Sold rental 4797, prorated refund of rental deductions taken Sch. E last year, how to handle?

[RoseTyler]

Hi! Thank you for reading this. 🙂

In 2021, property taxes and insurance were deducted on schedule E for a commercial rental property with active participation. There was a loss of -$6,000 for the rental which offset dividend and IRA income. Adjusted gross income line 11 was $44,000, taxable income line 15 was $27,000. Line 16 1040 tax was $0. A $3,400 refund was received due to the calculation of Premium Tax credit on form 8962.

On January 5th 2022, the rental property sold. A total of $3,800 for the prorated taxes and insurance policy refund were reimbursed. I am unsure how to handle the $3,800 recovery. I read this link: https://www.jklasser.com/askjk/i-received-a-refund-of-property-taxes-i-paid-on-my-rental-property-tw... which mentions tax benefit rules, but I’m a bit confused.

In 2021 the Federal tax was $0, but the Adjusted Gross Income gave a refund from the premium tax credit. If I recalculate the 2021 taxes as if the insurance policy and tax refund were instead refunded in 2021, there still would have been a rental loss. However, the premium tax credit refund would have been $600 less because the adjusted gross income would have been higher.

In 2021, for Pennsylvania state tax purposes income was $40,000 since PA doesn’t tax retirement distributions. The -$6,000 rental loss is not allowed to offset other income or be carry forward or back. It counted as $0. So if I recalculate the PA state taxes as if the insurance policy and tax refund were instead refunded in 2021, there still would have been a loss and it still would have been $0 with the same taxable income. It doesn’t seem like it benefited PA taxes.

For federal and Pennsylvania taxes in 2022, how much of the $3,800 refund is taxable as income and can you explain why?

If so, should this refund income be placed on Schedule E line 3 “Rents Received” or Schedule 1 1040 “Other Income” on line 8z? If I put it on Schedule E, it always carries over to the state tax Schedule E.

Thank you ever so much! 🙂 I also rounded the figures. 🙂

[MaryK4 · Accepted solution]

You will want to include it on Schedule 1 1040 “Other Income” on line 8z.  You do not have to recalculate your 2021 income tax- the adjustment is in the year you received the rebate.  You must add the amount as income because you received the benefit of the deduction in the prior year.  You are also correct that you do not have to include it as income on your Pennsylvania return because you did not receive any benefit from it at the state level.

A recovery is a return of an amount you deducted or took a credit for in an earlier year. The most common recoveries are refunds, reimbursements, and rebates of itemized deductions. Tax benefit rule. You must include a recovery in your income in the year you receive it up to the amount by which the deduction or credit you took for the recovered amount reduced your tax in the earlier year. 

[RoseTyler]

Thank you ever so much, MaryK4! I really appreciate your help and response. 🙂