IRS Clarifies Tax Treatment of State and Local Tax Refunds under new SALT Deduction Limit by Karen A. Lake, CPA
Posted on April 22, 2019 by Karen Lake
The IRS recently issued guidance to help taxpayers in high-tax states understand how the new tax law’s $10,000 annual limit on deductions for state and local taxes (SALT), and property and real estate taxes affects the tax treatment of SALT refunds they receive beginning in tax year 2019.
In general, taxpayers may exclude from their taxable income any dollar amount they receive as a refund for SALT paid in a prior year in which they claimed a standard deduction, which for 2018 is $12,000 for single filers or $24,000 for married couples filing jointly. This is not the case when taxpayers itemize their deductions. Rather, when itemizers receive a refund for all or a portion of the state and local taxes they paid in a previous year, they must report the recovered amount the following year on their federal returns as taxable income, to the extent the taxpayer received a tax benefit from the deduction in the prior year. The legal theory behind this rule is that taxpayers who receive a tax benefit in one year (in the form of a SALT deduction) should not be permitted to also benefit from a refund they receive for that tax benefit in a future year.
Taxpayers in high-tax states, such as New York, New Jersey, Connecticut and California, who paid state and local taxes, property taxes and real estate taxes in excess of the $10,000 cap in 2018 and who subsequently receive a SALT refund in 2019 will need to determine how much of that refunded amount they must include as taxable income when they file their 2019 tax returns in 2020. After all, if taxpayers received a tax benefit from deducting state or local taxes in 2018, they may not receive a second benefit in the form of a tax refund in 2019. Instead, the taxpayer who recovers any portion of state or local state or local tax, including state or local income tax and state or local real or personal property tax, must include in gross income for 2019 the lessor 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 IRS’s revenue ruling illustrates the recovery of tax benefits with four examples, including one in which a taxpayer paid local real property taxes of $4,250 and state income taxes of $6,000 in 2018. Due to the SALT cap, the taxpayer could deduct on his 2018 federal income tax return only $10,000 of the total $10,250 he paid in state and local taxes. Including other allowable itemized deductions, the taxpayer claimed a total of $12,500 in itemized deductions in 2018. In 2019, the taxpayer received a $1,000 state income tax refund due to an overpayment of state income taxes in 2018. Had the taxpayer paid only the proper amount of state income tax in 2018 ($5,000 instead of $6,000) his state and local tax deduction would have been reduced from $10,000 to $9,250, and his itemized deductions would have been reduced from $12,500 to $11,750, which is less than the standard deduction of $12,000 that he would have taken in 2018. The difference between the taxpayer’s claimed itemized deductions ($12,500) and the standard deduction he could have taken ($12,000) is $500. Therefore, the taxpayer received a tax benefit from $500 of the overpayment of state income tax in 2018, and he must include that $500 in his taxable gross income in 2019.
About the Author: Karen A. Lake, CPA, is state and local tax (SALT) specialist and an associate director of Tax Services with Berkowitz Pollack Brant, where she helps individuals and businesses navigate complex federal, state and local tax laws, and credits and incentives. She can be reached at the firm’s Miami office at (305) 379-7000 or via email at email@example.com.