Tax Benefit Rule

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Sometimes financial events straddle more than a single year. That can be a problem when your tax return needs to be filed on an annual basis.

The tax benefit rule is one way to address this timing difference.

For instance, say you take an itemized deduction on your federal income tax return for the amount of state income tax you paid during the year. Later, you discover you overpaid your state income tax and get a refund.

Since you received a benefit on your federal income tax return from the deduction, part of the refund may be taxable to you under the tax benefit rule. If so, you report that amount as income in the year you receive it–which generally is the year after you took the deduction.

What if you didn’t itemize in the prior year, but used the standard deduction instead? No tax benefit last year, no income this year.

The tax benefit rule began as a judicial holding (see Estate of Block v. Commissioner of Internal Revenue, 39 BTA 338 – Board of Tax Appeals 1939), and later became part of the Internal Revenue Code (Section 111).

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