Real Estate Taxes

Deductible real estate taxes are any state, local, or foreign taxes on real estate levied for the general public welfare. The taxing authority must base the taxes on the assessed value of the real estate and charge them uniformly against all property under its jurisdiction. Deductible real estate taxes generally do not include taxes charged for local benefits and improvements that increase the value of the property. See Taxes for local benefits, later.

If you use an accrual method of accounting, you generally cannot accrue real estate taxes until you pay them to the government authority. You can, however, choose to ratably accrue the taxes during the year. See Election to ratably accrue, later.

Taxes for local benefits. Generally, you cannot deduct taxes charged for local benefits and improvements that tend to increase the value of your property. These include assessments for streets, sidewalks, water mains, sewer lines, and public parking facilities. You should increase the basis of your property by the amount of the assessment.

You can deduct taxes for these local benefits only if the taxes are for maintenance, repairs, or interest charges related to those benefits. If part of the tax is for maintenance, repairs, or interest, you can deduct that part if you can show how much it is. If you cannot show how much of the tax is for maintenance, repairs, or interest, you cannot deduct any of it.

Example. City X, to improve downtown commercial business, converted a downtown business area street into an enclosed pedestrian mall. The city assessed the full cost of construction, financed with 10-year bonds, against the affected properties. The city is paying the principal and interest with the annual payments made by the property owners.

The assessments for construction costs are not deductible as taxes or as business expenses, but are depreciable capital expenses. The part of the payments that is to pay the interest charges on the bonds is deductible as taxes.

Charges for services. Water bills, sewerage, and other service charges assessed against your business property are not real estate taxes, but are deductible as business expenses.

Purchase or sale of real estate. If real estate is sold during the year, the real estate taxes must be divided between the buyer and the seller.

The buyer and seller must divide the real estate taxes according to the number of days in the real property tax year (the period to which the tax imposed relates) that each owned the property. Treat the seller as paying the taxes up to but not including the date of sale. Treat the buyer as paying the taxes beginning with the date of sale. For this purpose, disregard the accrual or lien dates under local law. You can usually find this information on the settlement statement you received at closing.

If you (the seller) cannot deduct taxes until they are paid because you use the cash method of accounting and the buyer of your property is personally liable for the tax, you are considered to have paid your part of the tax at the time of the sale. This lets you deduct the part of the tax to the date of sale even though you did not pay it. You must also include the amount of that tax in the selling price of the property.

If you (the seller) use an accrual method and have not chosen to ratably accrue real estate taxes, you are considered to have accrued your part of the tax on the date you sell the property.

Example. Al Green, a calendar year accrual method taxpayer, owns real estate in X County. He has not chosen to ratably accrue property taxes. November 30 of each year is the assessment and lien date. He sold the property on June 30, 1997. Under his accounting method he would not be able to claim a deduction for the taxes because the sale occurred before November 30. He is treated as having accrued his part of the tax, 180/365 (January 1-June 29), on June 30, and he can deduct it for 1997.

Election to ratably accrue. If you use an accrual method, you can choose to accrue real estate tax that is related to a definite period ratably over that period.

Example. John Smith is a calendar year taxpayer who uses an accrual method. His real estate taxes for the real property tax year, July 1, 1997, to June 30, 1998, amount to $1,200. The assessment and lien date is July 1.

If John chooses to ratably accrue the taxes, $600 will accrue in 1997 ($1,200 × 6/12, July 1-December 31) and the balance will accrue in 1998.

Separate elections. You can make a choice for each separate trade or business and for nonbusiness activities if you account for them separately. Once you choose to ratably accrue real estate taxes, you must use that method unless you get permission from the IRS to change from that method. See Revoking the election, later.

Making the election. If you make your election for the first year in which you incur real estate taxes, attach a statement to your income tax return for that year. You must file your return by the due date (including extensions). The statement should show:

1.The trades or businesses to which the election applies and the accounting method or methods used, 2.The period to which the taxes relate, and 3.The computation of the real estate tax deduction for the first year of the election.

If you make the election for a year after the first year in which you incur real estate taxes, file Form 3115, Application for Change in Accounting Method. Generally, you must file this form during the tax year for which the election is to be effective. For more information, see the instructions for Form 3115 .

Revoking the election. To revoke an election to ratably accrue real estate taxes, file Form 3115, as discussed above.

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Income Taxes

This section discusses federal, state, local, and foreign income taxes.

Federal income taxes. You cannot deduct federal income taxes.

State and local income taxes. State income taxes imposed on a corporation or partnership are deductible by the corporation or partnership as business expenses. State income taxes imposed on an individual are deductible by the individual only as an itemized deduction on Schedule A (Form 1040).

However, an individual can deduct a state tax on gross income (as distinguished from net income) directly attributable to a trade or business as a business expense.

Accrual of contested income taxes. If you use an accrual method, can deduct taxes before you pay them, and contest a state or local income tax liability, a special rule applies. The special rule requires you to accrue and deduct any contested amount only in the tax year in which the liability is finally determined.

Filing a tax return is not considered contesting a liability. If you do not make an objective act of protest or show some affirmative evidence of denial of the liability, you can deduct any additional state or local income taxes found to be due for a prior year only in the year for which they were originally imposed. You cannot deduct them in the year in which the liability is finally determined.

Foreign income taxes. Generally, you can take either a deduction or a credit for income taxes imposed on you by a foreign country or a U.S. possession. However, an individual cannot take a deduction or credit for foreign income taxes paid on income that is exempt from U.S. tax under the foreign earned income exclusion or the foreign housing exclusion. For information on these exclusions, see Publication 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad.

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Income Taxes

This section discusses federal, state, local, and foreign income taxes.

Federal income taxes. You cannot deduct federal income taxes.

State and local income taxes. State income taxes imposed on a corporation or partnership are deductible by the corporation or partnership as business expenses. State income taxes imposed on an individual are deductible by the individual only as an itemized deduction on Schedule A (Form 1040).

However, an individual can deduct a state tax on gross income (as distinguished from net income) directly attributable to a trade or business as a business expense.

Accrual of contested income taxes. If you use an accrual method, can deduct taxes before you pay them, and contest a state or local income tax liability, a special rule applies. The special rule requires you to accrue and deduct any contested amount only in the tax year in which the liability is finally determined.

Filing a tax return is not considered contesting a liability. If you do not make an objective act of protest or show some affirmative evidence of denial of the liability, you can deduct any additional state or local income taxes found to be due for a prior year only in the year for which they were originally imposed. You cannot deduct them in the year in which the liability is finally determined.

Foreign income taxes. Generally, you can take either a deduction or a credit for income taxes imposed on you by a foreign country or a U.S. possession. However, an individual cannot take a deduction or credit for foreign income taxes paid on income that is exempt from U.S. tax under the foreign earned income exclusion or the foreign housing exclusion. For information on these exclusions, see Publication 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad.

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Other Taxes

The following are other taxes that you can deduct if you incur them in the ordinary course of your trade or business.

Excise taxes. You can deduct all excise taxes you pay or incur as ordinary and necessary expenses of carrying on your trade or business.

Franchise taxes. You can deduct corporate franchise taxes as a business expense. If you are a cash method taxpayer, deduct the franchise tax in the year paid. If you are an accrual method taxpayer, deduct the tax in the year you become legally liable to pay it regardless of the year the tax is based on. For example, if your state imposes a franchise tax for 1997 that is based on your corporate net income for 1996, deduct the tax in 1997 if you use an accrual method because that is the year you became legally liable for the tax.

Fuel taxes. Taxes on gasoline, diesel fuel, and other motor fuels that you use in your business are usually included as part of the cost of the fuel. Do not deduct these taxes as a separate item.

You may be entitled to a credit or refund for federal excise tax you paid on fuels used for certain purposes. For more information, see Publication 378.

Occupational taxes. You can deduct as a business expense an occupational tax charged at a flat rate by a locality for the privilege of working or conducting a business in the locality.

Personal property tax. You can deduct any tax imposed by a state or local government on personal property used in your trade or business.

Sales tax. Treat any sales tax you pay on a service or on the purchase or use of property as part of the cost of the service or property. If the service or the cost or use of the property is a deductible business expense, you can deduct the tax as part of that service or cost. If the property is merchandise bought for resale, the sales tax is part of the cost of the merchandise. If the property is depreciable, add the sales tax to the basis for depreciation. For more information on basis, see Publication 551.

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Do not deduct state and local sales taxes imposed on the buyer that you must collect and pay over to the state or local government. Do not include these taxes in gross receipts or sales.

Self-employment tax. You can deduct one-half of your self-employment tax as a business expense in figuring your adjusted gross income. This is an income tax adjustment only. It does not affect your net earnings from self-employment or your self-employment tax.

To deduct the tax, enter on Form 1040, line 26, the amount shown on the "Deduction for one-half of self-employment tax" line of the Schedule SE (Form 1040).

For more information on self-employment tax, see Publication 533.

Unemployment fund taxes. As an employer, you may have to make payments to a state unemployment compensation fund or to a state disability benefit fund. Deduct these payments as taxes.