IS MY STATE TAX REFUND TAXABLE?

Taxpayers who itemize and receive a “tax benefit” from a specific deduction must report as taxable income any refund of the payment deducted you receive in a subsequent year to the extent that the refund provided a tax benefit on the previous return. 

This most frequently occurs when a taxpayer deducted the full amount of state income tax withheld in, for example, 2017 on their 2017 Schedule A and received a refund of some of the tax withheld in 2018.

What is a tax benefit? 

* You are married filing a joint return.  Your total allowed itemized deductions for 2017 was $15,000.  The Standard Deduction for a married couple filing jointly in 2017 was $12,700.  Your itemized deductions exceeded your Standard Deduction by $2,300 – so the tax benefit you received from itemizing for 2017 was $2,300.

* You deducted $3,000 for state income tax withheld on your 2017 Form 1040.  When you prepared your 2017 NJ-1040 you calculated you overpaid your state income taxes by $975.  In 2018 you received a check from NJ for $975.

* The $975 refund from NJ is less than the $2,300 overall tax benefit you received from itemizing.  If you had deducted the correct amount of your 2017 state tax liability, you would have only claimed $2,025 in state income tax and your total allowed itemized deduction for 2017 would have been $12,975.  This is still more than the $12,700 Standard Deduction. 

* You clearly received a tax benefit for the full amount of the $975 state income tax refund.  You must report as taxable income on your 2018 Form 1040 the $975 state tax refund.

States will issue a Form 1099-G for all state income tax refunds issued to a taxpayer during the calendar year.  Unfortunately, most, if not all, states, in an attempt to save money, do not mail this form to taxpayers.  Taxpayers MUST go online to the state tax department website to download and print their Form 1099-G. 

Just because the state issues you a Form 1099-G does not mean that any or all of the amount reported on that form is taxable income.  You only need to report a state income tax refund if –

1) you itemized deductions on Schedule A of the Form 1040 for the year to which the refund applies,

2) you did not deduct state and local sales tax on the applicable Schedule A instead of state and local income tax,

3) you deducted the total amount of state income tax withheld for the year on the applicable Schedule A, and

4) you were not subject to the dreaded Alternative Minimum Tax (AMT) for the applicable year (taxes of any kind, including state and local income tax, is not deductible in calculating the AMT – so you would have received no tax benefit from the deduction of state and local income tax, depending on the amount of AMT and the amount of the state income tax deduction).

The amount of the state income tax refund that is taxable is also limited to the amount that your Schedule A deduction for all state and local income taxes exceeds the amount of state and local sales tax you could have deducted.

You deducted $3,000 for state and local income tax withheld and $200 for state unemployment, disability or family leave taxes withheld (considered to be state and local income taxes for Schedule A purposes).  You could have deducted a total of $2,800 in state and local sales taxes (due to a used car purchase) instead – but that was less than $3,200.  So, you only received a tax benefit of $400 from the deduction for state income taxes.  The portion of the $975 state tax refund that must be included in taxable income for 2018 is only $400. 

This rule still exists.  However, the changes made by the GOP Tax Act substantially eliminated the need to claim state tax refunds as taxable income.  Most taxpayers who had consistently itemized in the past are no longer able to itemize.  And even if you can itemize, the deduction for all state and local taxes (state income taxes or state sales taxes, state and local personal property taxes and local property taxes combined) is limited to $10,000.

Let’s say you were able to itemize for 2018, your total property taxes for 2018 were $9,500, the total amount of state income tax withheld for 2018 was $3,200, and your actual 2018 state tax liability on your 2018 state income tax return was $2,300.  You could deduct only $10,000 in state and local (SALT) taxes on your 2018 Schedule A.  

Whether you claimed the $3,200 withheld or the $2,300 actual liability for state income taxes your 2018 itemized deduction for taxes would be only $10,000.  So, you received absolutely no tax deduction, or tax benefit, for the $900 excess withholding if you claimed the full $3,200.   No tax benefit – no taxable income.  None of the $900 in state income tax refund reported on your 2019 Form 1099G is taxable income - none of the $900 has to be reported on your 2019 Form 1040.

The $10,000 deduction is treated by the IRS as $9,500 in property taxes and $500 in state income taxes.  This has been verified by Internal Revenue Service Revenue Ruling 2019-11.

Taxpayers who were required to claim state income tax refunds as taxable income on their 2018 Form 1040 actually received a fortuitous tax savings as a result of the reduction in tax rates enacted by the GOP Tax Act.

In the original example of a tax benefit at the beginning of this post I showed that the taxpayers had to report $975 as taxable income on their 2018 Form 1040.  Let’s say their federal marginal tax rate for 2018 was 25% but was 22% for 2018.  When they filed their 2017 return the $975 deduction reduced their tax liability by $244 ($975 x 25%).  But the $975 in income reported in 2018 only cost them $215 in federal income tax ($975 x 22%).  So, the bottom line is that they actually saved $29 ($244 less $215).

Hey, better in the pocket of the taxpayer!

TTFN