Taxability of Recovery Items such as State Tax Refunds

Taxability of Recovery Items such as State Tax Refunds

Q:

Here’s the situation. A client made a large state tax payment in 2011. The payment turned out to be much larger than his state tax liability. He received a large state tax refund during 2012. As usual, the state reported the refund to the taxpayer and to the IRS via Form 1099-G. Nothing out of the ordinary so far.

The taxpayer was subject to Alternative Minimum Tax (“AMT”) on his 2011 return.

The question is whether the refund is taxable income on his 2012 return and if so, how much.

A:

This situation is quite common. Many taxpayers are over-withheld for state tax and end up receiving state tax refunds, and many people are subject to AMT.

Here’s some federal tax lingo that you don’t need to know unless you are a tax geek. A state income tax refund is a “recovery item” whose taxability on your federal return is governed by the “tax benefit rule” of Internal Revenue Code section 111. There are other kinds of “recovery items” but the most common is a state tax refund.

Could You Just Cut to the Chase and Tell Me If It’s Taxable?

A state tax refund is considered taxable income if and “to the extent” that you received a “tax benefit” on the prior year’s return.

What is a “Tax Benefit”

How do you know if you received a “tax benefit?” Generally it means one of two things: 1) Either your tax was reduced, or 2) A carryover item (such as a capital loss or passive loss carryover) was increased that will reduce your tax in a future year.

If you were subject to AMT in 2011, it is possible that you did not receive a “tax benefit” from the state tax payment and therefore the refund might not be taxable on your 2012 return.

“To the Extent”

However you can’t simply say, “I was subject to AMT last year, so my state tax refund is not taxable this year.” It’s not that simple because you may have been on the borderline of AMT, and if so it’s possible that you received a tax benefit from part but not all of your state tax payment.

IRS Confusion

So, like my client, you try to be a good taxpayer by figuring out the amount of your state refund that is taxable. The first place you might look for guidance is the instructions for line 10 in the Form 1040 instructions (because line 10 of Form 1040 is where you would include the state tax refund). Simple situations are dealt with there. However more complicated situations, such as AMT, are not dealt with there. Instead you are directed to Publication 525.

So you go to Pub 525. Depending on where you read, you might conclude that all of your refund is taxable. Or you might get the impression that you are supposed to use “Worksheet 2.” So you keep reading and when you finally see Worksheet 2 you get a warm fuzzy feeling because you’re on the right track. You read the top of Worksheet 2 and it talks about AMT. You must be in the right place.

Except you’re not.

Using wisdom that only the IRS possesses, they have written the “Itemized Deduction Recoveries” section of Pub 525 in a way that seems to point certain people to Worksheet 2 who should not be using it. My client was terribly confused. After I read through it myself, I agree. It is confusing. I can see why someone would end up in the wrong worksheet and get the wrong result. It nearly cost him thousands of dollars.

Here’s what you do if you, like my client, were subject to AMT in 2011 and received a state tax refund during 2012 for overpayments you made in 2011. Don’t use Worksheet 2. Instead, you have the harder job of doing your prior year’s return again, but this time remove the amount shown on the 1099-G from your state tax deduction. You must redo any portion of your return that is affected by the change to your state tax deduction. This will include at a minimum Form 1040, Schedula A, and Form 6251 (AMT).

That will help you determine whether you received a “tax benefit.” But you’re not quite done. If you fell on the borderline of AMT (like my client did), you need to compute how much of your state tax payment led to a tax benefit. If your situation is like the client’s, it involves determining the amount of taxable income that causes the regular tax (line 44 of Form 1040) to be precisely equal to the “tentative minimum tax” (line 33 of Form 6251). It’s not as difficult as it sounds. With a little math you will be able to figure out how much of the state tax deduction was lost due to the AMT.

For the client, we determined (after quite a bit of work) that slightly more than one-third of his refund was taxable. The other two-thirds was not taxable because the AMT took over at that point and prevented the state tax deduction from reducing his tax. That’s what the AMT does.

Since the tax refund was quite large, excluding two-thirds from income will save him a signficant amount of tax. Because of phaseout ranges of various deductions/credits, the tax savings could be larger than you would expect just by looking at his marginal bracket.

Interestingly a popular tax return preparation software product that he was using (I won’t name which one) attempted to walk him through the difficult calculations, but it reached the erroneous result that 100% of his refund should be taxable.

It’s a good thing he was skeptical. Had he simply done what the software said he would be paying thousands more than he owes.

I drafted a one page statement explaining our position and laying out our calculations, as required by Treas Reg 1.111-1(b)(1). He will attach it to his return.

 

16 Comments
  1. Well I doubt you read comments on two year old articles but:
    1. Thanks for posting this. Only clear explanation I could find on the vast internet.
    2. Not that you’ll answer this in time but why not ask a professional for free advice (“this is not advice”) on the internet: I had an overpayment in one state and an underpayment in another and performing the exercise you proscribe becomes even more complicated. Do I net the two, or just pretend the underpayment never happened for this purpose?

    • Bob:
      Due to a bad setting I didn’t see your comment until now. I hope you were able to figure out your issue.

      By the way I just demonstrated that not only do I read two year old articles but three years old!!

  2. Since recalculation of AMT will not be changed by state tax refund can do a fast calculation.
    That calculation is the additional tax from AMT for prior year above the ordinary tax for the prior year divided by the tax bracket to determine whether the AMT add was sufficient to completely reduce the possible benefit of the refund. If so, there is no additional impact of the refund on current year taxes.

  3. Is there a down and dirty way of determining how much to include. We have been taking the AMT tax and dividing it by the marginal tax rate. The result is then compared to the refund and if the refund is lower then the refund is not taxable.
    Any thoughts

    • To Neil and Shari:

      That seems like it should work and is my first-cut estimate. My general rule is to double-check everything when it comes to tax returns. Too often there is a hidden factor that I don’t understand or appreciate.

      Just to make sure, I plug it into the previous year’s tax software to make sure I get it right.

  4. I found your explanation comforting, in that I also took a hike down the same trail with the same basic conclusions that Worksheet 2 is actually meaningless if AMT is involved, and that at least one of the tax prep software products is probably costing some people a lot more money than the product’s price. Even if the calculation is something they do not want to support, the software people really should provide much better warning, especially when AMT is involved.

    Perhaps a trivial issue, but with the advent of forms 8959 and 8960, there can now be a tiny tax reduction with higher state income tax deductions even in the presence of a large AMT. So while your example works today if the total tax being recalculated was based on testing line 56, I would guess that it would not work precisely when testing for no change on line 63 (your total tax). Of course that change on line 63 is likely to be a miniscule advantage compared to the extra tax created by treating the full refund in the next year as fully taxable, but the instruction in the pub 525 ‘Subject to alternative minimum tax’ says ‘if your total tax increases by any amount’, so …

    If AMT is a dominant feature, better to now just claim less state income tax deduction in a present year by an amount of the expected state income tax return. In this way the recalculation to determine the taxability next year for this year’s state refund would not sense the tiny advantage that might be present on Line 62 from taking the larger, full state deduction this year. In essence, just rig things such that next year’s recalculation of this year’s federal tax will actually give the same answer as this year’s calculation with respect to total tax.

    • Craig:
      Great, insightful point.

      As of yet I haven’t looked into whether the appropriate basis for comparison is line 56 or 63. There may not be a well-defined answer.

      You could also claim a lower state tax deduction on Form 8960, although would cost you a slight amount of line 62 tax.

  5. Thanks for this! I too was unable to find any elucidation on the web until i read your article. However, i’m still confused. I will admit that i am challenged by the concept of AMT even though i have been preparing returns for over 35 yrs. You’d think that i would’ve figured it out by now but i confess i rely on my software for most AMT calcs. However, my software will not calculate the amount of state refund to include as income if the total tax (regular tax + AMT) after subtracting the 1099-G amount(s) from Schedule A is greater than the original total tax using the full Schedule A deduction. I’m tempted to say the tax benefit is simply the difference in the two total tax amounts, and then reporting that amount as the taxable portion of the refund. But if it was that simple, i think my tax software would have done that. Could you elaborate on a “little math” with a formula or worksheet? I ‘ve tried varying the Schedule A state tax deduction amount to make the regular tax equal the tentative minimum tax to no avail.

    • Hi Tom,
      My hunch is that most tax software will not calculate correctly for the simple fact that the calculation relies on the prior year’s return. For example if you’re using TurboTax for your 2016 return, the tax benefit depends on your 2015 return. But TurboTax 2016 does not access TurboTax 2015, so there is no way it could figure out the amount of the benefit.

      There may be more sophisticated tax software that accesses the prior year, but I haven’t used such a product.

      The “little math” involved opening up the prior year tax software and through algebra (or good ol’ trial and error) determining the amount of Sch A state tax deduction that led to the regular tax and tentative minimum tax being equal.

      You may wish to contact a CPA or attorney if there is enough tax at stake.

      Best,
      Jeff

  6. Mr. Jacobs,
    did the IRS ever dispute your calculation? I find myself in a similar situation and do not want to be audited. where can I find a sample calculation?

    • Hi Steve,

      No the IRS did not dispute the calculation. We did not hear from the IRS on that issue.

      I’m not sure where you could find a sample calculation online. If there is enough at stake you may want to contact a knowledgeable CPA or tax attorney.

      Best,
      Jeff

  7. Has the partial recovery of state tax refunds been tested in court, or is there a revenue ruling on the subject?

    • Hi David,
      I moved your comment to this post.

      I’ve never had to look into cases or rulings on this issue so I can’t tell you what’s out there. You may find what you need in Code section 111 and its Regulations.

      Best,
      Jeff

  8. This article is more complicated than the answer I need, I think, because I do not have any AMT involved. However wondering if you can help me out as I think the software I’m using ( freetaxusa) is leading me to believe that only some or none of my state tax refund is not taxable/needs to be included towards my income. Under “Income” it takes me to “Exceptions for Reduced Taxable State Refund” and it asks”would your itemized deductions from 2015 have been less than your standard deduction if you did not have any state or local taxes in your 2015 itemized deductions?”. Then it gives instructions to subtract schedule A Line 29 from Line 5, which for me would be 12,213. Standard deduction for me would be 12,600. Then, it tells me to complete worksheet 2- Recoveries of Itemized Deductions” ( of which is also confusing to me). I have always claimed the 1099-G as income, which says the number is the amount of our overpayment during previous year ( essentially our state/local income tax refund plus the school district refund). So, do you think this software is confusing it or have I done this wrong in years past by always claiming it? I even called the IRS and the rep. told me it wasn’t taxable but he had to “study” and put me on hold several times. Just didn’t bring me a lot of confidence in his answer. Thanks for any help!

  9. Thanks for the great article. I’ve have maybe another tricky situtation that I’d be curious do know your opinion. I generally receive a state tax refund from the previous years taxes. I also generally itemized and deduct state income taxes each year, so I include the refund from the prior years state income tax on this year’s return as income. But, this year I can take a child tax credit but I am within the $110,000 income phaseout for that tax credit. The increase in my income due to the state income tax refund from the previous year means I can take less of the child tax credit ($50 less for each $1,000 over $110,000). I understand why the refund from the prior year should be added to my income for calculating my tax as a took a benefit from it in the previous year, but don’t understand why this would affect my income for the purposed of the child tax credit eligibility as it is not real income and the credit eligibility is based on income before any deductions so I am not gaining any benefit, I’m actually losing $50 tax credit for every $1,000 of state income tax refund. How do I deal with this situation?

  10. after i recomputed my 2017 regular tax and amt tax, reduced by the refund amount, the recomputed tax is exactly the same as the original 2017 tax. Is the refund taxable in 2018. Thank you

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