Did you take the standard deduction on your 2019 Federal returns? If you did, you do not need to include the state tax refund as income for 2020. Since the reason for including the state tax refund is based on the state tax deduction on Sch A, you would need to determine each spouse proportional share of the state tax deduction from the 2019 Sch A. This is further complicated by the $10,000 limitation on the state and local tax deduction
Taxpayers who itemize deductions and who paid state and local taxes in excess of the state and local tax deduction limit may not be required to include the entire state or local tax refund in income in the following year. According to the IRS, a key part of that determination is calculating the amount the taxpayer would have deducted had the taxpayer only paid the actual state and local tax liability, with no refund and no balance due.
The IRS therefore ruled that if a taxpayer received a tax benefit from deducting state or local taxes in a prior tax year and the taxpayer recovers all or a portion of those taxes in the current tax year, the taxpayer must include in gross income the lesser of:
- The difference between the taxpayer's total itemized deductions taken in the prior year and the amount of itemized deductions the taxpayer would have taken in the prior year had the taxpayer paid the proper amount of state and local tax; or
- The difference between the taxpayer's itemized deductions taken in the prior year and the standard deduction amount for the prior year, if the taxpayer was not precluded from taking the standard deduction in the prior year.
