OK. The first question is, can you "use up" the money by applying it toward 2024 medical expenses and not using the FSA? If you can use up the money this way, there are no tax consequences. However, you don't want to leave money in the FSA because that is use-it-or-lose-it, and that would be worse than the taxes on the HSA refund, which I will explain next. You can also apply it to any unreimbursed medical expenses from 2023 and 2022, if you have them. Just be sure to make a good record of your expenses, reimbursements, and leftover amounts, so that if the IRS asks questions, you can clearly show them that you applied the refund against other allowable medical expenses.
Any part of the refund that you can't use up against 2024 medical expenses should be reported on your tax return as a "reimbursement of a previous deduction", otherwise known as a "taxable recovery." You didn't pay tax on the money because you used it for medical expenses, since those expenses were reduced and you got the money back, now you owe income tax on it (unless you can use it up against other expenses as I said). Fortunately, there is no additional penalty for this situation. Your withdrew the money in good faith in 2021 and your 2021 tax return was correct. This refund is taxable (if you can't apply to other expenses) but there is no additional penalty.
