A taxpayer who can take an itemized deduction for state and local taxes (SALT) paid in an earlier year may need to include some or all those taxes refunded as taxable income in a following year. This is considered by the Internal Revenue Service (IRS) to be a recovery because the taxpayer received a return of all or part of the amount deducted in an earlier year. The question that arises is: What amount is included in income? As a result of the significant increase in the standard deduction and the $10,000 limitation on claiming the SALT itemized deduction in the Tax Cuts and Jobs Act of 2017 (TCJA), more taxpayers are electing to take the standard deduction. The interaction of these changes has prompted the IRS to issue Rev. Rul. 2019-11 (2019-17 IRB 1041) to provide guidance on determining the appropriate refunded amount, if any, to include in income.

If a taxpayer elects the standard deduction in the year of payment (e.g., 2019) and receives a refund of his or her state income tax payments in the following year (e.g., 2020), none of the refunded amount is included in gross income because no tax benefit was generated. This is true regardless of whether the taxpayer elects to itemize or take the standard deduction in the refund year (e.g., 2020). The only time a taxpayer needs to determine whether to include some or all the state and local tax refund in his or her federal tax return is when the individual itemized the SALT deduction in the year of tax payment (e.g., 2019) to determine if a tax benefit was generated.


APPLYING THE GUIDANCE

To appreciate the calculation of the inclusion amount, let’s take a look at some examples similar to those given in Rev. Rul. 2019-11. Jamie and Wayne filed a married joint tax return in 2019. The couple paid state income taxes of $6,000 and property taxes of $7,000 for total taxes of $13,000 and other itemized deductions of $15,000. As a result, the couple claimed itemized deductions of $25,000 ($10,000 SALT limitation on the $13,000 tax deduction amount and $15,000 other itemized deductions). Their itemized deductions are still greater than their standard deduction of $24,400, so they would have elected to itemize. When the couple filed their 2019 state income tax return in April 2020, they received a $1,000 refund for overpaying their state income taxes.

If the couple had withheld the proper amount of state income taxes and thus weren’t owed a refund when they filed their 2019 income taxes, they wouldn’t have enjoyed any tax benefit because their SALT payments are now considered $12,000 (instead of $13,000), which is still limited to $10,000. Therefore, the couple wouldn’t include any of the $1,000 refunded amount for 2020.

Timothy filed as head of household in 2019. He had state income taxes of $5,000 withheld, made $2,000 of state estimated income tax payments, and paid $3,000 in local wage taxes for total taxes of $10,000. In addition, Timothy had $9,500 of other itemized deductions. He claimed an itemized deduction of $19,500 ($10,000 in SALT deductions with no limitation and $9,500 for other itemized deductions) since it exceeded the $18,350 standard deduction by $1,150.

In August 2020, Timothy received an $800 refund from the state as an overpayment. In this case, the entire $800 is included in income for 2020 because it’s less than the $1,150 and thus all of it is a tax benefit. Genie had $5,500 of state and local tax withholdings and $3,500 of property taxes on her primary residence and $1,700 of property taxes on her secondary residence. She also had other itemized deductions of $2,500 in 2019. Genie received a state income tax refund of $1,500.

Genie claimed an itemized deduction of $12,500 in 2019, which is the sum of $10,000 (of her $10,700 SALT payments) and $2,500 (other itemized deductions). She, however, was considered entitled to claim only $11,700 ($9,200 of her correct SALT payments plus $2,500 of other itemized deductions). But since Genie can claim the greater of her standard deduction ($12,200) or her itemized deductions ($11,700), she would only include $300 of the refund in her federal gross income (i.e., the difference between $12,500 and $12,200).


MEDICAL ITEMIZED DEDUCTION

Although this article considers the state and local tax refund, the same analysis applies if the taxpayer received a medical insurance reimbursement. That is, if a taxpayer receives a reimbursement for medical expenses incurred in the same year, the reimbursement is simply deducted from the medical expense. Any excess medical expenses are then deductible as an itemized medical expense.

If the taxpayer receives reimbursement in a subsequent year after claiming the medical cost as an itemized deduction, he or she must then include in federal gross income some or all the reimbursement amount. The general tax benefit rule is that the taxpayer includes the lesser of the reimbursement amount or the reduction in taxable income in the prior year if the medical expense wasn’t deducted.

Yasmine had a root canal on a tooth in 2019. She paid the $1,250 cost when the tooth repair was completed and deducted the cost on her 2019 tax return. Yasmine’s deductible medical expenses after the 10% adjustment totaled $4,000 and her itemized deductions totaled $12,350. In 2020, Yasmine learned root canal work is reimbursable under her dental plan less a $250 co-pay. She receives the $1,000 reimbursement in July 2020.

Yasmine would include $150 in federal gross income in 2020. The $150 is the net tax benefit Yasmine received from the medical expense. It’s computed as the lesser of the reimbursement amount ($1,000) and the reduction in taxable income ($12,350 actual deduction less $12,200 standard deduction).


LEARNING THE LAW

Although tax software programs generally calculate these taxable recovery amounts for state and local tax refunds, it’s beneficial to appreciate the black box operation to gather the right information and ask the best questions so that the taxpayer doesn’t overpay his or her income taxes. Otherwise, after receiving Form 1099-G or a substitute form from the state or local government, a taxpayer may be inclined to report as taxable income all of the refund received and shown in Box 2, “State or local income tax refunds, credits, or offsets” without further analysis. What a pity that would be when none or only a portion of it was taxable for the current year. And worse yet, the taxpayer will continue to overpay his or her taxes if this error was repeated for many years to come and the taxpayer has a similar tax position each year going forward.

© 2019 A.P. Curatola

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