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SALT Refunds Clarified

Are your state tax refunds taxable by the IRS? It’s complicated…

The $10,000 limit on deduction of state and local taxes (SALT) has been controversial since its enactment as part of the Tax Cuts and Jobs Act (TCJA). The IRS issued guidance in late 2018 on the effect of state tax credits designed to bypass the limit. Now, the IRS has addressed another point of confusion—whether state tax refunds are still taxable on a federal return. The answer is “yes” but the computation is different than it was before the SALT limitation took effect, and fewer taxpayers will have to pay.

Tax Benefit Rule

Whether state refunds are includable on a federal return depends on the tax benefit rule. The rule says, if a refund can be linked to a prior deduction which the taxpayer actually benefitted from, then the refund is taxable to the extent of that benefit. So, the question to answer is this: if a taxpayer received a tax benefit in a prior taxable year, and the taxpayer recovers all or a portion of those taxes in the current taxable year, what portion of the recovered amount must the taxpayer include in federal gross income? Revenue Ruling 2019-11 answers this question with four examples, shown below.

A key part of the calculation is determining the amount the taxpayer would have deducted if the taxpayer received no refund or had no balance due. Also relevant is whether the taxpayer itemized deductions or took the standard deduction. The rules illustrated below apply to the recovery of any state or local tax, including income, real estate or personal property tax. One important note—the ruling does not affect state tax refunds received in 2018 for tax returns currently being filed.

Examples

 

Situation 1: Albert paid local real property taxes of $4,000 and state income taxes of $5,000 in 2018. Albert’s state and local tax deduction was not limited because it was below $10,000. Albert claimed a total of $14,000 in itemized deductions on his 2018 federal income tax return and received a $1,500 state income tax refund in 2019.

Refund fully taxed. In this situation, the $1,500 state income tax refund is fully includable in federal income in 2019. Had Albert withheld only the exact amount due in state income tax for 2018 ($7,500), his SALT deduction would have been reduced from $9,000 to $7,500. As a result, his itemized deductions would have been reduced from $14,000 to $12,500, a difference of $1,500. Because he received a tax benefit in itemized deductions from the overpayment of $1,500, he will be taxed on the entire $1,500 state income tax refund.

 

Situation 2: Beth paid local real property taxes of $5,000 and state income taxes of $7,000 in 2018. Because of the federal SALT limitation, Beth could only deduct $10,000 of the $12,000 in taxes paid. Including other itemized deductions, she claimed a total of $15,000 in itemized deductions on her 2018 federal return. In 2019, Beth received a $750 state income tax refund due to overpayment of state income taxes.

Refund not taxed. In this situation, the state income tax refund is not includable in federal income. Had Beth withheld only the exact state and local tax owed, her state and local tax deduction would have remained the same ($10,000) and her itemized deductions would have remained the same ($15,000). She received no tax benefit from the overpayment of $750 in state income tax in 2018. Thus, she is not required to include the state income tax refund in 2019 gross income.

 

Situation 3: Taxpayer Chris paid local real property taxes of $5,000 and state income taxes of $6,000 in 2018. Chris could not deduct $1,000 of the $11,000 state and local taxes paid because of the federal SALT limitation. He claimed a total of $15,000 in itemized deductions on his 2018 federal return. In 2019, he received a $1,500 state income tax refund.

Refund partially taxed. His state income tax refund is partially includable. Had Chris withheld only the exact amount of state income tax owed, his state and local tax deduction would have been reduced from $10,000 to $9,500 and his total itemized deductions would have been reduced by $500. He received a tax benefit from $500 in 2018. Thus, he is required to include $500 of state income tax refund in his 2019 gross income.

 

Situation 4: Taxpayer Debra paid local real property taxes of $4,250 and state income taxes of $6,000 in 2018. She could not deduct $250 of the $10,250 state and local taxes paid because of the $10,000 limitation. She claimed a total of $12,500 in itemized deductions on her 2018 federal income tax return. In 2019, she received a $1,000 state income tax refund.

Partial tax, measured by standard deduction. In 2019, Debra received a $1,000 state income tax refund. Had she withheld only the exact amount owed, her state and local tax deduction would have been reduced from $10,000 to $9,250. Her itemized deductions would have been reduced from $12,500 to $11,750, which is less than the standard deduction of $12,000. The difference between her claimed itemized deductions, $12,500, and the standard deduction is $500 so she received a $500 tax benefit and is required to include that amount in 2019 gross income. In this situation, the amount of the state refund included in federal income is the difference between the itemized deductions taken and the standard deduction.

Have a question about dealing with the complicated situation with state and local tax refunds? Reach out to your Frazier & Deeter tax advisor.

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