Historically, individual taxpayers have been allowed an itemized income tax deduction for one hundred (100) percent of all state and local income taxes paid in a calendar year. The amounts paid were generally based on estimates and rarely matched the actual liabilities due to various nuances in the tax laws for each jurisdiction and fluid fact patterns considered prior to each year end. The outcome of this problem was often an overpayment or underpayment of state and/or local tax, which was ultimately resolved with the filing of the returns.
Where a previously-paid (and deducted) state or local income tax was refunded in a later tax year, the refund became taxable based on a general concept most often referenced as the tax benefit rule. In simple terms, the tax benefit rule requires an amount that was previously deducted and thus, provided an income tax benefit, must be added back to income at any later point in time when it is refunded or returned to the taxpayer.
In the Tax Cuts and Jobs Act (TCJA), enacted in December, 2017, the maximum state and local income tax deduction, inclusive of real property taxes, is $10,000. Thus, while there can be some tax benefit to a deduction at this level, if the taxpayer is able to itemize, any later refund may not be fully taxable to the extent that the cap prevented an income tax benefit in the earlier year.
This matter has received substantial attention within the commentary offered by tax professionals over the last 13 months and now the Internal Revenue Service has released a Revenue Ruling addressing the tax treatment of refunded state and local income taxes.
In Revenue Ruling 2019-11, the Internal Revenue Service has provided four examples of the interaction of the new limit ($10,000) on the deduction on state and local taxes (SALT) with the tax benefit rule for refunds. Under the guidance offered in the ruling, a taxpayer who is impacted by the SALT limit may not be required to include any refund in gross income depending on whether he or she only paid the actual amount of SALT liability.
The issue applies only to state and local income taxes being refunded in 2019 and forward for taxes paid, and deducted as an itemized deduction, in 2018 and forward. Thus, the ruling does not affect tax refunds received in 2018 for tax returns currently being filed.
SALT Deductions and Refunds – Clarified
As noted above, for tax years 2018 to 2025, the itemized deduction of SALT on Schedule A (Form 1040) by an individual is limited to $10,000 ($5,000 if married filing separately). For all tax years, SALT refunds received by a taxpayer who itemized deductions in a previous tax year may be included in gross income depending on amount of tax benefit received from the deduction.
The key element requiring assessment is determining the amount the taxpayer would have deducted had the taxpayer only paid the actual SALT liability.
The four examples cited in the Ruling are as follows:
Example 1
A taxpayer filing a joint return pays $9,000 of SALT in 2018 and his or her SALT deduction is not limited. The taxpayer claims a total of $14,000 in itemized deductions. In 2019, the taxpayer receives a refund of $1,500 of state income taxes. If he or she only paid the correct amount in 2018, the SALT deduction would have been $7,500 and total itemized deduction would have been $12,500. Thus, the taxpayer receives a tax benefit of $1,500 that must be included in gross income in 2019.
Example 2
A taxpayer filing a joint return pays $12,000 in SALT in 2018 but his or her SALT deduction is limited to $10,000. The taxpayer claims a total of $15,000 in itemized deductions. In 2019, the taxpayer receives a refund of $750 of state income taxes. If he or she had only paid the correct amount in 2018, the SALT deduction and total itemized deductions would remain the same.
Thus, under this fact patter, the taxpayer received no tax benefit and the $750 refund may be excluded from gross income in 2019.
Example 3
A taxpayer filing a joint return pays $11,000 in SALT in 2018 but his or her deduction is limited to $10,000. The taxpayer claims a total of $15,000 in itemized deductions. In 2019, the taxpayer receives a refund of $1,500 of state income taxes. If he or she had only paid the correct amount in 2018, the SALT deduction would have been $9,500 and total itemized deductions would have been $14,500.
Thus, in this case, the taxpayer received a tax benefit of $500 that must be included in gross income in 2019.
Example 4
A taxpayer filing a joint return pays $10,250 in SALT in 2018 but his or her deduction is limited to $10,000. The taxpayer claims a total of $12,500 in itemized deductions. In 2019, the taxpayer receives a refund of $1,000 of state income taxes. If he or she had only paid the correct amount in 2018, the SALT deduction would have been $9,250. His or her total itemized deductions would have been $11,750, less than the standard deduction of $12,000.
Thus, the taxpayer received a tax benefit of $500 that must be included in gross income. The $500 is the difference between the amount of itemized deductions claims and the standard deduction he or she could have taken.
A complete version of the ruling can be found at Rev. Rul. 2019-11
The size of these refunds is generally not significant but in the computation of one’s taxable income, especially for estimated income tax purposes ,a more accurate determination requires consideration of these refunds.
Questions and comments can be provided to Bob Grossman or Don Johnston.
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