Taxing Definitions

Definition — Stating the benefit

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In the case of state tax refunds, the idea of the “tax benefit rule” is fairly simple: When you claim a deduction for state income taxes on your federal income tax return and later receive a refund of those taxes, you have income to the extent you benefited from the deduction. However, as in much of tax law, while the idea may be simple, the computation often is not.

The Tax Cuts and Jobs Act, which affects 2018 federal income tax returns (those due in calendar year 2019), added the potential for a wrinkle to the calculation. That’s because the act limits the amount of the annual itemized deduction for state and local taxes to $10,000 ($5,000 if you’re married filing separately).

How does the limit affect the taxability of a state tax refund? The IRS released revenue ruling 2019-11 this week to answer the question.

The revenue ruling provides four examples and a rule for computing the amount you have to include in gross income when you receive a tax benefit from deducting state or local taxes in a prior taxable year and get a refund for all or a portion of those taxes in the current taxable year.

Using the calculation, you include in your gross income the lesser of

Your total itemized deductions taken in the prior year

minus

The amount of itemized deductions you would have taken in the prior year
had you paid the proper amount of state and local tax

 or

The itemized deductions you took in the prior year

minus

The standard deduction amount for the prior year,
if you were not precluded from taking the standard deduction in the prior year

Here’s the relevant tax law:

From internal revenue code section 111(a): Excludes from gross income amounts attributable to the recovery during the taxable year of any amount deducted in any prior year to the extent the amount did not reduce the amount of tax imposed.

From internal revenue code section 164: Generally provides an itemized deduction for certain taxes paid or accrued during the taxable year. “Certain taxes” include state and local, and foreign, real property taxes, state and local personal property taxes, state and local, and foreign, income, war profits and excess profits taxes, and the generation-skipping transfer tax imposed on income distributions. The definition also includes state and local, and foreign, taxes not previously described that were paid or accrued within the taxable year in carrying on any trade or business or an activity described in section 212 (relating to expenses for production of income). Taxpayers can elect to deduct state and local general sales taxes in lieu of state and local income taxes.

From internal revenue code section 164(b)(6) (added by the Tax Cuts and Jobs Act): Limits an individual’s deduction for the aggregate amount of state and local taxes paid during the calendar year to $10,000 ($5,000 in the case of a married individual filing a separate return). The dollar limitations apply to taxable years beginning after December 31, 2017, and before January 1, 2026, but they do not apply to foreign taxes described in section 164(a)(3) or to any taxes described in section 164(a)(1) and (2) that are paid or accrued in carrying on a trade or business or an activity described in section 212.

1

True or False: The revenue ruling applies to the recovery of any state or local tax, including state or local income tax and state or local real or personal property tax.

  or 

2

True or False: The revenue ruling has no impact on state or local tax refunds received in 2018 and reportable on 2018 returns.

  or 

Note: Read other Taxing Lessons posts explaining the tax benefit rule here and here.

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Note: Taxing Lessons provides a summarized version of sometimes lengthy court decisions and IRS documents. The full documentation may include facts and issues not presented here. Please use the link provided in the post to read the entire document.

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.

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