Prior to the Tax Cuts and Jobs Act (TCJA) there was no limit to the amount of State and Local Taxes (SALT) that could be deducted as an itemized deduction on an individual’s income tax return. Taxpayers had the ability to deduct all property taxes and to deduct either sales taxes paid, or state income taxes paid. For taxable years beginning after December 31, 2017, TCJA placed a $10,000 limitation on the amount of SALT deductions that are allowed as an itemized deduction. For the 2018 tax year, TCJA also increased the standard deduction to $12,000 for single filers, $18,000 for head of households, and $24,000 for married couples filing a joint return. The increase in the standard deduction along with the new limitation on SALT deductions have complicated the treatment of refunds for overpayments of state and local taxes. In previous years the treatment of state income tax refunds was straight forward; if a taxpayer took an itemized deduction which included state and local taxes paid, they were responsible for reporting any refund of those amounts as gross income. The changes caused by TCJA now force taxpayers to ask the question; what portion of SALT refunds must be included into gross income for tax purposes? Determining the additional benefit received by the taxpayer after taking the itemized deduction is the key to calculating the refund amount that is includable into gross income. Earlier this year, the IRS released Revenue Ruling 2019-11 to offer guidance on this issue.
The tax code states that “gross income does not include income attributable to the recovery during the taxable year of any amount deducted in any prior taxable year to the extent such amount did not reduce the amount of tax imposed by this chapter”. In short, this means that taxpayers that are unable to itemize their deductions when filing their income tax return receive no additional tax benefit from reporting state and local taxes and therefore any refund of state and local taxes would be excluded from gross income. In the event the taxpayer utilizes itemized deductions, the taxpayer must now consider the tax effect of the limit on SALT deductions and account for the benefit received by the deduction to figure how much of any SALT refunds are includable in gross income. In order to properly assess whether a benefit was received, taxpayers must now calculate what the itemized deduction would have been if the correct amount of taxes were paid in the prior year.
Impact on State and Local Tax Refunds
Revenue Ruling 2019-11 provides four situations to help taxpayers assess whether any SALT refunds received will be included in gross income. These situations will be addressed in detail below. For each scenario, assume that the taxpayer’s filing status is “single” and itemized deductions are used in lieu of the standard deduction. Situation 1: Taxpayer A paid local real property taxes of $4,000 and state income taxes of $5,000 in 2018. A's state and local tax deduction was not limited by the new TCJA limitation because it was below $10,000. Including other allowable itemized deductions, A claimed a total of $14,000 in itemized deductions on A's 2018 federal income tax return. In 2019, A received a $1,500 state income tax refund due to A's overpayment of state income taxes in 2018.
In Situation 1 the taxpayer paid $9,000 in taxes but only owed $7,500 which generated a $1,500 refund. Taxpayer A did not exceed the $10,000 SALT limitation so the full $9,000 of state and local taxes is included in the itemized deductions. If the taxpayer had only paid the $7,500 state and local taxes due, it is apparent that both the itemized deduction and SALT deduction would have been reduced by $1,500. Because Taxpayer A received a $1,500 benefit as a reduction in his 2018 gross income the full $1,500 refund in 2019 is includible as gross income.
Situation 2: Taxpayer B paid local real property taxes of $5,000 and state income taxes of $7,000 in 2018. The TCJA changes limited B's state and local tax deduction on B's 2018 federal income tax return to $10,000, so B could not deduct $2,000 of the $12,000 state and local taxes paid. Including other allowable itemized deductions, B claimed a total of $15,000 in itemized deductions on B's 2018 federal income tax return. In 2019, B received a $750 state income tax refund due to B's overpayment of state income taxes in 2018.
In Situation 2, Taxpayer B paid $12,000 in state and local taxes and received a $750 refund. Had Taxpayer B just paid the $11,250 tax liability, he would have still exceeded the $10,000 SALT limitation leaving the itemized deduction unaffected by the $750 refund. Regardless of the refund, Taxpayer B’s itemized deductions would remain unchanged, meaning the $750 overpayment provided no additional tax benefit to Taxpayer B. Therefore, Taxpayer B is not required to include the $750 refund in his 2019 gross income.
Situation 3: Taxpayer C paid local real property taxes of $5,000 and state income taxes of $6,000 in 2018. Changes to TCJA limited C's state and local tax deduction on C's 2018 federal income tax return to $10,000, so C could not deduct $1,000 of the $11,000 state and local taxes paid. Including other allowable itemized deductions, C claimed a total of $15,000 in itemized deductions on C's 2018 federal income tax return. In 2019, C received a $1,500 state income tax refund due to C's overpayment of state income taxes in 2018.
Taxpayer C has exceeded the SALT limitation by $1,000 and $10,000 of the $11,000 taxes paid is included in the itemized deductions. Because the actual tax liability was $9,500 and the taxpayer deducted $10,000, Taxpayer C will be responsible for reporting the additional $500 as gross income for 2019.
Situation 4: Taxpayer D paid local real property taxes of $4,250 and state income taxes of $6,000 in 2018. The changes under TCJA 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 state income tax refund due to D's overpayment of state income taxes in 2018.
Calculating the portion of a SALT recovery that should be included in gross income is tricky when the refund would have taken a client below the itemized deduction limit as in Situation 4. If Taxpayer D never overpaid his prior year taxes, his actual SALT liability would have been $9,250 ($10,250 less his $1,000 refund). The $9,250 is $750 below the SALT limitation. If the taxpayer only reported the $9,250 tax liability, he would not have met the $12,000 itemized deduction minimum. Under this scenario itemizing would not make sense because the standard deduction would have been higher than the benefit of taking the SALT deduction. The taxpayer received a $500 ($12,500 itemized deduction less the $12,000 standard deduction) benefit by including his SALT overpayment in his prior year 1040. Consequentially, $500 of the $1,000 refund must be included into gross income.
As with many other changes from TCJA, the $10,000 limit on SALT deductions has resulted in a greater need for tax professionals to analyze the net effect of SALT refunds. Determining the additional benefit received by the taxpayer after taking the itemized deduction is the key to calculating the refund amount that is includable into gross income. Taxes are not always straight forward, or easy. It is important to seek proper guidance when preparing tax returns. Please contact a member of the Tax Advisory Group at HBK if you have any questions regarding the inclusion of state and local tax refunds in gross income or any other changes to the tax law resulting from TCJA.
Jerrod E. Longley is an Intern in the West Palm Beach, Florida office of HBK CPAs & Consultants and contributed to this story.