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Taxable state income tax refund?!

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  • Taxable state income tax refund?!

    In February of this year, shortly after I had already filed my 2019 taxes, I received a form 1099-G from my state reporting the <$100 refund I received in 2019 for overpayment of my 2018 state income tax. The attached explanation stated that this refund may be taxable and must be reported on my 2019 tax return. I called the state IRS and we figured out together that this notice was sent to me in error because I took the standard deduction on my 2018 federal return, so the state income tax refund is not taxable. The state IRS sent me a corrected 1099-G reflecting this and all was good.

    However, this has me wondering: why are state income tax refunds considered taxable income if you itemize your deduction? The refund is money that you overpaid to the state and is being returned to you. This money was already taxed at the federal level in the year that you earned it, so wouldn’t including the refund as income in the next year’s federal return result in being taxed twice on the same dollars?

    Ex: You itemize your deductions and tax $10,000 state income tax deduction along with other itemized deductions. (In reality, you owed $15,000 in state income taxes and paid $17,500 through W2, but you were only allowed to deduct $10,000.) That year you receive a state income tax refund of $2,500.

    What I’m having difficulty understanding is: Why is that $2500 refund considered taxable income?

  • #2
    IR-2019-59, March 29, 2019 — The Internal Revenue Service today clarified the tax treatment of state and local tax refunds arising from any year in which the new limit on the state and local tax (SALT) deduction is in effect.


    • #3
      Understood. Just to be sure:

      In the example above, then, the $2500 refund does NOT need to be reported on Schedule A, Line 1 for the federal tax return in the year it was received. Correct?


      • #4
        Bumping this to see if anyone can confirm my understanding. I'm facing a situation this year of having to decide between itemizing and taking the standard deduction. I've paid >$10,000 in state income taxes and will have enough other deductions that add up to a total of $25,600 ($800 more than the standard deduction). Obviously, it would be better to itemize and receive an additional couple of hundred dollars with my federal refund, but I don't want to do this if it's going to impact my 2021 federal tax return.



        • #5
          It’s pretty clear from that link that what matters is whether you got any tax benefit from overpaying your SALT taxes. So if the amount of income and property taxes you owed the state and city was at least $10k, you’re fine. But if only by overpaying them you were able to claim at least $10k of SALT taxes paid for 2020, then you have some math to do.


          • #6
            I think it’s not worth putting a lot of thought or analysis to it

            if itemizing saves you money now vs standard deduction, then itemize


            • #7
              Thank you. It looks like I’ll be itemizing for 2020.

              Lithium, I read the explanation (link) that you posted and the instructions for Schedule 1. Thanks for pointing me in the right direction instead of spoon feeding me the answer. I learned something new today.