IRS Issues Guidance Explaining Inclusion in Federal Gross Income of State and Local Tax Refunds
With new rules under federal tax reform, such as the $10,000 itemized deduction limitation for state and local taxes, the IRS responded to requests for guidance regarding the taxability of state and local tax refunds.
By Jeff Glickman, SALT Partner
We are now in the second tax year of tax reform enacted pursuant to the Tax Cuts and Jobs Act (“TCJA”), and individual taxpayers have now either filed their first tax returns or extensions for the 2018 tax year. Some taxpayers may have benefited under the increased standard deduction while others may have experienced an increased liability due to the $10,000 state and local tax (“SALT”) limitation. As taxpayers receive refunds of state and local taxes in 2019, how much of that refund will constitute gross income?
On March 29, 2019, the IRS issued Revenue Ruling 2019-11, regarding the interplay of the new tax rules and the treatment of SALT refunds. In the ruling, the IRS explains that taxpayers should apply the tax benefit rule to determine the amount of SALT refunds that must be included in gross income. The tax benefit rule requires a taxpayer to include in gross income recovered amounts that the taxpayer deducted in a prior taxable year to the extent those amounts reduced the taxpayer’s tax liability in the prior year. Thus, the amount of any state and local tax refunds that a taxpayer will include in gross income is equal to the lesser of:
(1) the difference between the taxpayer’s total itemized deductions taken in the prior year and the amount of itemized deductions the taxpayer would have taken in the prior year had the taxpayer paid the proper amount of state and local tax, or
(2) the difference between the taxpayer’s itemized deductions taken in the prior year and the standard deduction amount for the prior year, if the taxpayer was not precluded from taking the standard deduction in the prior year.
The ruling provided several examples of the application of the tax benefit rule to SALT refunds received. In one example, the taxpayer (“T”) is a single individual who, in 2018, paid $11,000 of state income and had other itemized deductions of $5,000. In 2019, T received a $1,500 SALT refund. Since $1,000 of T’s state income tax paid in 2018 was not deductible (due to the $10,000 SALT limitation), Ts total itemized deductions were $15,000. Had T paid the proper amount of state taxes in 2018, T’s 2018 itemized deductions would have been $14,500 ($9,500 of state taxes and $5,000 of other itemized deductions). Therefore, T received a $500 tax benefit in 2018 from the $1,500 SALT refund, and must include $500 in federal gross income in 2019.
In another example, T is a single individual who, in 2018, paid $10,250 of state income and had other itemized deductions of $2,500. In 2019, T received a $1,000 SALT refund. T’s 2018 itemized deductions were $12,500 (due to the $10,000 SALT limitation). Had T paid the proper amount of state taxes, T’s total itemized deductions would have been $11,750 ($9,250 in state taxes and $2,500 other itemized deductions), which is less than the standard deduction of $12,000. Therefore, T received a $500 tax benefit in 2018 from the $1,000 SALT refund ($12,5000 less $12,000), and must include $500 in federal gross income in 2019.
The federal tax reforms made under the TCJA have numerous consequences on state income taxes, for both individual and corporate taxpayers. Some of these are favorable, some are not, and states differ on the extent to which they are incorporating these federal changes. Therefore, taxpayers that are making structural or operational changes based on the new tax rules must analyze the full tax impact, including state and local taxes.
Aprio’s SALT team has experience with the state tax impact of federal tax reform and can assist taxpayers with understanding how the new rules will affect them from a SALT perspective so that they can make informed decisions about how to structure and operate their businesses. We constantly monitor these and other important state tax topics, and we will include any significant developments in future issues of the Aprio SALT Newsletter.
This article was featured in the April 2019 SALT Newsletter.
Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding the matter.