Penalties and interest

[CHUCKles4me]

My wife and I were audited by NC this year for 2019, 20, & 21.  I was informed by OPM that my wife qualified for the Bailey Settlement which excludes her from paying state taxes on her annuities.  She doesn’t qualify and we got slapped with a hefty bill of 3 years of back taxes, penalties, and interest.  We took out a second mortgage and paid the state and I applied for consideration to receive the penalties and interest be refunded.  The state has refunded us for the penalties and some of the interest charges.  My question is does this refund of my debt in penalties and interest count as income on my federal or state taxes?  I don’t think it should because I haven’t really gained anything but received basically a reduction in funds owed.  I know this is a tough question and I am grateful for the person who can help me!

[rjs]

The refund of penalties and interest is not income and you do not report it on your federal or state tax returns.

(If you had claimed an itemized deduction for the penalties and interest on your federal tax return for the year that you paid them, then you would have to report the refund as income. But you should not have claimed a deduction for the penalties and interest because they are not deductible.)

[CHUCKles4me]

Thank you!

[Opus 17]

You were entitled to claim the state income taxes you paid as a federal itemized tax deduction in the year you actually paid the taxes, regardless of the years they were assessed for.  (Subject to the overall $10,000 cap on deducting state and local taxes.)  However, you can not claim an itemized deduction for penalties or interest.

If you accidentally took a deduction that included the penalties and interest, you would have to amend to fix that.  However, if you never deducted the penalties and interest, then a refund of those amounts is not taxable income to you. 

[CHUCKles4me]

Thank you for your valuable information!  We haven’t claimed anything yet, we were just assessed this year for 2019,20,&21.  We recently paid the state.  So can I claim what we owed/paid this year next year, or can I claim each year over the next 3 years?  In other words, can I claim the amount in taxes owed to NC in 2019 in 2023 taxes, 2020 in 2024, and 2021 in 2025?  Each year we could easily claim the maximum of $10,000, and that doesn’t include any interest or penalty.  I’m thinking though I can only claim what I actually paid this year for 2023 taxes, which grossly exceeds $10,000.  Because this was deemed a honest mistake and because I have never tried to defraud the government on my taxes, the state graciously agreed to refund my penalty and some interest.  I was worried that the amount they refunded would have to be reported as income even though it wasn’t income but a reduction in what we owed/paid.  I still paid over $6,000 in interest.  

[Opus 17]

@CHUCKles4me 

State taxes that are actually paid in 2023 are only deductible on your 2023 tax return, even if they exceed the $10,000 cap.  You can't stretch the deduction out over time.  That's one of the ways the SALT cap works to increase tax revenue to offset some of the other tax savings in the 2017 tax reform law (like reducing the actual tax rates from 15% to 12% and from 25% to 22%). The cap does have an impact on people who, for whatever reason, pay large amounts of state tax. 

[rjs]

You can claim an itemized deduction on your 2023 tax return for any state income tax that you pay in 2023, no matter what year the tax is for. But you can only deduct the actual tax, not interest or penalties. So the $6,000+ of interest that you paid is not deductible under any circumstances.

The total deduction for state and local taxes is a maximum of $10,000 ($5,000 if you are married filing separately). The maximum applies to the total of real estate tax, personal property tax, and either state and local income tax or state and local sales tax. In addition, since this is an itemized deduction, it will not give you any benefit unless your total itemized deductions are more than your standard deduction. For 2023 the standard deduction for married filing jointly is $27,700 (if both of you are under 65 and not blind), so the maximum $10,000 deduction for state and local taxes by itself will not be nearly enough to exceed your standard deduction.

As stated earlier, the refund of the penalty and some interest is not income and you do not report it on your tax return.