Property owners have been turning to online tax forums the past few years with a head-scratching question that usually goes something like this: “Why is my tax preparation software limiting my itemized deductions for property taxes to $10,000 on my federal return?”
In fact, the 2017 Tax Cuts and Jobs Act (TCJA) brought with it numerous changes affecting businesses and individuals. One controversial change for individuals was the $10,000 cap placed on itemized deductions for state and local taxes, including property taxes.
Like most tax code changes, this one prompts confusion and scores of questions, including the big one: “Is there any legal way around this cap?”
To the surprise of plenty of real estate owners, the $10,000 cap is not as absolute as they believe. Drilling into this issue one question at a time should provide REALTORS® with a useful, basic understanding as they field questions from their clients about how to address property taxes when filing their federal tax returns. Of course, specific questions about tax situations should be referred to qualified tax professionals.
How did the 2017 law change the way property taxes are treated by the IRS?
Before the change, individual taxpayers who itemized were allowed a deduction for property taxes paid to state and local taxing authorities, as well as a deduction for either state income tax or general sales tax. Under the TCJA, taxpayers who itemize are still allowed those deductions but with one major caveat: They are now limited to $10,000 ($5,000 for married filing separately).
This sweeping change has created much controversy, especially among residents of states with historically high property taxes—like Texas—who are now limited in the amount of deduction available to them.
Are there any exceptions to the $10,000 cap on property tax deductions?
Yes. One example is vacant land held for investment. Individuals who own vacant land generally do not receive any income from the land and also are not entitled to any business deductions related to it. The real estate taxes paid on vacant land before the passing of the Tax Cuts and Jobs Act were recorded as an itemized deduction on Schedule A. Therefore, it would appear that the new rules would subject these taxes to the $10,000 cap on deductions.
Upon further review, however, this might not always be the case. Section 164(b)(6) of the Internal Revenue Code provides exceptions for taxes that are paid or accrued in carrying on a trade or business and activities described in Section 212.
What does the IRS mean by “carrying on a trade or business”?
One activity described in Section 212 is the “management, conservation, or maintenance of property held for the production of income.” This section further states that income includes prior, current, and subsequent years. It also states that income includes not only recurring income but also gains from the disposition of the property. Most real estate investors purchase property with the intention of selling it in the future at a gain. So, it appears that property taxes paid on real estate investment property would not be subject to the $10,000 cap.
How should property taxes be reported to support the claim of carrying on a trade or business?
Taxes paid on investment property should be reported as “Other Taxes” on Line 6 of Schedule A, Form 1040. One note of caution, however, is that taxes are not a deduction for Alternative Minimum Tax purposes. Depending on the situation, claiming these additional tax deductions might not reduce total federal income taxes owed. In those situations, consideration should be given to making an election under Section 266 to capitalize the taxes paid to the basis of the property, thus reducing the amount of capital gain once the property is sold.
Are any other property taxes exempt from the $10,000 deduction cap?
Yes. Property taxes paid for rental properties (in service or available for rent) and those paid in the ordinary course of a trade or business, such as an operating company, are not subject to the $10,000 cap.
Unfortunately, property taxes paid on personal use property, second homes, and vacation homes, while still deductible as itemized deductions, are subject to the $10,000 limitation.
The laws are complex, to say the least. Property owners should be careful in calculating their deductions, and REALTORS® would be wise to advise their clients to seek input from a qualified CPA on their options.