Taxation of State Income Tax Refunds

Post Date: 4/4/19
Last Updated: 4/4/19


Cross References
- Rev. Rul. 2019-11

If a taxpayer receives a federal tax benefit from deducting state and local taxes, and in the following year the taxpayer receives a refund of all or a portion of those state taxes, a portion of the refund may be subject to federal income tax in the year the refund is received.

The issue is further complicated with the new $10,000 limit under the Tax Cuts and Jobs Act (TCJA). For tax years starting in 2018, the itemized deduction for taxes paid is limited to $10,000 ($5,000 MFS) for the aggregate of:
1) State and local property taxes not paid or accrued in carrying on a trade or business, or an activity related to the production of income (rental real estate activities), and
2) State and local income, war profits, and excess profits taxes (or sales taxes in lieu of income taxes, etc.) paid or accrued in the tax year.

It is this $10,000 limit under TCJA and the various situations that may apply that is the subject of a recent IRS revenue ruling. If a taxpayer pays only the proper amount of state and local tax in the prior year, then itemized deductions for that year may either be lower, or the taxpayer may have opted for the standard deduction. The taxpayer must determine in each situation the amount of itemized deductions (or standard deduction) that the taxpayer would have deducted in the prior year had the taxpayer paid only the proper amount of state tax. The taxpayer must then compare this amount to the total itemized deductions actually taken, or the standard deduction that could have been taken, and include the difference as income on the current year return if the taxpayer received a tax benefit in the prior tax year from that itemized deduction.
Assume that in the following examples, all of the taxpayers are single and itemize deductions on their federal income tax returns for 2018 in lieu of using the standard deduction of $12,000. The taxpayers did not pay or accrue the taxes in carrying on a trade or business or an activity for the production of income. Also assume that the taxpayers were not subject to AMT and were not entitled to any credit against income tax. Each taxpayer uses the cash method of accounting for reporting income and deducting expenses.

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