The calculation of the taxable amount is not based on a percentage. (The 12% figure is your own analysis. It does not appear on the worksheet.) The basic idea is to determine how your 2017 federal tax would have been affected if you had deducted only the net amount of state tax, i.e. the amount you actually deducted, minus the refund. There are several possible situations in which only a part of the full refund amount actually gave you a tax benefit.
For example, take the following hypothetical set of facts.
- Your itemized deduction for state income tax on your 2017 federal tax return was $2,000.
- You got a state tax refund for 2017 of $500.
- Your total itemized deductions for 2017 were $6500.
- If you had not itemized, your standard deduction for 2017 would have been $6,350.
If you had not included the amount of your refund, your state income tax deduction would have been only $1,500 instead of $2,000. That means your total itemized deductions would have been only $6,000. But that's less than the standard deduction of $6,350, so if that had been the situation you would have taken the standard deduction instead of itemized deductions. That means that you did not get a tax benefit from the full additional $500 state tax deduction. Only the $150 amount by which your itemized deductions exceeded the standard deduction actually gave you a tax benefit. In this situation, therefore, only $150 of your $500 refund would be reported as taxable income on your 2018 federal tax return. Deducting or not deducting the other $350 of the refund would have made no difference in your 2017 tax because you would have taken the standard deduction.
The calculation on the worksheet takes into account this possible interaction with the standard deduction, as well as a similar interaction with the possibility of deducting sales tax instead of state income tax, and several less common situations that could have limited the amount of the state income tax deduction for which you actually got a tax benefit.
The state income tax refund, when you claimed an itemized deduction for state income tax in the previous year, is called an itemized deduction "recovery." You recovered an amount that you deducted in the prior year. In the example above, the $350 that did not give you any tax benefit is the "recovery exclusion from standard deduction." As it says at the top of Part III of the worksheet, "The recovery exclusion is the part of the recovery amount which did not reduce tax in 2017."
If you want to dig into this in more detail, read the Recoveries section of IRS Publication 525, pages 22 through 25 (in the 2018 edition). You can download Publication 525 from the following link.
<a rel="nofollow" target="_blank" href="
https://www.irs.gov/pub/irs-pdf/p525.pdf">https://www.irs.gov/pub/irs-pdf/p525.pdf</a>
The IRS will not try to tax you on the rest of the refund because they know that a state income tax refund is not always fully taxable, and they understand how the taxable amount is calculated. If they want to verify it, they have all the information needed to reproduce the calculation, since they have your 2017 tax return.
