When is a state refund taxable? The TCJA raises some questions.

State tax refunds can be fully or partially taxable, or not at all. The introduction of the $10,000 SALT deduction limit can affect the results.

By: Gil Charney  /  April 26, 2019

As anyone not living under a rock these last 18 months knows, the Tax Cuts and Jobs Act (TCJA) imposed a $10,000 ($5,000 married filing separately) cap on deductions of state and local taxes (SALT) – including income, real estate, property, and sales taxes – paid after December 31, 2017. The law does not provide specific limits for deducting each of these taxes; it only provides that the total SALT taxes deducted on Schedule A cannot exceed $10,000 with no carryover of excess taxes paid.

Despite the controversy of this new law and various creative workarounds by several states, the SALT deduction calculation is all fairly mechanical However, a more interesting challenge will occur when taxpayers file in 2020 for those taxpayers who received a refund of SALT taxes paid in 2019, the first year for which a state tax refund will have been paid based on the $10,000 cap imposed in 2018.

Prior to 2018, approximately 30 percent of taxpayers itemized their deductions, with only 10 percent of taxpayers expected to itemize deductions for 2018 because of the higher standard deduction.

Yet for those 15 million or so taxpayers who do itemize, nearly all of them will have some SALT on Schedule A like a margarita at Cinco de Mayo. It’s fair to speculate that many of them will show the full $10,000 allowed. If they receive a refund while the TCJA limit is in effect (2019 through 2025) for SALT taxes paid in 2018, what part, if any, of the state refund will be taxable?

While state tax refunds paid to taxpayers who take the standard deduction are not taxed as income, taxpayers who itemize have different requirements. For a taxpayer who paid no more than $10,000 of state and local taxes in the prior year, a taxable state refund is the smaller of:

  1. The refund amount.
  2. The excess of itemized deductions over standard deduction for the previous year.
  3. The excess of state and local income taxes actually deducted the previous year over the sales taxes that could have been deducted that same year.

These taxpayers may be able to minimize the taxability of their state refunds.

A refresher on state tax recovery and the tax benefit rule

As with the federal tax system, state taxes paid or withheld in one year may be more or less than the actual state tax liability. This results in a refund for overpayments, or a balance due for underpayments. A refund of previously deducted state taxes may trigger income recognition in the year received, while a balance due payment may be deducted for the year paid.

Example 1: Parker had his employer withhold $8,000 in state income taxes in 2018. When he prepared his state tax return in early 2019, he discovered that his state’s income tax liability was only $7,000. Parker received a refund of $1,000 in April 2019.

Example 2: Same as Example 1, but Parker’s state tax liability turned out to be $8,500. He paid the remaining $500 in April 2019 and will include that payment as a state tax deduction for 2019, if he itemizes.

Several rules for the taxability of state tax refunds (“recoveries”) must be considered. First and foremost is the tax benefit rule, as stated in IRC §111(a), Recovery of tax benefit items.

“Gross income does not include income attributable to the recovery during the taxable year of any amount deducted in any prior taxable year to the extent such amount did not reduce the amount of tax imposed by this chapter.” [emphasis added]

In other words, the recovery of a deduction taken in a previous year is not taxable in the year received if the deduction did not give rise to a tax benefit in the year paid or withheld.

One of the most common examples is a taxpayer who claims the standard deduction. A state tax refund received by a taxpayer is not taxable if the taxpayer claimed the standard deduction during the year the payment was made. Thus, if Parker claimed the standard deduction in 2018, none of his $1,000 would be taxable.

Treatment of state tax refunds

For taxpayers who itemize and who claim a deduction for state taxes paid in 2018, a state tax refund in 2019 may be nontaxable, partially taxable, or fully taxable. Determining factors include the taxpayer’s filing status (and the standard deduction amount), the amount of refund received, the difference between total itemized deductions claimed, and whether the taxpayer paid any AMT due to the nondeductibility of state taxes.[1]

If a taxpayer itemizes, the excess of itemized deductions over the taxpayer’s standard deduction is the maximum amount that can be includible in income.

Example 3: Allie, a California taxpayer, is single and 35 years old, and her standard deduction for 2018 was $12,000. If her itemized deductions totaled $17,000 in 2018, the maximum taxable amount of any state tax refund received in 2019 is $5,000 ($17,000 – $12,000).

Example 4:  Allie had $5,000 in state income taxes withheld in 2018, and her state tax liability was only $3,200. In December 2018, a small fire caused by her old home’s faulty wiring resulted in $8,000 damage to her home. Allie was able to deduct $3,000 as an itemized deduction on her state tax return.[2] She received a state tax refund of $1,800 in 2019. This state refund is fully taxable on her 2019 federal tax return because it is less than the $5,000 maximum taxable amount (itemized deductions less the standard deduction).

Consider Examples 3 and 4 above, where Allie claimed itemized deductions of $17,000 on her federal return as follows:

Deduction Amount
Mortgage interest      6,000
State income tax      5,000
Real estate tax      3,000
Pers. property tax      1,000
Charitable contrib.      2,000
Total     17,000

 

Note that Allie’s SALT taxes (bolded in table) total $9,000, so the TCJA’s $10,000 cap does not apply.

How much of her $1,800 refund of state taxes paid in 2018 is taxable in 2019? Since the refund is less than the $5,000 excess of her itemized deductions over her standard deduction, it is fully taxed. She will report the $1,800 as income on her 2019 Schedule 1 (Form 1040), Line 10.

Enter the sales tax deduction

As shown on the Instructions for Schedule A (Form 1040), line 5a, a taxpayer can elect to deduct state and local income taxes or general sales taxes on line 5a, but not both. The state income tax deduction is usually greater than the general sales tax deduction (except for the nine states that impose no tax on earned income – Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming, and the two states that tax only dividends and interest – New Hampshire and Tennessee).

Moreover, IRS allows taxpayers who deduct their income tax to reduce any taxable state refund by the amount of sales tax they did not deduct but could have deducted instead of income tax. According to IRS Publication 525, Taxable and Nontaxable Income, in the section labeled State Tax Refund:

“You must include in your income the full amount of a refund of state or local income tax or general sales tax[3] if the excess of the tax you deducted over the tax you didn't deduct is more than the refund of the tax deducted.” (emphasis added)

Take Allie, who deducted $5,000 in California state income tax. She could have deducted sales tax, which would have been only $903 under the optional sales tax tables. However, she also bought a new car for $40,000 and paid sales tax of $4,000 – bringing her total sales taxes paid to $4,903, still slightly less than her state income tax deduction.

If Allie was not aware of her potential sales tax deduction, or just assumed that her state income taxes paid were greater (which they were, by $97), then she would totally ignore the state sales tax she could have deducted[4]. By doing so, the $1,800 state tax refund she received in 2019 is reported as fully taxable. However, if she was aware that she could have deducted $4,903 in sales tax, instead of $5,000 in state income tax, only $97 of her $1,800 state refund would have been taxable in 2019 (the excess of her state income taxes paid over her state sales taxes not paid ($5,000 – $4,903).

To summarize, her 2018 tax liability wasn’t affected by the sales tax deduction because she didn’t claim it, deducting instead the higher income tax amount. However, in 2019, when she receives her 2018 state tax refund, she can shield $1,703 from taxation because of the sales tax not taken.

The SALT Deduction under the TCJA

The TCJA SALT deduction limit of $10,000 raises the question about how a taxpayer can fill the $10,000 “bucket” if their total SALT deduction is greater than $10,000. Given that a state tax refund is related to an overpayment of income tax, the taxpayer is advised to fill the bucket with as many SALT taxes that are not income taxes. In other words, for a year when the taxpayer has an unusual amount of sales taxes, it may benefit the taxpayer to check box 5a on Schedule A (Form 1040) and elect to include general sales tax instead of income taxes.

Example 5: Winslow is an investment banker who lives in a high-rise condo in mid-town Manhattan. His qualified mortgage interest is limited to $1 million under pre-TCJA terms. His 2018 earnings (salary, commissions, and bonus) totaled $800,000.

Winslow’s itemized deductions for 2018 (before the $10,000 SALT deduction limit, and disregarding the choice between deducting state income or state sales taxes), are as follows:

Deduction          Amount
Qualified mortgage int.             50,000
State + NYC income taxes             94,000
Real estate tax             18,000
Pers. property tax             13,000
General sales tax               2,500
Charitable contrib.            25,000
Total          202,500

 

With the $10,000 SALT deduction limit, Winslow can deduct $85,000:

Deduction           Amount
Qualified mortgage int.              50,000
SALT taxes              10,000
Charitable contrib.              25,000
Total             85,000

 

His 2018 New York State and NYC tax liabilities totaled $81,000, or $13,000 less than was withheld and paid. This sum was refunded to Winslow in March 2019.

How should this refund be treated in 2020, when Winslow files his 2019 return? Clearly, despite the high amount of state income taxes he paid, he could not deduct them and therefore received no federal tax benefit. Therefore, a small silver lining for Winslow is that none of his state tax refund will be taxable in 2019.

Example 6: Jon, a single taxpayer and homeowner, lives and works in Kansas City, Missouri. He earns $225,000 and has the following gross itemized deductions (before the $10,000 SALT deduction limit):

 

Deduction          Amount
Mortgage interest             11,000
MO and KC income taxes             14,000
General sales tax              [900]
Real estate tax               4,500
Pers. property tax               2,000
Charitable contrib.               8,000
  Total             40,400

With the $10,000 SALT deduction limit, Jon’s itemized deductions total $29,000, as follows:

Deduction            Amount
Mortgage interest               11,000
SALT taxes               10,000
Charitable contrib.                8,000
Total              29,000

 

POP QUIZ: In 2019, he receives a state tax refund of $3,500. To what extent, if any, is it taxable?

  1. Jon must include in income the full refund of $3,500 because it is less than excess of itemized deductions actually claimed ($29,000) and the standard deduction for a single filer ($12,000).
  2. The state refund is fully taxable because of the $10,000 claimed, $6,500 was for real estate and property taxes, leaving $3,500 for state income taxes. Thus, the $3,500 refund was a refund of state income taxes.
  3. The state refund is partially taxable because only 35 percent of the $10,000 bucket was attributable to income taxes. Therefore, only $1,225 is taxable ($3,500 x 35 percent).
  4. The refund is only partially taxable because Jon could have deducted sales tax instead of income tax on his 2018 return.
  5. The state refund is not taxable at all because Jon's SALT taxes paid were higher than the $10,000 limit after his refund.

If you answered “E,” you are correct! Keep in mind the tax benefit rule – Jon’s refund of $3,500 means his SALT income taxes paid in 2018 would have been $10,500 ($14,000 – $3,500), if he paid the proper amount. This is still higher than the $10,000 limit, so he received no tax benefit by having claimed this amount. Therefore, none of the state tax refund of $3,500 refund is taxable.

This is similar to, but not identical with, IRS Rev. Rul. 2019-11, Situation 2, where a state tax refund resulting from an overpayment of taxes that produced no tax benefit is not taxable.

Regardless, taxpayers who receive a state tax refund should be cognizant of the opportunity to reduce any taxable portion by reducing it by the sales taxes not paid.

For more information, visit the Tax Information Center:

Related resources for H&R Block tax professionals:

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[1] AMT will be ignored here because the SALT deduction limit inherently reduces the state tax deduction add-back to AMTI, and a higher AMT exemption and phaseout range further reducing any likelihood of an AMT adjustment.

[2] California allows casualties that are not federally-declared disasters as an additional itemized deduction on her state return.

[3] A refund of sales or use tax received in a year after the tax was previously deducted may be taxable. However, the instructions to Form 1099-G address only state and local income tax refunds received and is consistent with IRC §6050E(a). Thus, taxpayers should not receive a Form 1099-G reporting refunds of state sales or use tax.

[4] IRS provides a state and local sales tax calculator at https://www.irs.gov/credits-deductions/individuals/sales-tax-deduction-calculator.

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Gil Charney

Gil Charney, CPA/PFS, CFP, CGMA, CMA, MBA, is director of tax law and policy analysis at The Tax Institute. Gil oversees a team of tax attorneys and CPAs who review and analyze legislation and the impact of tax laws on taxpayers. He has more than 30 years of experience in tax, accounting, and financial management.

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