The tax benefit rule (section 111) is a seemingly simple common sense attempt at equity that turns out to be a bit complicated in practice. You may know of the tax benefit rule as the “recovery” rule because of the way it works. When you receive a tax benefit because you take a deduction or a credit on your return, you’re required to recapture that benefit when you recover all or part of the expense later.
For example, say you itemize and deduct state income taxes on your federal return in one year. The following year you receive a refund. The refund is includable in your income to the extent you benefited from the deduction. You’d report the includable portion on Line 10 of your Form 1040 in the year of receipt.
Under current tax law, when you itemize you have the option of deducting state income tax or state sales tax. The tax benefit rule for this situation says the maximum refund you may have to include in income is limited to the excess of the tax you chose to deduct over the tax you did not choose to deduct.
Say you chose to deduct $11,000 in state income tax instead of $10,000 in state general sales tax. The next year you receive a $2,500 state income tax refund. Based on the rule, what is the maximum refund you may have to include in income?
Let’s change the scenario a bit. Say you chose to deduct $11,500 of state general sales tax based on actual expenses instead of $11,200 of state income tax. The next year you return an item you purchased and receive a $500 sales tax refund. You also receive a $1,500 state income tax refund. What is the maximum refund you may have to include in income?
Now say you did not have enough deductions to itemize and you used the standard deduction. The next year you receive a $2,500 state income tax refund. What’s the maximum you may have to include in income?
Other expenses you deduct, such as mortgage interest, are also subject to the tax benefit rule. If mortgage interest is refunded or applied to your principal balance in the same tax year you paid it, reduce your mortgage interest expense for that year.
What if the refund is mortgage interest you deducted in an earlier year? Then you’ll include the refund in income in the year you receive it, up to the amount that resulted in a tax benefit in the earlier year. Report the includable amount on Form 1040, line 21.
Application of the tax benefit rule can be affected by other situations too, including exposure to the alternative minimum tax, filing a joint return, and receiving a refund over several years. The tax court offers a good basic discussion of the tax benefit rule in 144 T.C. No. 8 (Maines). You can also find examples and information in IRS publication 525, under Miscellaneous Income, Recoveries.
This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.