Don't Prepay 2018 State Income Taxes (And Paul Makes a Mistake)

Published on: 22:48PM Dec 17, 2017

When it became apparent that state income taxes would either (a) not be deductible or (b) there would a be a limit of $10,000 on the deduction, many commentators suggested prepaying 2018 income taxes by December 31, 2017 in order to obtain a deduction.  Our firm had researched this issue and could find no authority for allowing this deduction.  We now no longer have to worry about whether it would be allowed or not.

In the Code Section dealing with the deduction of individual state income taxes, there is a specific portion that indicates any 2018 state income taxes paid before 2018 will be treated as if they were paid in 2018.  Therefore, make sure you do not prepay any 2018 state income taxes since you will be out the money for over a year and won't get a deduction.

If you do itemize for 2017, you for sure should go ahead and prepay your remaining 2017 state income taxes.  However, if you will be in the alternative minimum tax situation, skip prepaying your state income taxes since you will get no net tax benefit for the prepayment.  In that case, simply pay them in 2018 as you normally would.

One option that may say you a little bit is if you prepay your 2017 state income taxes and end up with an state tax refund in 2018, you may save a little bit of income tax.  This is due to tax rates being higher this year when you deduct the tax and lower next year when you are required to report the refund as taxable income.  Let's look at a quick example:

Bill and Sue Farmer have taxable income of $300,000 for 2017 which puts them right in the middle of the 33% tax bracket.  They prepay their state income taxes and receive a refund of $10,000 in 2018 when their income tax bracket will be 24% on the same amount of taxable income.  Prepaying the state income tax this year saves them $3,300 and costs them only $2,400 next year for a net tax savings of $900.

You would need to be careful not to prepay too much state income tax.  The IRS could assert that you did not pay an actual liability owed; but if you are over by less than 10% or so, there should be no issues.

Now for Paul's Mistake - In my post yesterday, I showed an example of how the 20% special farm income deduction would be limited and I made a mistake.  Here is the original example:

As an example, assume a farm earns $500,000, pays wages of $125,000 and has original asset cost of $2.5 million.  The gross 20% deduction is $100,000. It is limited to the greater of (1) $62,500 ($125,000 X 50%) or $125,000 ($125,000 X 25% plus $2.5 million X 2.5%).  Therefore, the farmer could deduct the full $100,000.

My mistake was in the calculation of the second limit.  $125,000 times 25% is only $31,250 and added to $62,500 for the 2.5% of $2.5 million my calculation should have been $93,750.  Instead of being able to deduct the full $100,000, the farmer would be limited to $93,750.  However, this is still $31,250 higher than the first option of 50% of wages paid.

Finally, I have gotten some questions regarding deducting interest for your farm operation.  If your gross income from farming is less than $25 million, then you can fully deduct all of your business interest.  If you are over $25 million, you can make an election to deduct 100% of your business interest.  In return, you are required to depreciate all assets with a 10 year life or greater using ADS (a longer system) and you can't take bonus depreciation.  This is a special provision for farmers only and does not apply to cash rent landlords.