California Tax Ruling Comes Too Late For Most Filers

Sometimes it pays to procrastinate. In a surprise gift to taxpayers, the State of California office that collects taxes announced Friday that most kinds of property tax are fully deductible on 2011 income tax returns.

The change could cost the state $200 million, board spokesman Daniel Tahara said. Individual property owners could gain a few hundred dollars each in new deductions.

The last-minute announcement reverses a campaign that the California Franchise Tax Board launched in November 2011. In press releases and on its website, the tax board told taxpayers that they could only deduct from their income taxes those property taxes that are based on the assessed value of their real estate.

In addition to these "ad-valorem" taxes, most property owners also pay flat-rate taxes – taxes that are the same for all property owners regardless of whether the property is a tiny shack or a gigantic mansion. These types of property tax are not deductible from income taxes, the tax board said.

One example is "vector control," assessments to pay for government efforts to control pests such as mosquitoes. Another is "Mello-Roos" assessments (special taxes for improvements to roads, libraries and emergency services).

However, the board has changed its mind. "What you have heard since November, go back and forget it," said Tahara. The board has removed from its website all instructions about not deducting for flat rate taxes.

Why the change? The state bases most of its income taxes on the federal income tax rules, and it interpreted one of these rules as stipulating that the flat-rate taxes could not be deducted. But after starting its campaign,  "in response to some conflicting information provided by the IRS," the board says in a press release, it asked the federal agency for clarification.

Although the IRS responded in February, the state tax board says it didn't receive it and found out about the different interpretation in April.

After analyzing IRS' interpretation, the Franchise Tax Board finally announced the change on Friday.

Tahara acknowledged that by Tuesday morning, as the word was filtering out, 11.6 million out of 15.5 million California taxpayers had already filed their returns. "We're having a discussion about how we deal with this," he said.

Any taxpayer who paid taxes without taking the deduction is free to file an amended return. But that takes time and anyone who hires a professional tax preparer would probably have to pay that person to file the amendment, Tahara acknowledged.

The board has no estimate of how many people may be affected. The board's accountants estimated the total value of the flat-rate deductions at $200 million.

But the story is more complicated than that. The IRS is not saying that all flat-rate taxes are deductible, Tahara said. Here's the relevant passage from its letter to California:

Assessments on real property owners, based other than on the assessed value of the property, may be deductible if they are levied for the general public welfare by a proper taxing authority at a like rate on owners of all properties in the taxing authority’s jurisdiction, and if the assessments are not for local benefits (unless for maintenance or interest charges).

Got that?

Didn't think so. "It's still very confusing," said Tahara. The state is waiting for further clarification from the IRS.

So what should taxpayers do in the meantime? "Talk to your tax preparer," Tahara said.

Again.