Here’s what HIVE AI had to say about “Are state refunds taxable on federal returns?”:
State tax refunds may be taxable on your federal income tax return, but this depends primarily on whether you itemized deductions in the previous tax year and whether you received a tax benefit from deducting your state taxes. Here’s a comprehensive explanation:
General Rule for State Tax Refunds
Most taxpayers receiving state tax refunds do not have to include the state tax refund in income for federal tax purposes. As a general rule, taxpayers who choose the standard deduction on their federal income tax returns do not owe federal income tax on state tax refunds. The vast majority of taxpayers claim the standard deduction. IRS Newsroom – IR-2023-158 For instance, in tax year 2021, 90% of individuals claimed the standard deduction instead of itemizing their deductions. IRS Newsroom – IR-2023-158
When State Tax Refunds Are Taxable
Whether or not your state income tax refund is taxable on your federal income tax return depends on whether you took an itemized deduction (Schedule A) for the tax that was later refunded. Don’t report any of the refund as income if you didn’t itemize your deductions on your federal tax return for the tax year that generated the refund. If you took an itemized deduction in an earlier year for taxes paid that were later refunded, you may have to include all or part of the refund as income on your tax return. IRS.gov FAQ
A state tax refund is generally taxable to a recipient who deducted the tax for a prior year unless the deduction provided no Federal tax benefit. This is governed by Section 111(a) of the Internal Revenue Code and section 1.111-1(a) of the Income Tax Regulations. Dawson U.S. Tax Court Opinions: Philip S. Glover
The Tax Benefit Rule
State payments that are properly treated as State tax refunds generally are not includible in the recipient’s Federal gross income because, as the return of an overpayment of the recipient’s State tax liability, these refunds are not an accession to wealth. Notice 2023-56 However, there’s an important exception to this rule.
Certain State payments that are properly treated as State tax refunds may result in Federal gross income due to the application of the “tax benefit rule.” Notice 2023-56 This rule is codified in Section 111 of the Internal Revenue Code.
As all federal taxpayers who itemize their deductions learn, a state income-tax refund has to be added to one’s federal taxable income in the year it’s received if one took a deduction for state income-tax payments for a preceding year. Dawson U.S. Tax Court Opinions: David J. Maines & Tami L. Maines
How the Tax Benefit Rule Works
If a taxpayer receives state payments as a recovery of the payments which the taxpayer deducted in a prior year, then the taxpayer has income to the extent that the prior deduction resulted in a tax benefit. Refunds are subject to the tax benefit rule only to the extent that the taxpayer took a deduction in a prior year for that payment. For example, a taxpayer who took a federal income tax deduction (e.g., Schedule A or Schedule C) for personal property taxes would be taxable on the recovery of those taxes to the extent the taxpayer benefited from the deduction. Likewise, a taxpayer who did not take a federal income tax deduction for personal property taxes would not be taxable on the recovery. In sum, if payments received from the state represent refunds of previously deducted amounts, then the taxpayer must include in income such amounts to the extent that the prior deduction resulted in a tax benefit. CCA-0522023
Special Situations
Alternative Minimum Tax (AMT)
If you reported alternative minimum tax (“AMT”) for the year in which you paid the state taxes, you may not need to include the refund in your income. This is because state income tax is not deductible in computing the AMT income on which the AMT is based (Section 56(b)(1)(A)(ii)). Therefore, a taxpayer who itemizes State tax on Schedule A but is also liable for AMT does not receive a Federal tax benefit for the tax within the meaning of section 111(a). Dawson U.S. Tax Court Opinions: Alka Sham
According to tax court cases, a taxpayer is not required to include a State income tax refund in income if the deduction for State income taxes paid did not result in a tax benefit. This is the case when the taxpayer was liable for the alternative minimum tax for the year the taxes were paid. Dawson U.S. Tax Court Opinions: Jagtar Singh Khinda
State Tax Credits
Although many state tax credits are only used to reduce a state tax liability, some may also be refundable. The amount of a state tax credit that reduces a potential tax liability as part of computing how much tax is due to the state does not represent an accession to wealth. Therefore, this amount is not includable in gross income; instead, it will generally be reflected in a reduced federal deduction for state tax under § 164 of the Code. CCA-201423020
Refundable Credits
Generally, a refundable state tax credit is treated for federal income tax purposes as a reduction in the recipient’s state tax liability, and any excess over the state tax liability is treated as a payment from the state and is includible in gross income under § 61 unless an exclusion applies. CCA-201423020
Reporting Requirements
Information reporting for refunds of state and local taxes may be required under § 6041 or 6050E. Section 6050E requires information reporting for state and local income tax refunds. Payments of refunds to individuals aggregating $10 or more must be reported. CCA-0814022
Every person required to make a return for state tax refunds must furnish to each individual whose name is required to be set forth in such return a written statement showing the name of the State or political subdivision, and the information required to be shown on the return with respect to refunds, credits, and offsets to the individual. The written statement must be furnished to the individual during January of the calendar year following the calendar year for which the return was required to be made. No statement shall be required with respect to any individual if it is determined that such individual did not claim itemized deductions under chapter 1 for the taxable year giving rise to the refund, credit, or offset. IRC § 6050E(b)
Determining the Taxable Amount
To determine the taxable amount of your state or local refunds to report on your tax return, you can use Worksheet 2, Recoveries of Itemized Deductions in Publication 525, Taxable and Nontaxable Income. IRS.gov FAQ
If you receive a refund from claiming a credit on a timely filed amended return, you may have made state tax payments with respect to that tax year during multiple tax years. A refund or other recovery that is for amounts paid in two or more different tax years must be allocated on a pro rata basis. CCA-0814022
Federal Tax Refunds
Unlike state tax refunds, Federal tax refunds are not taxable because Federal taxes are not allowed as a deduction. Accordingly, while a State tax refund may be includible in your income, a Federal tax refund is not. Dawson U.S. Tax Court Opinions: Blessing U. Anyanwu
Conclusion
To summarize:
- If you claimed the standard deduction in the year you paid the state taxes, your state tax refund is not taxable.
- If you itemized deductions and deducted state income taxes in the year you paid them, your state tax refund is generally taxable to the extent you received a tax benefit.
- If you itemized but were subject to the Alternative Minimum Tax (AMT), your state tax refund may not be taxable since state taxes aren’t deductible under the AMT.
- If you itemized but didn’t receive a tax benefit from the state tax deduction (perhaps due to the $10,000 SALT deduction cap), the refund isn’t taxable.
Given the complexity of these rules, it’s advisable to consult with a tax professional if you’re uncertain about the taxability of your state tax refund.
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