The state and local tax deduction limit (SALT) may affect treatment of tax refunds from years when SALT is in effect under the tax benefit rule. The IRS has provided four examples of the how the SALT affects these refunds.
Tax Benefit Rule and SALT Deduction
Taxpayers must use the tax benefit rule to determine whether they include a refund amount in gross income. Under the tax benefit rule:
- taxpayers include in gross income refunds they receive that gave rise to a deduction in previous tax years; and
- taxpayers do not include these amounts in gross income to the extent they did not reduce income tax in the year of the deduction.
The SALT deduction generally limits an individual’s itemized deduction for state or local taxes paid or accrued to $10,000, or $5,000 if married filing separately. The deduction limit applies to taxes that are not directly connected with:
- a trade or business; or
- property held for the production of income.
Examples of the SALT Deduction Limit and Refunds
The IRS provides examples that involve taxes paid in 2018 and refunded in 2019, both years when the SALT limit is in effect.
The examples address:
- a situation in which a taxpayer paid and deducted less than $10,000 in state and local taxes;
- three situations in which the taxpayer paid and deducted more than $10,000 in state and local taxes.
One of the four examples appears below.
Example: Taxpayer D paid local real property taxes of $4,250 and state income taxes of $6,000 in 2018. Section 164(b)(6) limited D’s state and local tax deduction on D’s 2018 federal income tax return to $10,000, so D could not deduct $250 of the $10,250 state and local taxes paid. Including other allowable itemized deductions, D claimed a total of $12,500 in itemized deductions on D’s 2018 federal income tax return.
In 2019, D received a $1,000 refund of state income taxes paid in 2018. Had D paid only the proper amount of state income tax in 2018, D’s state and local tax deduction would have been reduced from $10,000 to $9,250, and, as a result, D’s itemized deductions would have been reduced from $12,500 to $11,750, which is less than the standard deduction of $12,000 that D would have taken in 2018. The difference between D’s claimed itemized deductions ($12,500) and the standard deduction D could have taken ($12,000) is $500. D received a tax benefit from $500 of the overpayment of state income tax in 2018. Thus, D is required to include $500 of D’s state income tax refund in D’s gross income in 2019.
Steps Taxpayers Must Take
Each taxpayer in the examples must take the following steps:
- determine the amount of itemized deductions that the taxpayer would have deducted in the prior year had the taxpayer paid only the proper amount of tax;
- compare this amount to the total itemized deductions actually taken on the return, or the standard deduction that could have been taken on the return; and
- include the difference as income on the current year return if the taxpayer received a tax benefit in the prior tax year from that itemized deduction.
If a taxpayer received a tax benefit from deducting state or local taxes in a prior tax year and the taxpayer recovers all or a portion of those taxes in the current tax year, the taxpayer must include in gross income the lesser of:
- 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
- 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.
These examples apply to the recovery of any state or local tax, including state or local income tax and state or local real or personal property tax.
By Robert Recchia, J.D., M.B.A., C.P.A.