One of the provisions of the Tax Cuts and Jobs Act of 2017 (TCJA) is that TCJA imposed a $10,000 ($5,000 if married filing separately) cap on deductions of state and local taxes (SALT). SALT includes income, real estate, property and sales taxes paid after Dec. 31, 2017.
While the law does not provide specific limits for each one of these taxes, TCJA provides that the total SALT taxes deducted on Schedule A (as part of itemized deductions) cannot exceed $10,000.
The real challenge in the $10,000 SALT limitation is for those individuals who itemize (file Schedule A) on their federal income tax returns but receive a refund of state income taxes paid in the previously year. For example, any individual who itemized on his or her 2018 federal income taxes (the first year the TCJA took effect) and received a state income tax refund in 2019 has to determine if that state income tax refund is taxable income for 2019.
As employees and annuitants are currently preparing their 2019 federal income returns, many of these individuals may have received a 2019 1099-G from their comptroller or state revenue departments. The 1099-G shows a refund of state and local income taxes they received during 2019 when they filed their 2018 state tax returns. The question these individuals need to be asking: Do they need to include these refunds of state and local income taxes on their 2019 federal income tax return? This column will discuss when a state income tax refund from the previous year is included in taxable income on the current year’s federal income tax return.
It is important to start with the basic federal tax rule with respect to state income tax refunds; in particular, a review of the state tax recovery and the tax benefit rule which can affect individuals who itemize on their federal tax returns.
State tax refunds paid to individuals who elect to take the standard deduction on their federal income tax returns (rather than itemizing – filling out Schedule A of Form 1040), are not taxed as income in the year received. But individuals who itemize on their federal income tax returns have different requirements. This is because part of the itemized deductions on Schedule A are state and local taxes. An individual chooses the higher of state and local income or sales taxes paid in the previous year for inclusion on Schedule A.
For an individual who paid no more than $10,000 of state and local taxes (income or sales) during 2018, a taxable state tax refund of the year 2019 is the smaller of:
- The refund amount (normally shown on 2019 Form 1099-G).
- The excess of itemized deductions over the standard deduction for 2018.
- The excess of state and local taxes actually deducted during 2018 over the sales taxes that could have been deducted during 2018. Note that the IRS has a publication that shows the sales taxes an individual normally pays during the year. The amount of sales taxes paid depends on which state an individual lives.
In reality, an individual may be able to minimize the taxability of their state tax refunds. To understand how, it is important to explain the state tax recovery and the tax benefit rule.
As is true with the federal tax system, state taxes paid or withheld in one year may be more or less than the actual state tax liability for that year. The result is a refund for overpayments or a balance due for underpayments. A refund of previously deducted state taxes may trigger income recognition in the year received for federal income purposes. On the other hand, a balance due payment may be deducted on the federal income tax return as an itemized deduction.
The “tax benefit” rule, as stated in Internal Revenue Code (IRC) Section 111(a) (Recovery of tax benefit items), states that “gross income does not include income attributable to the recovering during the taxable year of an amount deducted in any prior taxable year to the extent such amount did not reduce the amount of tax imposed by this chapter.”
This means that the recovery of a “deduction” (in this case a state income tax deduction) taken in a previous year is not taxable in the year received if the deduction did not give rise to a tax benefit in the year paid or withheld. An example of this is an individual who claims the standard deduction on his or her federal income tax return. A state tax refund received by that individual is not taxable because the tax refund was received in the same year the standard deduction was claimed. The following example illustrates:
Paul claimed the standard deduction in 2018 when he filed his 2018 federal income tax return. During 2018, Paul had $5,000 of state income taxes withheld from this paycheck. When he filed his 2018 state income tax return in March 2019, Paul determined that his 2018 state income tax liability was $4,500. Paul received a $500 ($5,000 less $4,500) state income tax refund in March 2019. None of the $500 state income tax refund is taxable income on Paul’s 2019 federal income tax return because Paul claimed the standard deduction.
How are State Tax Refunds Treated on the 2019 Federal Income tax Return?
For those individuals who itemize on their 2018 federal income tax return and thereby include as part of itemized deductions any state and local income taxes paid during 2018, a state income tax refund received in 2019 may be nontaxable, partially taxable or fully taxable on the individual’s 2019 federal income tax return. The determining factors for taxability include: (1) the individual’s filing status and standard deduction amount on their 2018 federal return; (2) the amount of the state tax refund received in 2019; (3) the different between total itemized deductions claimed and the standard deduction amount on their 2018 federal tax return; and (4) whether the individual paid any alternative minimum tax (AMT) due to the nondeducibility of state income taxes with respect to the AMT.
If an individual itemizes, then the excess of itemized deductions over the individual’s standard deduction is the maximum taxable amount that can be included in income for federal tax purposes. The following example illustrates:
Allison is a single individual, 45 years old and her standard deduction for 2018 was $12,000. Her itemized deductions totaled $18,500 in 2018. This means that the maximum taxable amount of any state refund that Allison received during 2019 is $6,500 ($18,500 less $12,000).The excess of what Allison paid in state and local income taxes over sales taxes in Allison’s state is $4,000.
Allison received a state tax refund of $2,300. How much of the $2,300 is taxable income for 2019? To determine the amount taxable, we will need to know Allison’s itemized deductions for 2018:
Note that Allison’s state income and real estate taxes totaled $9,000, less than the $10,000 maximum under TCJA.
How much of Allison’s $2,300 refund of state income taxes paid in 2018 is taxable in 2019? Since the $2,300 refund is less than the $6,500 excess of her itemized deductions over her standard deduction (and less than the $4,000 excess of state income taxes over sales taxes paid), the $2,300 is fully taxable. Allison will report the $2,300 as income on her 2019 federal income tax return Form 1040 or Form 1040 SR (Schedule 1, Part I, line 1).