A mistake in the rule that says you can’t deduct State income tax prepaid in 2017 [updated 1/3/2019 and 6/12/2019]
[As explained below, there was a technical error in the 2017 Republican tax bill relating to the limitation on the deduction for State income tax. The loophole created by this error allowed individuals to prepay 2018 tax in 2017 and take a deduction in 2017. The Tax Technical and Clerical Corrections Act Discussion Draft, as published by outgoing Ways and Means chair Brady on Jan. 2, 2019, fixes the mistake identified by this article. However, the question remains whether this technical correction will be included in any technical corrections legislation to be enacted in the new Congress. Anyone who prepaid 2018 State income tax in 2017 and took a deduction on their 2017 return might want to contact their member of Congress. Please note that this issue is unrelated to deductions for property tax prepaid in 2017, which raise different concerns.]
[Update on June 12, 2019: on Feb. 12, 2018, Sheldon Smith and Lynn Smith wrote an article in Tax Notes, Tax Reform and the Deduction of State and Local Taxes. They argued there that the mistake I identified may not have been a mistake, and that the 2017 Act can be read as saying that if someone prepays 2018 state income tax in 2017, the statute described below does not deny the deduction for 2017, but rather affects the limitation for that person in 2018. Any prepayment in 2017 is counted against the 2018 limit and reduces the amount that the person could deduction for 2018. Under this reading, the provision is not in error but it does not affect the deduction for 2017. One advantage of this approach is that it applies the 2017 law as written. Under this view, there is no need for a technical correction (so far, technical corrections to the 2017 tax legislation have not been marked up by either tax writing committee). I cannot say whether this view or the view I expressed in my original article is “correct” (I am not changing it because it is published and I don’t want to confuse things between what I wrote originally and what I am adding). The basic problem is that the Republicans enacted a tax law hastily, without hearings, and without explanations that were subject to public comment. It is not surprising that when you enact a tax law with such a procedure, you end up with interpretation problems of the kind discussed here.]
The intent of the conferees seems pretty clear: the writers of the Republican tax bill don’t want taxpayers taking a deduction in 2017 for state income tax that is not due until 2018. Otherwise, taxpayers could make payments before Dec. 31, 2017, and claim a deduction in 2017, thereby avoiding the limitation that would apply in 2018. Here is how the conference report explains it:
“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.”
The only problem is that the statutory language does not correspond with the above explanation of the conference report. Here is the statutory language:
SEC. 11042. LIMITATION ON DEDUCTION FOR STATE AND LOCAL, ETC. TAXES.
(a) IN GENERAL. — Subsection (b) of section 164 is amended by adding at the end the following new paragraph:
‘‘(6) LIMITATION ON INDIVIDUAL DEDUCTIONS 2 FOR TAXABLE YEARS 2018 THROUGH 2025. — In the case of an individual and a taxable year beginning after December 31, 2017, and before January 1, 2026–
‘‘(A) foreign real property taxes shall not be taken into account under subsection (a)(1), and
‘‘(B) the aggregate amount of taxes taken into account under paragraphs (1), (2), and (3) of subsection (a) and paragraph (5) of this subsection for any taxable year shall not exceed $10,000 ($5,000 in the case of a married indi vidual filing a separate return). The preceding sentence shall not apply to any foreign taxes described in subsection (a)(3) or to any taxes described in paragraph (1) and (2) of subsection (a) which are paid or accrued in carrying on a trade or business or an activity described in section 212. For purposes of subparagraph (B), an amount paid in a taxable year beginning before Jan uary 1, 2018, with respect to a State or local income tax imposed for a taxable year beginning after December 31, 2017, shall be treated as paid on the last day of the taxable year for which such tax is so imposed.’’.
(b) EFFECTIVE DATE. — The amendment made by this section shall apply to taxable years beginning after December 31, 2016.”
I bolded the language that is supposed to implement the rule that you can’t take a deduction in 2017 for 2018 taxes prepaid in 2017. I could spend a lot of time parsing through this confusingly drafted provision, but let’s just focus on one thing. Notice that the bolded language is part of a new paragraph (6) of section 164. Read the introductory language of that new paragraph (6). It says: “ In the case of an individual and a taxable year beginning after December 31, 2017, and before January 1, 2026”. What this means is that, by its terms, the provision applies only for taxable years beginning after 2017. Whatever the bolded language means (its meaning is not clear to me), it applies to 2018, not 2017. So despite what the explanatory statement in the conference report hopefully says, the provision by its terms does not apply to 2017. This is also clear from the bolded language which, by its terms, applies only “for purposes of subparagraph (B).” In other words, the rule in the bolded language does not apply for any other purpose, such as denying a deduction for 2017, as the conference report explanation would have it. (The fix would be pretty simple. Change “subparagraph (B)” to “this section” so that the bolded language would read: “For purposes of this section,…”) Maybe the conferees can scribble this in by hand.
Absent such scribbling, what can taxpayers do? Can you take a deduction in 2017 for taxes you prepay in 2017? Perhaps, if the conference report is passed as is. (There are a couple of issues. First, your state has to let you pay 2018 estimated tax in 2017. This may not be the case for all states; it is not the case for all jurisdictions in the case of property tax. Second, there is an issue as to whether the deduction is allowed. The conferees’ explanation of the TCJA certainly seems to assume that a deduction would be allowed. There does not seem to be much authority on this, the general principle being that a deduction for estimated tax is allowed if the estimated tax is paid in good faith, as this would be as long as the amount is a reasonable estimate for 2018. But some may question whether one can go into the next taxable year. Is this truly a payment of a tax, or is this just a deposit?) Also, a technical corrections act passed in 2018 might fix this mistake (with retroactive effect) — or not. On the other hand, despite the uncertainty, one approach may be to make the payment and take the deduction on the basis that there is not much to lose. If the deduction is denied, then that will be the result anyway if the payment were made in 2018. On this analysis, there is little to be lost as long as one is open to the possibility of the deduction ultimately not being allowed.
Caveat: Suppose that someone prepays 2018 tax in 2017, takes a deduction, and the drafting error identified here is not fixed in a technical corrections bill. If the IRS challenges the deduction and the matter is litigated, how would it turn out? Impossible to say. A court could either rule that the words of the statute should be followed as written, or it could interpret the provision to implement congressional intent. Either outcome is conceivable.
Update (Dec. 23, 2017): The tax act as passed did not fix the technical error identified in this article.