State asks homeowners to stop deducting some taxes

Via The San Francisco Chronicle
Kathleen Pender

The California Franchise Tax Board is leaning on taxpayers and tax preparers to start complying with a widely ignored law that prevents property owners from deducting certain real estate taxes on their income tax returns.

Many tax preparers are telling clients about the law and asking to see their property tax bills for the first time this year so they can determine which charges can and cannot be deducted.

"We put it in our organizer checklist and in our cover letter," says Daniel Morris, a CPA and partner with Morris + D'Angelo. He will no longer deduct a client's property taxes until he sees a bill.

"It sounds strong," he says. But he considers the tax board's warning "a shot across the bow" and does not want to "risk fines and licensure issues by inadvertently deducting nondeductible items."

Federal and state laws generally limit the real estate deduction to ad valorem taxes, which are calculated as a percentage of the property's assessed value. Any tax that is a flat amount per property or benefits a specific property is generally not deductible. There are some minor exceptions, however, and property tax statements do not spell out which charges are not deductible.

Until this year, almost everyone, including tax preparers, ignored this law and deducted 100 percent of property taxes, says Mary Canning, dean of the taxation and accounting schools at Golden Gate University.

"We weren't looking at the bills," says Canning, who also has a tax practice. "Nobody was trying to do anything deceptive."

Once uncommon, nondeductible charges began creeping on to California property tax bills after Proposition 13 in 1978 sharply limited general property tax increases. Since then, many local governments and school districts have been raising money with voter-approved parcel taxes and other charges that are not deductible.

Millions in added revenue

The Franchise Tax Board estimates that Californians are improperly deducting billions of dollars in real estate taxes each year. If everyone deducted only the allowable amount, the state could raise about $200 million in added tax revenue per year, FTB spokeswoman Denise Azimi says.

The tax board had planned to enforce compliance by adding three lines to 2011 state-tax returns that would require property owners to show their parcel number, total property tax bill and the deductible amount. But it postponed those changes until 2012 returns. This year, it is hoping to educate the public and tax preparers. It estimates that voluntary compliance could generate about $20 million in additional tax revenue this year.

Sam Gurbaxani, a volunteer with the AARP Tax-Aide program, which provides free tax preparation for low- to moderate-income people, says volunteers have been instructed to enforce the law to the best of their abilities this year.

He says many clients document their deduction with a mortgage statement or canceled check, but that won't work anymore because they don't show itemized taxes. "For these clients we could look up their tax bills online or send them home to fetch the property tax bills. Either way we are going to have some unhappy taxpayers," he says.

"The impact of this on the clients we serve is going to be considerable," Gurbaxani adds. "For example, Oakland residents will see their deduction amounts drop by $900. Some Berkeley residents will see the deduction amount drop by over $2,000."

For some people, it will no longer make sense to itemize deductions after they lose part of their property tax deduction; instead, they should take the standard deduction, he adds.

Although the Internal Revenue Service explains that not all property taxes are deductible in its tax guide, it has not cracked down on abusers because it's not an issue in most states outside California, tax pros say. In most states, it is easier to raise ad valorem taxes, and property tax bills are not loaded with nondeductible charges.

More federal tax revenue

California's efforts to raise state tax revenue will bring in even more federal tax revenue. Because federal income tax rates are higher than California's rate, the loss of some property tax deductions will increase most people's federal tax bill more than their state tax bill. But loss of property tax deductions will not affect some people who are subject to the federal alternative minimum tax because they already do not benefit from property tax write-offs on their federal return.

The FTB has published information on how to comply with this law at www.ftb.ca.gov/individuals/Real_Estate_Tax_Deduction/index.shtml. This page includes a link where most people can look up their tax bill online (not all counties offer online lookup) and find a sample tax bill for their county. The sample bill attempts to show which charges are and are not deductible. But most people have taxes that are specific to their city, neighborhood or school district that do not show up on the sample bill.

It would be much easier to comply with this law if counties separated deductible and nondeductible charges on tax bills. But that's not likely to happen soon because it would take "a massive reprogramming of their software," says Paul McIntosh, executive director of the California State Association of Counties. "Even within a county, there are hundreds of different taxing jurisdictions."

Kip Dellinger, a senior tax partner at Cooper Moss Resnick Klein, says the Franchise Tax Board is leveraging tax preparers to enforce the property tax law because "there are not enough IRS agents or FTB auditors" to do the job.

He admits that many CPAs "have ignored their responsibilities" in this area. As an expert in CPA ethics, he advises CPAs to tell clients "in their engagement letters that not all amounts showing on a property tax bill are necessarily deductible and they should review it to determine the correct amount and, if unable to do so, please provide the CPA a copy of the tax bill."

One of the biggest nondeductible charges some people face are Mello-Roos fees, which finance schools and infrastructure improvements in many communities.

Seeking to add deductions

On Jan. 26, Assemblyman Jim Silva, R-Huntington Beach (Orange County), introduced a bill that would designate Mello-Roos fees as tax deductible on California returns.

"Whether certain portions of Mello-Roos fees are tax deductible for federal purposes remains uncertain," according to Spidell Publishing, a tax information service.

If passed, AB1552 would be effective for tax years starting Jan. 1, 2012. "It would severely reduce the amount of revenue generated as part of the FTB's plan to require parcel numbers and a computation of the nondeductible portion of property tax on 2012 personal tax returns," Spidell says.