Taxability of Refunds of Paid State and Local Taxes
Internal Revenue Code (“I.R.C.”) § 164(a)(1) provides state and local property taxes and state and local income taxes are allowed as a deduction against income for the year within which such taxes are paid. However, I.R.C. § 164(b)(b) limits the aggregate amount (the “SALT Limit”) of the deduction to $10,000.00 even if more than $10,000.00 in such taxes is paid. Revenue Ruling (“Rev. Rul.”) 2019-11 answers the following question: if a taxpayer received a tax benefit from deducting state and local taxes under I.R.C. § 164 in a prior taxable year, and the taxpayer recovers all or a portion of those taxes in the current taxable year, what portion of the recovery must the taxpayer include in gross income?
In answering the question posed in Rev. Rul. 2019-11 the Internal Revenue Service (“I.R.S.”) first cites I.R.C. § 111(a). This Section excludes from gross income amounts attributable to the recovery during the taxable year of any amount deducted in any prior year to the extent the amount did not reduce the amount of tax imposed by Chapter 1 of the Internal Revenue Code. I.R.C. § 111 partially codifies the tax benefit rule, which generally requires a taxpayer to include in gross income recovered amounts the taxpayer deducted in a prior taxable year to the extent those amounts reduced the taxpayer’s tax liability in the prior year. See Rev. Rul. 93-75, 1993-2 C.B. 63.
In reliance upon I.R.C. § 111 and the tax benefit rule, the I.R.S. in Rev. Rul. 2019-11 concludes if a taxpayer received a tax benefit from deducting state or local taxes in a prior taxable year and the taxpayer recovers all or a portion of those taxes in the current taxable year, the taxpayer must include in gross income the lesser of (1) the difference between the taxpayer’s total itemized deductions taken in the prior year and the amount of itemized deductions the taxpayer would have taken in the prior year had the taxpayer paid the proper amount of state and local tax or (2) the difference between the taxpayer’s itemized deductions taken in the prior year and the standard deduction amount for the prior year, if the taxpayer was not precluded from taking the standard deduction in the prior year.
To assist taxpayers in understanding the impact of Rev. Rul. 2019-11 the I.R.S. provides the below four examples:
Situation 1: State income tax refund fully includable. In 2019, A received a $1,500 refund of state income taxes paid in 2018. Had A paid only the proper amount of state income tax in 2018, A’s state and local tax deduction would have been reduced from $9,000 to $7,500 and as a result, A’s itemized deductions would have been reduced from $14,000 to $12,500, a difference of $1,500. A received a tax benefit from the overpayment of $1,500 in state income tax in 2018. Thus, A is required to include the entire $1,500 state income tax refund in A’s gross income in 2019.
Situation 2: State income tax refund not includable: In 2019, B received a $750 refund of state income taxes paid in 2018. Had B paid only the proper amount of state income tax in 2018, B’s state and local tax deduction would have remained the same ($10,000) and B’s itemized deductions would have remained the same ($15,000). B received no tax benefit from the overpayment of $750 in state income tax in 2018. Thus, B is not required to include the $750 state income tax refund in B’s gross income in 2019.
Situation 3: State income tax refund partially includable. In 2019, C received a $1,500 refund of state income taxes paid in 2018. Had C paid only the proper amount of state income tax in 2018, C’s state and local tax deduction would have been reduced from $10,000 to $9,500 and as a result, C’s itemized deductions would have been reduced from $15,000 to $14,500, a difference of $500. C received a tax benefit from $500 of the overpayment of state income tax in 2018. Thus, C is required to include $500 of C’s state income tax refund in C’s gross income in 2019.
Situation 4: Standard deduction. In 2019, D received a $1,000 refund of state income taxes paid in 2018. Had D paid only the proper amount of state income tax in 2018, D’s state and local tax deduction would have been reduced from $10,000 to $9,250, and, as a result, D’s itemized deductions would have been reduced from $12,500 to $11,750, which is less than the standard deduction of $12,000 that D would have taken in 2018. The difference between D’s claimed itemized deductions ($12,500) and the standard deduction D could have taken ($12,000) is $500. D received a tax benefit from $500 of the overpayment of state income in 2018. Thus, D is required to include $500 of D’s state income tax refund in D’s gross income in 2019.