Michael on March 22nd, 2010
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Line 10 of Form 1040 says “Taxable refunds, credits, or offsets of state and local income taxes.”

You: So?

So this is where most people put their income tax refund they received.

You: Isn’t that where it goes?

Yes, if it’s taxable.

You: Why wouldn’t it be taxable?

A few reasons actually.  First let me explain the concept for why a state income tax refund might be taxable.

Say you itemized deductions last year. This part the state income taxes you paid.  Then, you find out that you overpaid your state income taxes and you get some back – that’s your refund.  The feds say, “That’s not fair – you already deducted those taxes and they weren’t really taxed you owed – you got them back. So, give me back that deduction you took.”   To do so, you have to include the refund in income the next year.

But not everyone falls into this neat simple case.  Some have more confusing facts.

You: But if I have more confusing facts, won’t my tax software catch this issue properly?

It should, but it might not. It will partially depend on whether you did your return last year with the same program and what data you enter where.

You: What if I used a paid preparer?

I’ve seen paid prepares miss this too – twice in the last three weeks.

You: So what might cause my state income tax refund to not be taxable?

One example: If you didn’t itemize last year, you don’t have to pay tax on your income tax refund this year. This is true – even if you do itemize this year.  That’s just one reason why every competent tax preparer requests a copy of your prior year return if he/she didn’t do it.

A second reason: you might be in AMT.

You: What’s AMT?

The alternative minimum tax.

You: Is that a bad thing or a good thing?

Mostly, it’s a bad thing – except when it comes to state income tax refund, when it’s a good thing.

You: Huh?

Taxpayers in AMT don’t receive any tax benefit from their state income tax deduction.

You: That part sounds bad.

It is bad.  But, as a result, part or all of their state income tax refund isn’t taxable the following year. Figuring out how much of the income tax refund is taxable is a complicated process that more or less requires one to recompute the prior year’s tax liability as though the amount previously deducted for regular tax purposes was not.

You: If I understood you correctly, that’s crazy.

I agree. If you understood that last sentence, that is crazy.

You: That’s not what I meant.

I know.  Nonetheless, don’t just absentmindedly include that refund.  You might just overpay on your taxes. To me, that’s crazy.

Total Candor Tax Prep has capacity for just a few more tax clients this year, so if you want in, please contact us soon!  Our rates are right on our site as are answers to frequently asked questions.

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2 Comments to “Don’t just include that state income tax refund”

  1. Stuart Leven says:

    Hi Michael,

    Oy. My situation is a little different. I paid $5220 in estimated state taxes in 2014, which was way too much. In 2015, I’ll get a state tax refund of like $4000. Problem is that the dang $5220 deduction in 2014 triggers the AMT! What I’d really like to do is not take the entire $5220 deduction in 2014, thus avoiding the AMT. And then in 2015 pay taxes on only that portion of the refund that I actually deducted. Something like deduct only $2000 of the $5220 in 2014, and then include only $2000 of the refund in 2015 in my 2015 income. Thoughts? Thanks!

    Stuart Leven

  2. Michael says:

    Don’t stress (too much). It should all come out in the wash; the only issue being timing. Whatever you can’t actually deduct (because AMT takes it away) won’t be includable in income in 2015 (when your refund would have otherwise been taxable). That’s the most important point.

    You can play with the numbers and try to deduct less than the full amount, but given the way AMT works, whatever you save in AMT should be the same amount of the increase in regular tax. So it shouldn’t matter.

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