Tax planning to maximize real estate tax deductions.
Overview of allowable methods
There are three methods that a taxpayer may use to deduct real estate taxes on its 1992 tax return: 1. The payment method. 2. The payment method with the recurring item exception. 3. The ratable accrual method. Both forms of the payment method are governed by Sec. 461(h). A taxpayer who does not affirmatively elect the ratable accrual method described in Sec. 461(c) will be governed by one of the two payment methods under Sec. 461(h).
In general, Sec. 461(h)(1) states that an expense is deductible by an accrual-basis taxpayer in the tax year in which it meets three tests:
1. As of the end of the tax year, all of the events must have occurred that determined the fact of a liability (the liability must be fixed).
2. As of the end of the tax year, the amount of the liability must be determinable with reasonable accuracy (the liability must be determinable).
3. As of the end of the tax year, economic performance must have (or be deemed to have) occurred. With regard to real estate taxes, the proposed regulations under Sec. 461 (which become effective for all tax years beginning after Dec. 31, 1991) state that economic performance occurs when payment is made.
The first two tests together are known as the all-events test; the third test is known as the economic performance test.
In certain circumstances, a taxpayer that is not a tax shelter can avoid the restrictive economic performance test in determining the timing of a deduction by electing the recurring item exception. If the recurring item exception is elected, the economic performance test will be deemed to occur as of the close of the tax year, if the all-events test is satisfied, the accrued liability is paid by the earlier of 81/2 months after the close of the tax year or the date on which the tax return for the year in question is filed and certain other requirements of Sec. 461(h)(3) are met. It should be noted that the Sec. 461 regulations deem real estate tax to meet each of these requirements, except actual payment.
Payment method: The payment method applies to all taxpayers that have not elected the ratable accrual method and that have not elected the recurring item exception. Under this method, taxpayers may not deduct their real estate taxes until the taxes are paid. Therefore, for real estate taxes, the payment method is equivalent to the cash method of accounting.
Payment method with the recurring item exception: This method applies to taxpayers who have not elected the ratable accrual method but who have elected the recurring item exception. If the payment of the real estate taxes meets the requirements of the recurring items exception, it is deductible in the tax year in which they became fixed and determinable rather than in the tax year in which the payment was made. Thus, real estate taxes that become fixed and determinable in 1992 are deductible for 1992 if they are paid within the earlier of 81/2 months of the close of the tax year or by the date on which the 1992 tax return is filed.
Ratable accrual method: The ratable accrual method applies to taxpayers who elect it under Sec. 461(c) regardless of whether they have elected the recurring item exception. If an accrual-basis taxpayer elects the ratable accrual method, any real property tax related to a definite period of time will be accrued ratably over that time. For example, suppose that a calendar-year taxpayer operates in a state in which real estate taxes relate to the fiscal year July 1 to June 30. For 1992, the taxpayer may deduct one-half of the real estate tax related to the fiscal year from July 1, 1991 to June 30, 1992, and one-half of the real estate tax related to the fiscal year from July 1, 1992 to June 30, 1993.
Implications of changing an
existing accounting method
In general, prior IRS consent is required for a taxpayer to change an accounting method once the method has been previously established. However, Rev. Proc. 92-28 gives taxpayers a one time opportunity to make an automatic election to use (or abandon the use of) any of the three real estate tax accounting methods. A taxpayer can use this "window" to maximize its real estate tax deduction by choosing the method most appropriate for its situation.
Change of accounting method for deducting real estate taxes is automatic in 1992, but the change may result in a taxpayer deducting a particular tax expense twice. For example, suppose a calendar-year taxpayer was on,the lien method for 1991 - a method that allows a taxpayer to deduct real estate taxes in the year in which the tax is assessed (no longer allowable) - and there are two payments due on the assessment, one in December 1991 and one in April 1992. These two payments relate to a real estate tax year beginning July 1, 1991 and ending on June 30, 1992. Under prior law, both of these payments would be deductible in 1991, because they relate to a lien assessed in 1991. However, if a taxpayer elects the payment method for 1992, since the April payment is made in 1992, the taxpayer would be allowed to deduct that payment again in 1992 - a "double-dip."
To address this problem, the Service requires a taxpayer electing a different method of accounting for real estate taxes to elect one of two approaches to convert from one accounting method to another: (1) a cut-off approach or (2) a full-year change approach. The cut-off approach essentially denies to a taxpayer a deduction under its new accounting method of a deduction already taken under its previous accounting method. In contrast, the full-year change approach allows a taxpayer to "double dip" a deduction, but the taxpayer must amortize the second deduction in accordance with Temp. Regs. Sec. 1.46l-7t and Sec. 481(a), generally over a three-year period. If the "double-dip" occurs in the tax year of the change or the subsequent tax year, the full-year change approach is often more beneficial. Conversely, if a "double-dip" occurs more than one tax year after the tax year of the change, a cut-off approach is usually more beneficial to the taxpayer.
The number of allowable accounting methods, the choice of conversion approaches and the many specific fact patterns that can occur can make determining the most beneficial combination of elections a difficult and time-consuming analysis. Adding to the complexity of the issue is the fact that this election is made separately for each entity (or each trade or business if the taxpayer so chooses) included in a taxpayer's Federal tax return. The following examples may be helpful in understanding the interrelationships of the various factors relevant to this decision.
Example 1: Calendar-year taxpayer X has historically been on the lien date method, here, January 1 of the tax year. For 1991, X deducted the payments made on May 1, 1992 and Nov. 1, 1992 in its return filed Apr. 4, 1992. For its 1992 return, under the ratable accrual method, X can deduct both the May 5, 1993 and Nov. 1, 1993 payments because they represent its tax liability for its 1992 tax year. Under the payment method, for the 1992 return X can deduct the May 5, 1992 and Nov. 1, 1992 payments and take a Sec. 481(a) adjustment for both of these payments.
Under the payment method with the recurring item exception, assuming the 1992 return is filed on Sept. 15, 1993, a taxpayer can choose to (1) deduct only the May 1, 1993 payment; (2) pay the Nov. 1, 1993 payment early (before September 15) and therefore deduct that payment in addition to the May 1 payment; (3) deduct the May 1, 1992 payment, the Nov. 1, 1992 payment and the May 1, 1993 payment and have a Sec. 481(a) adjustment of one-third of both 1992 payments; or (4) pay the Nov. 1, 1993 payment before Sept. 15, 1993, deduct all four 1992 and 1993 payments and have a Sec. 481(a) adjustment for one-third of both the 1992 payments.
Example 2: Calendar-year taxpayer X deducted $600,000 in state A property taxes in its 1991 calendar-year return on the basis that the occurrence of the lien date (January 1 of its tax year) during its 1991 tax year satisfied the all-events test. A uses a calendar property tax year and requires that property taxes be paid on or before the first day of October of the calendar year that immediately follows the calendar year of the lien date. X paid the 1991 property taxes on Oct. 1, 1992.
If a taxpayer is on the payment method and opts for the full-year change alternative, it will deduct the $600,000 property tax expense again in 1992 and will have a positive Sec. 481(a) adjustment (an increase in income) of $600,000, one-third of which will be recognized in each of its 1992-1994 tax years (assuming that less than 75% of the Sec. 481 (a) adjustment is attributable to the tax year immediately preceding the tax year of change and that the client used its lien date method for more than two tax years).
In contrast, if the taxpayer opts for the payment method cut-off approach, it will not deduct any state property taxes for 1992, assuming that the client for the 1992 property tax year once again does not pay the taxes until October of the following year, in 1993. Recurring item exception: ff the taxpayer in Example 2 paid the 1991 property taxes on Sept. 1, 1992, and filed its 1991 return on Sept. 15, 1992, there would be no Sec. 481(a) adjustment under the full-year change alternative, assuming that the taxpayer elected the payment method with the recurring item exception on its 1992 tax return. As of Jan. 1, 1992, there would be no difference in property tax deductions between the taxpayer's old method (lien date) and new method (payment method in combination with the recurring item exception).
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|Author:||Rosen, Ira H.|
|Publication:||The Tax Adviser|
|Date:||Mar 1, 1993|
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