The IRS published Revenue Ruling 2019-11 at the end of March 2019 in order to answer questions that arose due to limitations imposed on itemized deductions for state and local taxes (SALT) by the 2017 Tax Cuts and Jobs Act (TCJA). The law limited the itemized deduction for SALT to $10,000 except in the case of married people who filed a separate return. They were limited to a $5,000 deduction.
But what happens if a taxpayer overpays SALT and takes the deduction? Do they need to include the amount of their refund in their next year’s gross income? It depends.
How the SALT Limitation Affects Refunds
The TCJA was vague about the federal tax consequences when taxpayers receive a refund due to an incorrect amount paid for state or local taxes. Revenue Ruling 2019-11 clarified that if a taxpayer takes a standard deduction, they need not worry about including a SALT refund in their next year’s gross income. However, if a taxpayer itemizes deductions on Schedule A, Itemized Deductions, there are situations where they may have to include all or part of a SALT refund in their gross income for the following year.
Under Section 111, the taxpayer need only include a refund from the previous year in gross income if it provided them with a tax benefit. But if a taxpayer deducted state and local taxes and received a refund that gives them a tax benefit from the overpayment, they must include the amount of that benefit in the gross income the following year. This may be calculated in one of two ways, and the taxpayer may take the lesser figure as follows:
- The difference between the itemized deductions the taxpayer actually took and the correct amount they should have taken for state and local tax, or
- The difference between the itemized deductions the taxpayer took and the standard deduction assuming they were eligible to take the standard deduction.
The pivotal questions are:
- How much would the taxpayer have paid in taxes had they paid the correct amount for state and local taxes?
- Would their error in figuring out their SALT deduction have affected their tax liability?
- Did they receive a tax benefit from the error?
In Revenue Ruling 2019-11, the IRS provided four examples. Here are two of them:
1. Refund Not Included in Gross Income for Next Year
- In 2018, an individual taxpayer itemized deductions totaling $15,000.
- They listed payment of $12,000 in state and local taxes and of that amount, $7,000 was state and local income tax.
- Due to the statutory limitation, they could only claim $10,000 in SALT deductions rather than $12,000.
- In 2019, taxpayers received a $750 refund of state income taxes they paid for the year. This means that their actual state income tax liability was only $6,250, arrived at by subtracting the $750 refund from the $7,000 paid for state income tax.
- Because the taxpayer was not able to claim an additional $2,000 in SALT deductions in 2018 due to the $10,000 limitation, they received no tax benefit from overpayment. Even if they had correctly figured that they owed $6,250 rather than $7,000 for state income tax, it would have made no difference in their refund.
- Because they received no tax benefit, the taxpayer did not need to include the refund on their return for the following year.
2. Refund Partially Includable in Gross Income for Next Year
- In 2018, taxpayer claimed $15,000 in itemized deductions.
- $10,000 of that was for a state and local tax deduction.
- Taxpayer overpaid for state income. Had they paid the proper amount, the SALT deduction would have been $9,500 rather than $10,000. This would have reduced taxpayer’s itemized deductions to $14,500, a $500 difference.
- In 2019, taxpayer received a $1,500 refund of state income taxes paid the previous year.
- Taxpayer received a benefit of $500 due to overpayment of state income tax. Therefore, they must include $500 of the refund in their gross income in their 2019 tax return.
What It All Boils Down To
What this amounts to is that $10,000 in SALT deductions are allowed, but your client does not get to benefit twice. If they made a tax error on their state and local tax liability and claimed the deduction, causing them to receive a refund larger than they deserved, then they do not get to keep the refund and still claim that amount for the SALT deduction. However, your client will not need to include any part of their refund in the following year’s gross income if their error did not affect the amount of their refund. No tax benefit, no inclusion in the next year’s gross income.