Do Taxes on Investment Real Estate Escape the $10,000 Cap? It Seems Likely.

There’s an interesting problem with the limitation on the deduction for taxes on Schedule A that led to a recent discussion on Twitter among tax professionals.[1] 

We’ve likely all heard the comment that a deduction for state and local taxes is limited on Schedule A to no more than $10,000 ($5,000 for a married individual filing a separate return), so that real estate taxes imposed on raw land a taxpayer was holding for appreciation would be trapped by the $10,000 cap along with their other state and local taxes.

Or would it?  IRC §164(b)(6), added by the Tax Cuts and Jobs Act (TCJA) starts out with the general rule that we are familiar with:

(6) Limitation on individual deductions for taxable years 2018 through 2025In the case of an individual and a taxable year beginning after December 31, 2017, and before January 1, 2026—

…

(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 individual filing a separate return).

If that was all that IRC §164(d)(6) said, then the taxes on that raw land would clearly be subject to this limit.  But the provision doesn’t end there—rather, two sentences are found at the end of the section that limits the application of the $10,000 cap.  The section ends:

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 January 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.

So, what is an activity described in §212?  IRC §212(1) and (2) give us that answer—it relates to property held for the production or collection of income:

In the case of an individual, there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year—

(1) for the production or collection of income;

(2) for the management, conservation, or maintenance of property held for the production of income;

But you might protest, §212 expenses, aside from those incurred as part of a rental or royalty, are barred from being deducted following TCJA.  After all, IRC §67(g) clearly states that “[n]otwithstanding subsection (a), no miscellaneous itemized deduction shall be allowed for any taxable year beginning after December 31, 2017, and before January 1, 2026.”

But note that only affects miscellaneous itemized deduction—and IRC §67(b)(2) excludes from the definition of miscellaneous itemized deductions an itemized deduction for taxes under IRC §164.  And, of course, these real property taxes are deductible under IRC §164(a)(2), which gives a deduction for “[s]tate and local property taxes.”

While it is true that §212 expenses are miscellaneous itemized deductions, the tax in this case is not being deducted under §212.  The law simply tells us to reference §212 to see if the activity upon which the tax is being imposed (holding real property for investment) would be covered by that section.  The actual deduction remains under §164, and thus should be excluded from being impacted by §67(g)’s bar on miscellaneous itemized deductions.

So, is there a way the IRS could try and attack the deduction?  It is possible the IRS might argue the use of the word “activity” requires more than merely the passive holding of property.  After all, §212 itself doesn’t use the word activity when referring to items.  But that ignores the fact that we distinguish a trade or business from a §212 undertaking primarily by looking at the taxpayer’s level of activity.

The IRS could argue that “activity” was Congress’s attempt to insure no one believed that the $10,000 cap applied to rental properties—but Congress could have much more easily directly referenced rental and royalty property, as they did in IRC §62 when allowing such deductions in computing adjusted gross income.

As well, the IRS has yet to issue any guidance suggesting that the §163(d) $10,000 limitation on deduction of real estate taxes should be applied to the holding of land held for speculation, nor has there been any reports of the IRS or Treasury officials giving such guidance at conferences.

So, at least for now, it appears that deducting such taxes on line 6 of Schedule A, not subject to the $10,000 limit, has at least a reasonable basis, if not outright substantial authority under the law.