When completing a Form 1040, there is often confusion related to Form 1040, Line 10. When are state and local income tax refunds taxable? When are they not taxable?
Prior-Year State and Local Taxes Deduction and Taxable Income
Whether or not refunds of state or local taxes are taxable depends on the answers to the following questions:
- Whether or not the taxpayer itemized their deductions on their prior-year federal income tax return?
- If the answer to question 1 is yes: Whether or not the taxpayer claimed the state and local income tax deduction on Form 1040, Schedule A, Line 5 on their prior-year federal income tax return?
- If the answer to question 2 is yes: Whether or not the amount of federal taxes paid on their prior-year federal income tax return was actually impacted by claiming the state and local income taxes deduction?
In reference to the above list, state and local income tax refunds are taxable only in situations where all three of the above considerations are true. The key take-away is that state and local income tax refunds received by the taxpayer are only taxable if the taxpayer received a refund of taxes paid that the taxpayer derived a tax benefit from paying in the first place. If, however, the taxpayer did not get any special tax benefit from paying state or local income taxes because the taxpayer either did not claim the state and local income tax deduction or because claiming the deduction didn’t actually reduce the taxpayer’s taxable income, then the taxpayer’s state and local income tax refunds are not taxable.
So when would the amount of federal taxes someone pays actually not be impacted by claiming the state and local income taxes deduction? This could occur in a handful of diverse ways, but one example could be a situation where the taxpayer pays the alternative minimum tax. In many situations, taxpayers who pay alternative minimum tax are no better off for claiming the state and local income taxes deduction.
Timing of Refund Taxability
For calendar-year taxpayers, generally they will recognize as part of their gross income all refunds received on their prior-year tax returns. The following example illustrates how this would commonly work for taxpayers:
Example 1: Carol is a calendar-year taxpayer who filed a Form 1040 individual tax return for the 2015 tax year. On her filed return, she itemized her deductions and claimed a state and local income taxes deduction for $3,000 withheld from her wages by her employer and paid to the state of Arizona – a deduction that effectively reduced her taxable income. Carol also filed an individual tax return with Arizona and ended up receiving a $350 refund from the state of Arizona. Because Carol claimed the state and local taxes deduction for the 2015 tax year and the deduction impacted her taxable income for the year, Carol must recognize the $350 refund she received from filing her 2015 Arizona individual income tax return on her 2016 federal income tax return.
Why should tax refunds ever be taxable?
A question often comes up regarding these rules: why are refunds ever taxable anyway? After all, when a taxpayer gets a tax refund, it usually doesn’t mean the taxpayer is making any money. Rather, they’re just getting back some money from income they already made (and were taxed on) and had withheld on their behalf, right? In most cases this is true, but taxing refunds based on the above rules makes sense even in these cases because of the way that the state and local income tax deduction works. So it helps to understand the state and local income tax deduction first. To briefly summarize, the state and local income taxes deduction can be taken on all amounts paid by the taxpayer or withheld on behalf of the taxpayer during the tax year. The way the deduction works is illustrated in the following example:
Example 2: Jeffrey is a calendar-year taxpayer who works as a contractor for one business and as a part-time employee of another. Jeffrey files quarterly estimated payments to both the federal government and the state of Arizona each year for the income he receives from working as a contractor. He also receives a W-2 each year from the employer he works for part-time. During 2015, Jeffrey paid $75 each quarter of estimated tax payments to the state of Arizona, for a total of $300 for the year. Jeffrey also had $500 of state tax withheld from the paychecks he received from his part-time job during 2015, and this $500 amount is reflected on the 2015 Form W-2 that Jeffrey received from his employer. Jeffrey paid no local income taxes during the year 2015. Thus, in total Jeffrey paid $800 of state income tax during 2015. Jeffrey claims the full $800 of state income tax paid to Arizona on his federal tax return (Schedule A, Line 5) even though Jeffrey ends up filing a tax return with Arizona from which Jeffrey gets $150 of the $800 of taxes paid back in the form of a tax refund.
Note that in the above example, Jeffrey ended up getting back $150 of the $800 he paid to the state of Arizona back in a refund. However, because of the way the state and local income taxes deduction works, Jeffrey still claims all $800 of the taxes he paid as a deduction. If Jeffrey were clever and wanted to game the system, he might actually try and pay A LOT more in estimated taxes to Arizona and get a large benefit on his federal income tax return, knowing full-well that he’ll end up getting most of his estimated payments back anyway when it comes time for him to file his Arizona income tax return.
By taxing state and local income tax refunds received by the taxpayer whenever they claimed the state and local income tax deduction in the prior year, the federal government avoids allowing taxpayers to abuse the tax system in this manner.
Under Section 6050E of the Internal Revenue Code, all government agencies that issue refunds of $10 or more for state or local taxes to individual taxpayers are required to file a Form 1099-G with the IRS and send a copy to the individual taxpayer.1 This informs the IRS of refunds that taxpayers receive from their state and local income taxes paid, but it also can assist the taxpayer in knowing the amount of the tax refund they received from their prior-year tax return filed with the state/local tax administration. However, note that even in cases where the taxpayer does not receive a Form 1099-G from an agency the taxpayer received a refund from, they still are required to recognize their refund as part of gross income if the above rules apply.
- See I.R.C. § 6050E, available online here: https://www.law.cornell.edu/uscode/text/26/6050E.