Refund of Prior Year Deduction

[Burke]

I am trying to wrap my head around the repayment of a medical deduction taken on a previous tax return and need some confirmation of my calculations. TP paid an upfront entrance fee to a life-care institution. This was deducted in 2017 based on the percentage of it attributable as a medical expense per the institution. Then in 2018, he decided to leave. A refund was given to the TP based on the contract he signed. (He forfeited roughly 2% per month). So I am using the refunded amount X the same percentage used on the tax return in 2017, to calculate the amount as income to be reported in 2018. However, part of the deduction last year was disallowed due to the 7.5% exclusion. Therefore, I am thinking that should also be considered in calculating the reportable income in 2018 amount, since he did not really get a deduction for the entire amount last year. On the 2018 return, it has to be listed on Line 21 which is not subject to any exclusion. AND, on top of that the entire itemized deductions were also limited so there is a further reduction in the amount he actually was able to claim. I have a headache......

[rbynaker]

You're on the right track. This is the "Tax benefit rule." There's not much there, but it's on TTB 3-14. It's taxable to the extent that the deduction reduced the tax in 2017.

I am trying to wrap my head around the repayment of a medical deduction taken on a previous tax return and need some confirmation of my calculations. TP paid an upfront entrance fee to a life-care institution. This was deducted in 2017 based on the percentage of it attributable as a medical expense per the institution. Then in 2018, he decided to leave. A refund was given to the TP based on the contract he signed. (He forfeited roughly 2% per month). So I am using the refunded amount X the same percentage used on the tax return in 2017, to calculate the amount as income to be reported in 2018.

Great so far.

However, part of the deduction last year was disallowed due to the 7.5% exclusion. Therefore, I am thinking that should also be considered in calculating the reportable income in 2018 amount, since he did not really get a deduction for the entire amount last year.

Here we arrive at "maybe". It depends on how much was allowed (over 7.5%). Essentially this will be treated as the "last" money spent, so it's the first money refunded. Let's say he spent $100K total in 2017, of which 40% was considered medical expense. So that got you $40K on Sch A medical. Plus all the other medical expenses, minus 7.5% AGI.

Now you have a refund of of let's say $70K total in 2018, of which 40% was medical = $28K recovery. Recompute your 2017 return as if the deduction was $12K instead of $40K. If there would have still been *something* over the 7.5% floor, then the entire recovery ($28K) would be taxable. If not, then, the amount allowed on Schedule A line 4 would be the taxable recovery amount.

On the 2018 return, it has to be listed on Line 21 which is not subject to any exclusion. AND, on top of that the entire itemized deductions were also limited so there is a further reduction in the amount he actually was able to claim. I have a headache......

Are you talking about the Pease limitation on overall itemized deductions? I think medical is outside the Pease limitation math (crunch the numbers anyway) so probably no impact. The thing that *may* come into play is that your refigured itemized deductions could be lower than your standard deduction would have been. That's another "bar" for taxable recovery. Probably not a factor for 2017 but could easily be for 2018-2025 with the much higher standard deductions.

Are we having fun yet? (And if you're in VA, you get to have even more fun since VA decoupled from federal for the 7.5% vs. 10% Medical limit in 2017. So, there's that.)

Rick (in Arlington)

[kathyc2]

Would it work to open 2017 return and put the new amount (original less refund) on return and let the software do the math of tax benefit? IOW, tax benefit of 2017 return less revised benefit of what you know now?

[Lion]

Your software might have a worksheet where it pulls the appropriate 2017 info to compute the tax benefit for you.

[Burke]

Well, I have determined that the itemized deductions were not impacted by the limitation on all deductions, so there's that I don't have to worry about. As for the 2017 deduction, he would have still had a medical deduction over the 7.5% threshold, and would still have been able to itemize overall. Its the same principle as that which governs state income tax refunds. You deduct all withholding/estimated state tax paid in one year, and if you get a refund, it comes back the next year as income. However, there is no exclusion to calculate for that item. At least there wasn't in 2017. Now you have the $10K limitation on taxes on Schedule A, so that might come into play for 2020! I'll let the software programmers worry about that. Anyway, a long-time representative at the VA Dept of Taxation once told me how to account for the medical exclusion on the LTC medical deduction. VA allows a credit for LTC premiums on its return. So you have to remove that itemized deduction from the total Sche A amount that flows through to VA, as you cannot double-dip. To determine that amount, you took the LTC deduction and to determine the portion of the 7.5% exclusion applicable to just that item, you calculated the ratio of the excluded amount to the total medical deductions allowed, and that gives you the percentage applicable to the LTC. I am not sure I have explained that correctly, but I know how to do it.