This week a number of questions arose in different online tax discussion forums regarding the potential taxability of a state income tax refund for taxpayers where the taxpayers had their state tax deductions limited by the $10,000 limit on such deductions under IRC §164(b)(6). The question was whether a portion of the refund equal to the refund amounts times the ratio of income taxes to total state and local taxes subject to the $10,000 limit will be considered taxable in 2019 .
Some tax software have been providing reports of potentially taxable refunds based on the ratio calculation. The rumors suggest that at least some sources at the IRS have indicated that this prorated refund calculation is what should be reported in 2019. But is such a calculation correct?
IRC §111 is a provision that should keep most of these refunds from being taxable. IRC §111(a) provides:
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.
The law does recognize that a deduction, while not reducing current year tax, might impact a carryover that later could reduce tax. So there is a special rule found at IRC §111(c) to deal with carryovers:
(c) Treatment of carryovers
For purposes of this section, an increase in a carryover which has not expired before the beginning of the taxable year in which the recovery or adjustment takes place shall be treated as reducing tax imposed by this chapter.
Reg. §1.111-1(b)(2)(i) provides the definition of the recovery exclusion which will not be subject to tax.
The recovery exclusion for the taxable year for which section 111 items were deducted or credited (that is, the “original taxable year”) is the portion of the aggregate amount of such deductions and credits which could be disallowed without causing an increase in any tax of the taxpayer imposed under subtitle A (other than the accumulated earnings tax imposed by section 531 or the personal holding company tax imposed by section 541) of the Internal Revenue Code of 1954 or corresponding provisions of prior income tax laws (other than the World War II excess profits tax imposed under subchapter E, chapter 2 of the Internal Revenue Code of 1939). For the purpose of such recovery exclusion, consideration must be given to the effect of net operating loss carryovers and carrybacks or capital loss carryovers.
This provision is often referred to as the “tax benefit rule” and is what has served to limit inclusion of the state income tax deduction in the past due to various circumstances, including when the alternative minimum tax applied to a taxpayer.
The provision looks at whether, had the amount that was later recovered not been claimed on the original return, there would be either a change in tax for that year or a change in a carryover (net operating loss, capital loss, etc.) that could affect tax in a different year. If the removal of the deduction would not have impacted either the tax for the year of deduction or any of the carryovers, the recovery is not taxable.
To illustrate the application of this provision to the current situation, let’s consider the following example:
Joe and Denise Smith itemize deductions on their 2018 income tax return. On Schedule A they listed real estate taxes of $7,000 and state income taxes of $7,000. When their 2018 state income tax return was prepared, the couple received a state tax refund of $2,000.
The Smith’s total taxes subject to the $10,000 limit was $14,000, resulting in an allowed deduction of $10,000 and a similar reduction in their taxable income. If $2,000 of their state income taxes were to be disallowed by the IRS, their total taxes before the limit would drop to $12,000. However, their deduction would remain at $10,000 and their taxable income and tax would remain unchanged. The change would also have no effect on any net operating loss or capital loss on the Smith’s return for 2018.
Thus, the $2,000 refund is excluded from their 2019 income due to the operation of IRC §111.
Assume the same facts except their state tax refund was $5,000. In this case only $4,000 of the refund represents amount that would not serve to increase their tax should it be disallowed on exam. If the full $5,000 refund were disallowed, their limited tax deduction under §164 would drop to $9,000 from $10,000, resulting an increase in taxable income and an increase in tax that can be traced to $1,000 of the refund.
IRC §111 would still serve to exclude $4,000 of the refund from their 2019 income. But $1,000 of the refund would be reported as income on their 2019 income tax return, as that amount is not protected by this tax benefit rule.