Why do I have to pay tax on my state tax refund from last year?

[surfdoc509]

I never paid tax on my state tax refund before, why is this year different?

[hbl3973 · Accepted solution]

I presume this is because you itemized deductions last year and the state taxes withheld during 2015 were used as part of the itemized deductions.  As you received some or all of those state taxes back, you effectively got a larger deduction last year than you would have had if only the actual state tax paid been used.  The way this is handled is that the excess, i.e. your refund, is added back into the following year's income, i.e. the current 2016 tax return.

The reason this is handled this way is that the federal return needs to be completed before the state return is handled.  Had the IRS insisted that only the actual state income tax be used, it would have led to a nightmarish circular set of updates between the federal and state tax returns.  Indeed, the IRS instructions said you needed to include all your 2015 state tax prepayments, whether from paychecks, retirement distributions, estimated tax payments or payments made with your 2014 tax return in the 2015 itemized deduction.