California Real Property Tax Deduction--Where Do We Stand Now?
Last year, long before the beginning of the 2011 tax season, the FTB initiated a new compliance program that required every California county real property tax bill to be carefully analyzed to determine what portion of the taxes levied were deductible.
The FTB’s position was that only the portions of the taxes levied as a percentage of the property value (ad valorem taxes) were deductible. The FTB even added to its web site samples of all the tax bills from every county in California, identifying what they believed was not deductible.
California conforms to federal tax law on deductible property taxes. Although there is no proof, the FTB apparently based their opinion on an IRS publication or instructions to Schedule A; see, for example, the excerpt from Publication 17 below (the pertinent passage is underlined for clarity).
As a reminder, IRS publications are not citable and cannot be quoted for precedent. They only represent the IRS’s opinion and can be ignored with impunity. If the FTB actually based their compliance program on an IRS publication that was in error on their part as will be seen when in the IRS Chief Council Advisory Letter later.
The FTB initially indicated that they were going to require the parcel numbers for the taxpayer’s home and second home to be included on the FTB Schedule CA for 2011. They received so much heat over that idea that they rescinded the requirement for 2011 but indicated that the information, along with a breakdown of the deductible and non-deductible tax amounts, would be required for 2012 filings, allowing them to match the deduction against information provided by the various counties as to what is allowable on the property tax bills.
This placed a substantial additional burden on the tax practitioner. Although in the past, most subtracted the Mello-Roos taxes, few gave much thought to other items that might not be deductible. Practitioners are now forced to obtain a copy of their clients' property tax bills and allocate the taxes between those that the FTB identified as being deductible and those that were not. Many even began accumulating the parcel numbers in preparation for the 2012 reporting requirement.
Those practitioners who followed the FTB guidance on the web site received a negative reaction from their clients and in some cases lost clients who went to other practitioners who ignored the FTB guidance and continued to deduct the entire amount of property taxes.
Then on April 13, 2012, the IRS Chief Counsel Office issued an Information Letter (2012-0018, dated February 6, 2012, for release March 30, 2012), which indicates that deductible taxes are not just limited to ad valorem taxes--as the FTB contended--and indicated that their publication was not correctly worded and would be changed in the future. To fully understand the IRS's position on deductible real estate taxes, with which, by law, CA conforms, see the General Counsel's letter, reproduced below.
Although the letter was in response to an FTB inquiry last December with the IRS Chief Counsel office, the FTB claim they did not actually received a copy and first found out about it from a posting on the web.
As a result of the Information Letter, on April 13, 2012, the FTB Public Affairs office issued a news release acquiescing to the IRS position. In that news release, they revised their definition of deductible real estate property taxes to the following:
In addition, the FTB indicated that they
- had removed from their web site the material that limits the deductibility of real estate taxes to those imposed on an ad valorem basis;
- will berevising the California tax form instructions to reflect this update;
- will review the IRS' revisions to their forms and publications when they are released to provide comparable changes to California tax form instructions; and
- do not, at this time, plan to add additional reporting requirements related to the real estate tax deduction beginning with the 2012 tax return. Presumably, this means that they will not be requiring the first and second home parcel numbers on the 2012 Schedule CA.
On Monday, April 16, the FTB re-issued the information as part of their Tax News service. In that notice, the FTB solicited suggestions and comments that can be sent by e-mail to firstname.lastname@example.org.
The Aftermath (Where Do We Go From Here?)
(1) Those practitioners who followed the FTB's guidance
- have angered and lost clients;
- are left wondering why they paid attention to the FTB; and
- are faced with the task of amending both California and Federal returns.
(2) How difficult will the FTB make it to file amended returns? They have clearly avoided the issue thus far and have not provided any special guidance. Knowing the FTB, copies of the tax bills would need to be attached and carefully analyzed for the deductible part of the taxes.
(3) How receptive will clients be to paying a fee to the practitioner to amend the returns? After all, when they limited the real estate tax deduction, those practitioners were merely following the dictates of the FTB and attempting to keep their clients out of trouble with the tax agency. So should they not be entitled to compensation for preparing the amended returns? However, in cases where the property tax to be added on an amendment represents a minor percentage of the total tax paid, filing amended returns may not be cost-effective for the client when comparing the preparation fee to the tax savings from claiming the additional deduction.
(4) Those practitioners who ignored FTB guidance are smiling.
(5) The IRS and FTB definition of deductible taxes is still not all that clear and generally leaves it up to the taxpayer or practitioner to determine which items on the county tax bills, in addition to the ad valorem-based taxes, meet the “for the general public welfare issued at a like tax rate on owners of all properties in the taxing authority's jurisdiction” requirement (and are therefore also deductible).
Clearly, school taxes--and in some cases, a portion of the Mello-Roos taxes-- could fit the deductible definition. However, what portion of the Mello-Roos is deductible depends on its use by the local governments--which is not always clear. So there is no bright-line guidance, and the issue remains as muddled as ever.
If you are one of those who followed the FTB directive and limited your clients' real property tax deduction ClientWhys has prepared a suggested client letter that explains the situation and options.
Lee Reams Sr.
Lee T. Reams is the Chief Technical Officer of ClientWhys. He is also an Enrolled Agent having managed a 600-plus client tax practice. Educated as an engineer, with a Bachelor's Degree in Mechanical Engineering, Lee left his engineering career in 1975 to expand his part-time tax practice into a full-time career.