11.5 Refunds of State and Local Income Tax Deductions

A refund of state or local income tax is not taxable if you did not previously claim the tax as an itemized deduction in a prior year. For example, if you claimed the standard deduction on your 2011 return and in 2012 you received a refund for state tax withheld from your 2011 wages, the refund is not taxable on your 2012 return.

Refund of deduction for state/local income taxes or state/local general sales taxes.

If in 2012 you received a refund for state or local income tax that you claimed as an itemized deduction for a prior year, the taxable portion of the refund depends on the amount of the state/local general sales tax that you could have deducted in lieu of the state/local income tax (16.3). In general, the full amount of the refund is taxable for 2012 if it is less than the excess of the state/local income tax claimed as a deduction in the prior year over the state/local general sales tax that you could have but did not deduct. If the refund is more than the excess, the amount subject to tax is limited to the excess. For example, on your 2011 return, you claimed an itemized deduction for $11,000 in state/local income taxes, as this exceeded your payment of $10,000 in state/local general sales taxes. If in 2012 you received a $750 refund of 2011 state income tax, the entire refund would be taxable, since it is less than the $1,000 excess of the state/local income taxes over the state/local general sales taxes for 2011. However, if the refund had been $2,500 instead of $750, only $1,000 of the refund would be includible in 2012 income ($11,000 deduction minus $10,000 in state sales tax that could have been deducted).

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image Planning Reminder
Refund of State and Local Tax
A state and local tax refund received in 2012 is taxable only if you claimed the tax as an itemized deduction, and only to the extent that your itemized deductions in that year exceeded the standard deduction you could have claimed.
To help you figure the taxable portion of 2011 itemized deductions recovered in 2012, 2011 standard deduction amounts are shown in Table 11-1.
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Table 11-1 2011 Standard Deduction (For Determining Whether Recovery in 2012 of 2011 Itemized Deductions Is Taxable for 2012)

If you were— 2011 standard deduction was—
Married filing jointly $ 11,600
Single 5,800
Head of household 8,500
Married filing separately 5,800
Qualifying widow or widower 11,600
Single age 65 or over 7,250
Single and blind 7,250
Single age 65 or over and also blind 8,700
Married filing jointly with:
  One spouse age 65 or over 12,750
  Both spouses age 65 or over 13,900
  One spouse blind under age 65 12,750
  Both spouses blind under age 65 13,900
  One spouse age 65 or over and also blind 13,900
  One spouse age 65 or over and other spouse blind and under age 65 13,900
  One spouse age 65 or over and also blind; other spouse blind and under age 65 15,050
  Both spouses age 65 or over and also blind 16,200
Qualifying widow or widower age 65 or over 12,750
Qualifying widow or widower and blind 12,750
Qualifying widow or widower age 65 or over and also blind 13,900
Head of household age 65 or over 9,950
Head of household and blind 9,950
Head of household age 65 or over and also blind 11,400
Married filing separately age 65 or over* 6,950
Married filing separately and blind* 6,950
Married filing separately age 65 or over and also blind* 8,100

*If on your 2011 return you claimed your spouse as an exemption (21.2), add $1,150 if he or she was either blind or age 65 or older; add $2,300 if he or she was both blind and age 65 or older.

Similarly, if in 2011 you deducted state/local general sales taxes in lieu of state/local income taxes, and you received a sales tax refund in 2012, the IRS generally requires you to include the entire sales tax refund in your income if it is less than the excess of your sales tax deduction over the income tax deduction that could have been deducted.

The amount subject to tax could be further reduced because of the standard deduction limit discussed below.

Note: If your itemized deductions in the earlier year were subject to the overall reduction (13.7), follow the IRS method in Publication 525 for determining the taxable portion of a refund.

If AMT applied in year of deduction.

If the refunded state tax was claimed as an itemized deduction but you were subject to the alternative minimum tax (AMT) for that year, the deduction was not allowable for AMT purposes (23.2). The refund is taxable only if the deduction gave you a tax benefit in the prior year. To determine if there was a tax benefit, you must recompute regular tax liability and AMT for the prior year after increasing your income by the refunded amount. If the recomputation does not increase your total tax, there was no tax benefit and the refund is not taxable. If your total tax increases by any amount, the deduction gave you a tax benefit and the refund is taxable to the extent that the deduction reduced your tax in the prior year.

Standard deduction limit.

The taxable portion of a refunded state tax cannot exceed the standard deduction limit. You include in income the lesser of the refund or the excess of your itemized deductions for the prior year over the standard deduction that could have been claimed.

The standard deduction limit applies to your total recoveries where you had other recoveries in addition to a refund of state tax (11.6).

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image Filing Instruction
Negative Taxable Income
If your taxable income was a negative amount in the year in which the recovered item was deducted, you reduce the recovery includible in income by the negative amount. For example, if the taxable recovery would be $1,700 but you had a negative taxable income of $500 for the year the deduction was claimed, only $1,200 is taxable.
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EXAMPLE
On your 2011 return, you filed as a single taxpayer. You claimed itemized deductions of $6,050, of which $3,850 was for state and local income taxes, $1,500 was for mortgage interest, and $700 was for charitable contributions. Your deductions exceeded by $250 the $5,800 standard deduction you could have claimed. You were not subject to alternative minimum tax.
In 2012, you received from the state a $750 refund for 2011 state income tax. The $3,850 deduction for state and local income tax exceeded your 2011 state and local general sales taxes by more than $750. You must report $250 of the refund as income on your 2012 Form 1040. The taxable recovery is limited to the $250 difference between the claimed itemized deductions of $6,050 and the $5,800 standard deduction for 2011.
If you had a negative taxable income in 2011, the taxable recovery figured under the above rule is reduced by the negative amount. If you had a negative taxable income of $100 in 2011, only $150 of the refund would be taxable in 2012.

Allocating a refund recovery.

If in 2012 you received a refund of state or local income taxes and also a recovery of other deductions, and only part of the total recovery is taxable, you allocate the taxable amount of the recovery according to the ratio between the state income tax refund and the other recovery. You do this by first dividing the state income tax refund by the total of all itemized deductions recovered. The resulting percentage is then applied to the taxable recovery to find the amount to report as the unrefunded state income tax on Line 10 of Form 1040; other taxable recoveries are reported on Line 21.

EXAMPLE
In 2012, you received a refund of state income taxes of $500 and a recovery of other itemized expenses of $2,000 deducted for 2011. You figure that only $1,500 of the recovery is taxable because your total 2011 itemized deductions were $1,500 more than the standard deduction you could have claimed. As a state income tax refund is reported separately from other recoveries, you must find how much of the taxable recovery is attributed to the refund. By dividing the state income tax refund by the amount of the total recovery, you find that 20% is attributed to the refund ($500/$2,500). Thus, 20% of the taxable recovery, or $300 (20% of $1,500), is reported as a state income tax refund on Line 10, Form 1040, and the balance of $1,200 on Line 21, Form 1040. Also attach a statement showing that the allocation of recoveries required the reporting on Line 10, Form 1040, of an amount less than the actual state income tax refund shown on Form 1099-G.

Refund of state tax paid in installments over two tax years.

If you pay estimated state or local income taxes, your last tax installment may be in the year you receive a refund. In this case, you allocate the refund between the two years; see the following Example.

EXAMPLE
Your estimated state income tax for 2011 was $4,000, which you paid in four equal installments. You made your fourth payment in January 2012. No state income tax was withheld during 2011. In 2012, you received a state income tax refund of $400 for 2011. You claimed itemized deductions on your 2011 federal return. You allocate the $400 refund between 2011 and 2012. As you paid 75% ($3,000 ÷ $4,000) of the estimated tax in 2011, 75% of the $400 refund, or $300, is treated as a recovery of taxes paid in 2011. On your 2012 return, you include $300 as income on Line 10, Form 1040. You also attach a statement explaining that the amount on Line 10 is less than the $400 refund shown on the Form 1099-G received from the state in 2012 because of the allocation required for the estimated tax installment made in January 2012.
When you figure your 2012 deduction for state income taxes, you reduce the $1,000 paid in January by $100 (25% of $400 refund), which is the portion of the refund attributed to your January 2012 payment of estimated state income tax. Your 2012 deduction for state income taxes will include the January net amount of $900 plus any estimated state income taxes paid in 2012 for 2012, any state income tax withheld during 2012, and any state income tax for 2011 that you paid in 2012 when you filed your 2011 state return.
Note: If the $300 refund allocated to 2011 in the previous Example was more than the excess of your 2011 itemized deductions over the 2011 standard deduction you could have claimed, you report only that excess as income on your 2012 return.
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