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IRS Clarifies Tax Treatment of State and Local Tax Refunds
(Parker Tax Publishing April 2019)
If a taxpayer received a tax benefit from deducting state or local taxes in a prior tax year and the taxpayer recovers all or a portion of those taxes in the current tax year, the taxpayer must include in gross income the lesser of: (1) the difference between the taxpayer's total itemized deductions taken in the prior year and the amount of itemized deductions the taxpayer would have taken in the prior year had the taxpayer paid the proper amount of state and local tax, or (2) the difference between the taxpayer's itemized deductions taken in the prior year and the standard deduction amount for the prior year, if the taxpayer was not precluded from taking the standard deduction in the prior year. This rule applies to the recovery of any state or local tax, including state or local income tax and state or local real or personal property tax. Rev. Rul. 2019-11.
Background
Code Sec. 164 generally provides an itemized deduction for certain taxes paid or accrued during the tax year. Under Code Sec. 164(a), a deduction is allowed for (1) state and local, and foreign, real property taxes; (2) state and local personal property taxes; (3) state and local, and foreign, income, war profits and excess profits taxes; and (4) the generation-skipping transfer tax imposed on income distributions. Code Sec. 164(a) also provides a deduction for state and local, and foreign, taxes not previously described that were paid or accrued within the tax year in carrying on any trade or business or an activity described in Code Sec. 212 (relating to expenses for production of income). Under Code Sec. 164(b)(5), a taxpayer can elect to deduct state and local general sales taxes in lieu of state and local income taxes.
The Tax Cuts and Jobs Act of 2017 (TCJA) added Code Sec. 164(b)(6), which limits an individual's deduction for the aggregate amount of state and local taxes paid during the calendar year to $10,000 ($5,000 in the case of a married individual filing a separate return). The dollar limitations apply to tax years beginning after December 31, 2017, and before January 1, 2026, but they do not apply to foreign taxes described in Code Sec. 164(a)(3) or to any taxes described in Code Sec. 164(a)(1) and (2) that are paid or accrued in carrying on a trade or business or an activity described in Code Sec. 212.
Code Sec. 111(a) excludes from gross income amounts attributable to the recovery during the tax year of any amount deducted in any prior year to the extent the amount did not reduce the amount of income tax. Code Sec. 111 partially codifies the tax benefit rule, which generally requires a taxpayer to include in gross income recovered amounts that the taxpayer deducted in a prior tax year to the extent those amounts reduced the taxpayer's tax liability in the prior year.
Rev. Rul. 2019-11
In Rev. Rul. 2019-11, the IRS ruled that, if a taxpayer received a tax benefit from deducting state or local taxes in a prior tax year and the taxpayer recovers all or a portion of those taxes in the current tax year, the taxpayer must include in gross income the lesser of: (1) the difference between the taxpayer's total itemized deductions taken in the prior year and the amount of itemized deductions the taxpayer would have taken in the prior year had the taxpayer paid the proper amount of state and local tax, or (2) the difference between the taxpayer's itemized deductions taken in the prior year and the standard deduction amount for the prior year, if the taxpayer was not precluded from taking the standard deduction in the prior year. This rule applies to the recovery of any state or local tax, including state or local income tax and state or local real or personal property tax.
In the ruling, the IRS discusses four situations involving taxpayers who receive state tax refunds, some of whom were subject to the limitation under Code Sec. 164(b)(6). In Situations 1 through 4, below, the taxpayers are unmarried individuals whose filing status is "single" and who itemized deductions on their federal income tax returns for 2018 in lieu of using their standard deduction of $12,000. The taxpayers did not pay or accrue the taxes in carrying on a trade or business or an activity described in Code Sec. 212. For 2018, the taxpayers were not subject to alternative minimum tax and were not entitled to any credit against income tax. The taxpayers use the cash method.
The IRS noted that, if the taxpayers in Situations 1 through 4 had paid only the proper amount of state and local tax in the prior tax year, their itemized deductions may have been lower or they may have opted for the standard deduction. Thus, the taxpayer in each situation must determine the amount of itemized deductions that the taxpayer would have deducted in the prior year had the taxpayer paid only the proper amount of tax. The taxpayer must then compare this amount to the total itemized deductions actually taken on the return, or the standard deduction that could have been taken on the return, 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.
Situation 1
Julia paid local real property taxes of $4,000 and state income taxes of $5,000 in 2018. Julia's state and local tax deduction was not limited by Code Sec. 164(b)(6) because it was below $10,000. Including other allowable itemized deductions, Julia claimed a total of $14,000 in itemized deductions on her 2018 federal income tax return. In 2019, Julia received a $1,500 state income tax refund due to her overpayment of state income taxes in 2018.
Had Julia paid only the proper amount of state income tax in 2018, her state and local tax deduction would have been reduced from $9,000 to $7,500 and as a result, Julia's itemized deductions would have been reduced from $14,000 to $12,500, a difference of $1,500. Julia received a tax benefit from the overpayment of $1,500 in state income tax in 2018. Thus, Julia is required to include the entire $1,500 state income tax refund in her gross income in 2019.
Situation 2
Patrick paid local real property taxes of $5,000 and state income taxes of $7,000 in 2018. Code Sec. 164(b)(6) limited Patrick's state and local tax deduction on his 2018 federal income tax return to $10,000, so Patrick could not deduct $2,000 of the $12,000 state and local taxes paid. Including other allowable itemized deductions, Patrick claimed a total of $15,000 in itemized deductions on his 2018 federal income tax return. In 2019, Patrick received a $750 state income tax refund due to his overpayment of state income taxes in 2018.
Had Patrick paid only the proper amount of state income tax in 2018, his state and local tax deduction would have remained the same ($10,000) and his itemized deductions would have remained the same ($15,000). Patrick received no tax benefit from the overpayment of $750 in state income tax in 2018. Thus, Patrick is not required to include the $750 state income tax refund in his gross income in 2019.
Situation 3
Katrina paid local real property taxes of $5,000 and state income taxes of $6,000 in 2018. Code Sec. 164(b)(6) limited Katrina's state and local tax deduction on her 2018 federal income tax return to $10,000, so Katrina could not deduct $1,000 of the $11,000 state and local taxes paid. Including other allowable itemized deductions, Katrina claimed a total of $15,000 in itemized deductions on her 2018 federal income tax return. In 2019, Katrina received a $1,500 state income tax refund due to her overpayment of state income taxes in 2018.
Had Katrina paid only the proper amount of state income tax in 2018, her state and local tax deduction would have been reduced from $10,000 to $9,500 and as a result, Katrina's itemized deductions would have been reduced from $15,000 to $14,500, a difference of $500. Katrina received a tax benefit from $500 of the overpayment of state income tax in 2018. Thus, Katrina is required to include $500 of her state income tax refund in gross income in 2019.
Situation 4
Dustin paid local real property taxes of $4,250 and state income taxes of $6,000 in 2018. Code Sec. 164(b)(6) limited Dustin's state and local tax deduction on his 2018 federal income tax return to $10,000, so Dustin could not deduct $250 of the $10,250 state and local taxes paid. Including other allowable itemized deductions, Dustin claimed a total of $12,500 in itemized deductions on his 2018 federal income tax return. In 2019, Dustin received a $1,000 state income tax refund due to his overpayment of state income taxes in 2018.
Had Dustin paid only the proper amount of state income tax in 2018, his state and local tax deduction would have been reduced from $10,000 to $9,250, and, as a result, Dustin's itemized deductions would have been reduced from $12,500 to $11,750, which is less than the standard deduction of $12,000 that he would have taken in 2018. The difference between Dustin's claimed itemized deductions ($12,500) and the standard deduction he could have taken ($12,000) is $500. Dustin received a tax benefit from $500 of the overpayment of state income tax in 2018. Thus, Dustin is required to include $500 of his state income tax refund in gross income in 2019.
For a discussion of the state and local income tax deduction, see Parker Tax ¶83,125.
Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.
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