Why is only a portion of state return taxable this year?

[magimagss]

Question on taxable refund. In the past year my entire state refund from the previous year was taxable on my current federal return (I itemize deductions). This year, only a fraction of my state refund is taxable and it is taxable on both federal and current state refunds. For example (numbers are not real), I got $500 NY state refund last year and I quoted this number in my current year federal return and TT is showing that only $55 dollars out of $500 will be taxable on my current federal return. It will also be taxable for $55 on my NY state return. Is this correct? I was under the impression that the entire state refund is taxable on federal return and none of it on state return.

[rjs · Accepted solution]

Are you sure it's actually being taxed on your New York return? The New York return starts off with a complete list of your federal income, then later it subtracts things that are not taxable by the state. On Form IT-201 the state tax refund is entered on line 4, but then it's also entered on line 25, which gets subtracted when calculating your New York taxable income.

A state tax refund is not always fully taxable on your federal tax return. It's taxable only to the extent that you received a tax benefit by deducting it on the previous year's federal tax return. The calculation of the tax benefit amount is fairly complicated. It has to take into account a lot of factors from the previous year's federal return, including the amount of state and local income tax that you deducted, the amount of sales tax that you could have deducted instead, your total itemized deductions, what your standard deduction would have been if you had not itemized, and so on. You can see the calculation on the State and Local Income Tax Refund Worksheet. Since you are using the CD/Download TurboTax software you can look at the worksheet in forms mode. It will also be included if you save your tax return as a PDF with all forms and worksheets included.

[magimagss]

I double-checked and you are correct on the NY State return - indeed, the amount got subtracted in line 25 - so all good there.

However, still trying to understand why only 12% of my NY state refund from last year is being taxed on this year's federal?  I looked at the forms as you advised and they mathematically make sense however I would like to understand why only 12% is being taxed? This amount has been quoted on an additional form called "Schedule 1" of form 1040 - something that was not there in any of my previous returns. Is this "Schedule 1" some new addition to this year's 1040? Additionally, I can see that the calculation to come up with this 12% amount was computed on a form called "State and Local Income Tax Refund Worksheet" where the full refund amount is quoted first and then, something called "Recovery exclusion from standard deduction" is being computed and subtracted from the refund amount and that's how this small number of 12% is being derived and then linked to "Schedule 1". Do you know what "Recovery exclusion from standard deduction" is?

I am just concerned that if only portion of my state refund gets taxed by IRS now, then IRS might realize I owe them tax for the rest of taxable refund and will want me to pay them back.

[rjs]

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.

[magimagss]

I finally got the time this weekend to sit down and analyze this and I have to admit I am very impressed with your knowledge of the tax calculations.
I applied your hypothetical scenario to my 2017 tax return and refund and guess what - it worked!
Using your step by step approach I was able to come up with exactly the same amount for the taxable part of the refund as turbo tax is quoting!
Thank you so much for taking the time to explain it so clearly and thoroughly - I feel much more confident knowing  where the numbers are coming from. I have moved to the US in 2015 and have been doing taxes myself so I always try to understand where the numbers are coming from, in case someone asks. Thanks again! Cheers, Magdalena