State Income Tax Refunds - Recovery of Two or More Years

From TaxAlmanac

According to IRS Publication 525, if a state or local income tax refund is received during the tax year, the refund must generally be included in income if the taxpayer deducted the tax in an earlier year. In the case of a state or local income tax refund that is received when payments are made in two or more separate years (i.e. a state estimated tax payment for 2004 made on January 15th, 2005), the refund must be allocated, on a pro rata basis, between the years in which the tax was paid. The allocation is necessary to determine the amount (if any) of the taxpayer's allowable deduction for this item for the current year.

Example:

The taxpayer paid 2004 estimated state income tax of $4,000 in four equal estimated tax payments. The fourth payment was made in January 2005. There was no state income tax withheld during 2004. In 2005, a $400 refund was received based on the taxpayer's 2004 state income tax return. The taxpayer itemized deductions on both the 2004 and 2005 federal income tax return.

The $400 refund must be allocated between 2004 and 2005, the years in which the taxpayer paid the tax on which the refund is based. The taxpayer paid 75% ($3,000 ÷ $4,000) of the estimated tax in 2004, so 75% of the $400 refund, or $300, is for amounts paid in 2004 and is a recovery item. If all of the $300 is a taxable recovery item, the taxpayer will include $300 on Form 1040, line 10, for 2005, and attach a copy of the computation showing why that amount is less than the amount shown on the Form 1099-G received from the state.

The balance ($100) of the $400 refund is for the taxpayer's January 2005 estimated tax payment. When figuring the deduction for state and local income taxes paid during 2005, the taxpayer will reduce the $1,000 paid in January by $100. The deduction for state and local income taxes paid during 2005 will include the January net amount of $900 ($1,000 - $100), plus any estimated state income taxes paid in 2005 for 2005, and any state income tax withheld during 2005.

Source: IRS Publication 525