I filed for 2017 by paper and itemized, taking the SALT deduction.
I filed for 2018 using TurboTax and took the standard deduction.
Since I filed 2017 late, I got the state refund for both years in 2019. Now that I am working on my 2019 return in the "Refunds Received for State/Local Tax Returns" section, TurboTax already had the 2018 refund in, and I manually entered the 2017 refund. It then asked me if I itemized in 2018 and I said that I took the standard deduction. Then it said "Good News! Your 2018 New Jersey Refund Is Not Taxable."
But it never asked me about whether I itemized for 2017! How can I tell TurboTax that I need to pay taxes on the 2017 state refund I received in 2019?
It does not matter that you itemized for 2017, since you did not receive the 2017 refund in 2018. You received it in 2019. On your 2019 return, you were asked about state and local refunds received in 2019.
Your state tax refund is taxable income on your federal tax return in the year you received the refund, if you itemized your deductions for the year that you claimed the refund.
You are correct that your 2017 state tax refund, which was paid in 2019, is taxable income on your 2019 return because you itemized on your 2017 federal return, even though your 2018 state tax refund is not taxable.
Any refund of a previous deduction is taxable income, also called a “taxable recovery.“ The most common type is a state tax refund, but this can also apply if you receive a refund of mortgage interest, or a refund from a medical provider of a medical expense that you previously deducted.
To enter a taxable recovery, go to the “other uncommon income” section at the bottom of the wages and income page and start that interview, taxable refunds will be one of the choices in that section.