If you were to receive a federal tax benefit from deducting state/local taxes, and in the following year you receive a refund of all or a portion of those state taxes, that portion of this refund may be subject to federal income tax the year this refund happens to be received.
The issue also becomes further complicated with the new $10,000 limit, under the Tax Cuts and Jobs Act. Tax years starting in 2018, see that the itemized deduction for taxes paid is limited to $10,000 ($5,000 MFS) for the aggregate of:
1) State and local property taxes not paid/accrued in carrying on a trade/business, or an activity related to the generation of income (rental real estate activities)
2) State, local income, war profits, and excess profits taxes (or sales taxes in lieu of income taxes, etc.) paid or accrued in the tax year.
It is under TCJA that the $10,000 limit and other various situations may apply, and that is the main subject of a recent IRS revenue ruling. If you were to pay only the proper amount of state and local tax in the prior year, then itemized deductions in that year may be lower, or the you may have opted for a standard deduction.
You must determine in each situation the amount of itemized deductions (or standard deduction) that the you would have deducted in the prior year had you paid only the proper amount of state tax. You then must compare this amount to the total itemized deductions taken, or standard deduction that would have been taken, and include the difference as income on the current year return if you received a tax benefit in the prior tax year from the itemized deduction.
Let us assume that in the following examples, all of these taxpayers are single and have itemized deductions on their previous federal income tax returns for 2018 in lieu of using the standard deduction of $10,000. The taxpayers did not pay or accrue the taxes in carrying on a trade or business or an activity for the production of income. Also assume that these particular taxpayers were not subjected to AMT and thus were not entitled to any credit against income tax. Each of these taxpayers may use the cash method for reporting income and deducting expenses.
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