State Income Tax Refunds - Tax Benefit Rule

From TaxAlmanac, A Free Online Resource for Tax Professionals
Note: You are using this website at your own risk, subject to our Disclaimer and Website Use and Contribution Terms.

From TaxAlmanac

Jump to: navigation, search

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. However, under the tax benefit rule, the taxpayer must only include the refund up to the amount by which the deduction taken for the refunded amount, reduced tax in the earlier year. Due to this rule, a state or local income tax refund may not be entirely taxable if the taxpayer claimed unused tax credits, or was subject to the alternative minumum tax in the ealier year.


Unused Tax Credits


If the taxpayer receives a refund of state income taxes deducted in a year in which there were unused tax credits, the earlier year’s tax must be refigured to determine if the state income tax refund must be included in income. To do this, reduce the state and local income tax deduction on the earlier year’s Schedule A by the amount refunded, and refigure tax and credits for the year using the revised Schedule A. If the recomputed tax, after application of the credits, is more than the actual tax in the earlier year, include the refund in income up to the amount of the deduction that reduced the tax in the earlier year. For this purpose, any increase to a credit carried over to the current year that resulted from deducting the recovered credit in the earlier year is considered to have reduced tax in the earlier year. If the tax, after application of the credits, does not change, there was no tax benefit from the deduction and the refund should not be included in income.


Subject to Alternative Minimum Tax

If the taxpayer receives a refund of state income taxes deducted in a year in which the alternative minimum tax applies, the earlier year’s tax must be refigured to determine if the state income tax refund must be included in income. To do this, reduce the state and local income tax deduction on the earlier year’s Schedule A by the amount refunded, and refigure regular tax, credits, and alternative minimum tax for the year using the revised Schedule A. If inclusion of the refund does not change the total tax, the refund should not be included in income. However, if total tax increases by any amount, a tax benefit was received from the deduction and the taxpayer must include the refund in income up to the amount of the deduction that reduced tax in the ealier years.


Source: IRS Publication 525

Personal tools