State and Local Tax Deduction Guidance May Provide Relief for Some Taxpayers (article)
One of the most publicized and contentious provisions of the new tax law commonly known as the Tax Cuts and Jobs Act (TCJA) is the $10,000 limitation on state and local tax deductions. The limitation prevents individual taxpayers from deducting more than $10,000 in combined state and local sales, income, and property taxes. But one overlooked point was the effect that it would have on the taxability of state tax refunds.
One’s first reaction might be, “State tax refunds are taxable?” But the better question is, “When are state tax refunds taxable, and what effect does the $10,000 limitation have on state tax refunds?”
The Logistics of State Tax Refunds
State tax refunds are taxable to the extent that a taxpayer obtained a tax benefit from the original tax payment in a prior year. This rule is commonly known as the “tax benefit rule.”
For example, consider a taxpayer who had $20,000 in itemized deductions in 2016, $13,000 of which is from state and local tax payments. If this taxpayer received a $4,000 refund of state taxes in 2017, the tax benefit rule requires that the taxpayer must calculate the taxable portion of the $4,000 refund. In applying this rule, the taxpayer would have claimed only $16,000 of itemized deductions in 2016 had the proper amount of state and local taxes been paid in 2016 ($9,000, with no $4,000 refund). And because the difference between the amount actually deducted in 2016 and the amount that would have deducted using the correct payment of state and local taxes is $4,000, the full refund is taxable in 2017.
But the TCJA changed this calculation with the advent of the $10,000 limitation. Recent IRS guidance now clarifies how this change is implemented. The general rule is:
[T]he taxpayer in each situation must 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. The taxpayer must then 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 taxable year from that itemized deduction.
Under this guidance, if, in 2018, the taxpayer again paid $13,000 in state and local taxes, had the same $7,000 of other itemized deductions and received the same $4,000 state tax refund in 2019, the result would be quite different.
In 2018 the taxpayer is subject to the $10,000 limitation on state and local tax deductions. This means that the taxpayer’s total itemized deductions for 2018 are $17,000, even though the taxpayer actually paid $13,000 in state and local taxes plus $7,000 in other deductible expenses.
Like the above scenario, if the proper amount of state and local taxes had been paid in 2018 ($9,000, with no $4,000 refund), the total itemized deductions would have been $16,000. Hence, only a portion of the $4,000 refund is taxable in 2019, because the taxpayer received a 2018 tax benefit of $1,000 with respect to the amount refunded ($17,000 of itemized deductions reported less $16,000 of itemized deductions that would have been claimed had the taxpayer paid the proper amount of state income tax). Because the $10,000 limitation caused the taxpayer to lose the excess $3,000 deduction for state and local taxes paid in 2018, there was no tax benefit. As a result, $3,000 of the refund is not taxable in 2019.
Additional TCJA Considerations
But this is not the end of the story. The new guidance also clarifies situations where the amount refunded would have been enough to push the taxpayer from itemizing deductions to the standard deduction, had the correct amount been paid initially. For example, consider a single taxpayer who paid $15,000 in total deductible expenses for 2018, $10,000 of which were state and local taxes, and who received a $5,000 refund of state taxes in 2019.
This refund amount is large enough that the taxpayer would have claimed the standard deduction in 2018, had the proper amount of state and local taxes been paid. The standard deduction for an individual in 2018 is $12,000, and the $5,000 refund means that the correct itemized deductions in 2018 would have been $10,000. And as a taxpayer will claim the larger of the standard or itemized deduction amount, the $12,000 standard deduction would have been claimed. So in this case, the difference between the actual deduction of $15,000 and the $12,000 standard deduction that would have been claimed is $3,000. Therefore, only $3,000 of the $5,000 refund is taxable in 2019.
In summary, taxpayers with refunds of state and local taxes in 2019 may turn to this guidance for answers concerning the taxability of such refunds. Moreover, this guidance alleviates some emerging concerns about a whipsaw situation where state taxes are limited to the $10,000 cap, but a subsequent state tax refund is taxable. The new guidance provides that this will not be the result, so taxpayers and their advisors may continue with conventional strategies to calculate estimated tax deposits using “safe harbor” or conservative assumptions that might result in excess state tax payments. For questions on the state and local tax deduction and the tax treatment for state tax refunds, please contact your local CBIZ tax professional.
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