes each paid on that property. Rev. Rul. 71-268.

      Other Forms of Jointly Held Property. In other instances of property held jointly, the allocation of the tax deduction depends on the extent of liability under local law. If the co-owners are jointly and severally liable for the property taxes, the deduction is allocated to the party who pays the tax. Rev. Rul. 71-268; Conroy v. Comm'r, T.C. Memo 1958-6. But where each party is limited under local law as to responsibility for the property taxes, a deduction under I.R.C. § 164(a) is only allowed to the extent of that liability. Therefore, joint tenants, who usually are jointly and severally liable for the property taxes, share the deduction based on who paid the taxes. But tenants in common, who typically have a right to contribution from the other co-owners for a share of property taxes paid, are usually each allowed to deduct only a pro-rata share of taxes imposed on the commonly owned property, even if one person pays the entire tax owed. James v. Comm'r, T.C. Memo 1995-562. However, if a party who is not jointly and severally liable for payment of the property taxes pays the entire amount in order to protect an interest in the property or avoid liability, the payment may be deducted in full, even though there is a right to reimbursement from the other property owners. See Powell v. Comm'r, T.C. Memo 1967-32; James v. Comm'r, T.C. Memo 1995-562.
    3. Proration of Taxes for Property Sold During the Year
      If real property is sold during the real property tax year, the seller and buyer must allocate the deduction for that year. I.R.C. § 164(d). The property tax is allocated to each party based on the period of time during the year that each party owned the property. I.R.C. § 164(d)(1); Treas. Reg. §1.164-6(b). Generally, this is taken care by way of an adjustment on the closing statement so that the seller is credited for the property taxes paid allocable to the period after the sale date.

      The term "real property tax year" refers to the period which, under the law imposing the tax, is regarded as the period to which the tax imposed relates. Treas. Reg. § 1.164-6(c). Where the property is subject to taxes imposed by multiple state or local jurisdictions, the real property tax year for each tax must be determined for purposes of applying the rule of apportionment of Section 164(d)(1) to each tax. Id. The allowable deduction for the seller is the amount of real property tax allocable to the part of the real property tax year that ends the day before the sale date. I.R.C. § 164(d)(1)(A). The purchaser's allowable deduction is for the amount allocable to the part of the real property tax year that begins on the date the property is sold. I.R.C. § 164(d)(1)(B).
  4. When is the Deduction Taken?
    Taxes are deductible "for the taxable year within which paid or accrued," depending on the taxpayer's accounting method. I.R.C. § 164(a). Therefore, the year in which the deduction is taken depends on the accounting method of the taxpayer.
    1. Cash Method Taxpayer
      A cash method taxpayer deducts payments for real estate taxes in the year in which the payments are made. I.R.C. § 461(a). Payments made to a creditor by a cash method taxpayer to accumulate in escrow for payment of the next year's taxes may only be deducted when the creditor makes the payment. Rev. Rul. 78-103, 1978-1 CB 58.

      The rules differ slightly if property is sold during the year and the property taxes are pro rated under I.R.C. § 164(d). A cash method seller who is liable for the tax deducts it in the year the tax is paid, while a cash method purchaser who is not liable may elect to deduct the tax in the year of the sale or when the tax is actually paid. Treas. Reg. §1.164-6. A cash method purchaser who is liable for the tax must deduct it in the year paid, while a cash method seller who is not liable for the tax may elect to deduct it in the year of the sale or the year the tax is paid. Id.
    2. Accrual Method Taxpayer
      Generally, an accrual method taxpayer may deduct a deductible expense when all events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy; and economic performance has occurred for the liability. Treas. Reg. §1.461-1(a)(2)(i). For accrual of taxes, economic performance does not occur until payment has been made. Treas. Reg. §1.461-4(g)(6). This special rule effectively puts accrual method taxpayers on a cash method for purposes of deducting property taxes. However, accrual basis taxpayers can elect to accrue real property taxes that relate to a definite period of time, ratably over that period. I.R.C. § 461(c). If the election is made, the deduction under 164(a) will be the property taxes ratably accrued over the tax year for which the taxpayer's return relates.

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About the Authors

Heather Anson, a graduate of the University of Arizona College of Law, runs her own practice, Anson Law Offices, in Tucson, AZ. Her practice focuses on financial/tax law issues. Heather's emphasis on educating her clients and colleagues about the services she provides has given her the pleasure of having knowledgeable, loyal clients who in turn develop a trust in her knowledge of the law and their businesses.

Matthew P. McLaughlin is an associate with the Jackson, Mississippi office of Balch & Bingham LLP where he focuses his practice on advising individual clients, emerging businesses and existing companies on real estate related matters, federal and state financing incentives as well as representing clients in mergers and acquisitions. Mr. McLaughlin is admitted to practice in the State of Mississippi and is a member of the American Bar Association Sections of Business Law, Taxation and Real Property, Probate and Trust Law.

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