State tax refund

[Ken]

I hope I'm reading this right because I have already ran accross the situation and gone with "common sense" part of me, but I started having doubts.

The way I understand it is, any prior year state tax refund does not have to be considered income on the Federal if the taxpayer used the (sales tax method) instead of the state withholding, as an itemized deduction on prior year return.

Am I correct in this?

PS I checked the taxbook already and I think thats what it says, I just want verification from someone else.

[Black Bart]

Yes, that's right.

Now -- what's goin' on out there in the sagebrush?

[Chief]

Ken

It's my understanding if in a previous year the client itemized and claimed states sales tax as an itemized deduction he claims the state refund as income. Fl does not have state income tax as a deduction so thats no problem. Claiming incom e tax state as a deduction raises an interesting point.

[Larmil]

Explaining to clients

It's my understanding if in a previous year the client itemized and claimed states sales tax as an itemized deduction he claims the state refund as income. Fl does not have state income tax as a deduction so thats no problem. Claiming incom e tax state as a deduction raises an interesting point.

why the refund of state and local income taxes are included in income is often a chore. They deduct the s/l income taxes in the year paid/withheld regardless of any obligation to have paid them. If the deduction is more than they are entitled to creating a refund of the overpayment then the overpayment is included in the following years income rather than amending the year paid (because more was deducted that they were entitled to). Its like the chicken and egg thing - one of them has to come first. So you deduct what was actually paid rather than what was due. Then balance it the next year.

Sales tax refunds are rare. Usually there is no refund to include in income. My software (Taxworks) actually prompts me if the s/l income tax is higher but the sales tax might be taken because of the refund inclusion.

If this makes no sense to you it is because I do not know how to explain it any better. But, believe me there are actually times that your want to take the sales tax dedution for the client rather than the higher income tax deduction.

[Ken]

which one to take

This is not the problem with me. Taxslayer has a really easy calculation to decide which is the best one to take, however I dont know if I have to add the state refund in as income in the following year if I take the sales tax. I KNOW I have to if I take the sate withholding tax.
The taxbook kinda says you dont have to add the state refund back if you use sales tax instead of state withholding. (At least thats the way I read it).

[Gene V]

Ken, In the 1040 instruction line 10 under TIP: None of your refund is taxable if, in the year you paid the tax, you either (a) did not itemize deductions, or (b) elected to deduct state and local general sales taxes instead of state and local income taxes.

[Ken]

Thanks Gene and guys. (Bart I'm still kicken)

I knew I didn't have to add the state refund if I had not itemized the prior year. And I (suspected) I shouldn't have to add it if I had used sales tax in the prior year.
However, it has taken me two years to realize this. I was doing a persons taxes the other day and it just popped into my mind that I had taken the sales tax the previous year instead of the state income tax as a deduction.

Bart, southern Arizona is finally starting to warm up. This has been the coldest winter I can remember, and I'm ready for summer. We actually had snow on the ground a couple of weeks ago.

[LawrenceGR]

Lamil

I put up a post last week asking if anyone used Taxworks or Great Tax software. I see you use it and wonder how you like it, how long have you used it and in what state do you do business. I tested it last year but couldn't get the hang of how it worked since it runs on an Adobe format. I also found later that it doesn't do a good job with all the cities we have in Michigan. Just wonder how it works for you.

[Larmil]

I put up a post last week asking if anyone used Taxworks or Great Tax software. I see you use it and wonder how you like it, how long have you used it and in what state do you do business. I tested it last year but couldn't get the hang of how it worked since it runs on an Adobe format. I also found later that it doesn't do a good job with all the cities we have in Michigan. Just wonder how it works for you.

I have used Taxworks about 5 or 6 years (since TAASC screwed it's clientele). It is good on the Federal and a little weak on states and cities. I still like it and have no plans to change. I am on the Kansas/Missouri border and do a lot of returns with both states. It works good with the crossover.

[LawrenceGR]

Thanks

for the info. Like I said I tried last year but I didn't like it as well as what I have been using.

[dyne]

I just prepared a 2006 tax return using Drake Tax Software. It started with a
state refund of 746.00. I then added $300 for sales tax paid for a new car purchased to the
Drake STAX screen and the result was that the total general sales tax exceeded the state
tax withholding. A carryover screen displayed by Drake shows that the state income tax
refund taxable next year is $746 even though the corrected state refund is greater. So,
Drake Tax Software is interpreting the law to indicate that the tax refund applicable to
the state tax withholding is taxable and if the general sales is deducted instead, the
increased state refund is not fully taxed but only the amount which would have been
refund without deducting the general sales tax IS taxable. The makes sense. Only
the additional state refund received because the general sales tax was deducted is
NOT taxable. So, there will always be a portion of the state income refund which IS
taxable.

[rosieea]

I just prepared a 2006 tax return using Drake Tax Software. It started with a
state refund of 746.00. I then added $300 for sales tax paid for a new car purchased to the
Drake STAX screen and the result was that the total general sales tax exceeded the state
tax withholding. A carryover screen displayed by Drake shows that the state income tax
refund taxable next year is $746 even though the corrected state refund is greater. So,
Drake Tax Software is interpreting the law to indicate that the tax refund applicable to
the state tax withholding is taxable and if the general sales is deducted instead, the
increased state refund is not fully taxed but only the amount which would have been
refund without deducting the general sales tax IS taxable. The makes sense. Only
the additional state refund received because the general sales tax was deducted is
NOT taxable. So, there will always be a portion of the state income refund which IS
taxable.

Huh? The rule seems pretty clear: If state income tax is not deducted (i.e., no tax benefit was derived), then a refund of state income tax is not taxable. I quit Drake a few years ago - for reasons such as this.

[Larmil]

Sorry, I disagree

I just prepared a 2006 tax return using Drake Tax Software. It started with a
state refund of 746.00. I then added $300 for sales tax paid for a new car purchased to the
Drake STAX screen and the result was that the total general sales tax exceeded the state
tax withholding. A carryover screen displayed by Drake shows that the state income tax
refund taxable next year is $746 even though the corrected state refund is greater. So,
Drake Tax Software is interpreting the law to indicate that the tax refund applicable to
the state tax withholding is taxable and if the general sales is deducted instead, the
increased state refund is not fully taxed but only the amount which would have been
refund without deducting the general sales tax IS taxable. The makes sense. Only
the additional state refund received because the general sales tax was deducted is
NOT taxable. So, there will always be a portion of the state income refund which IS
taxable.

If you are only deducting SALES TAX and not INCOME TAX why would a refund of INCOME TAX be taxable? You got no benefit of the INCOME TAX paid. Even state and local INCOME TAX deductions are not alway fully taxable in the following year - only the amount that one received a benefit from.

[Brad Imsdahl]

TTB, page 3-21 has a worksheet to figure the taxable portion of a state refund when State and Local Income taxes were deducted as an itemized deduction on Schedule A. Below the worksheet, it says, “If a refund was for tax paid in 2005 and deducted as state and local income taxes on line 5 of the 2005 Schedule A, use the worksheet above to calculate the taxable portion for line 10, Form 1040. Do not use the worksheet if any of the following apply. Instead, see Itemized Deduction Recoveries in IRS Pub. 525.”

The second bullet says, “The refund was for taxes other than income taxes, such as general sales tax or real property tax.”

Thus, if you took the general sales tax deduction rather than state income taxes, you are directed by TTB to see IRS Pub 525.

Page 20 of the 2006 version of IRS Pub 525 says the following:

“After 2003, you could choose to deduct for a tax year either:
- State and local income taxes, or
- State and local general sales taxes.”

“For 2006, the maximum refund that you may have to include in income is limited to the excess of the tax you chose to deduct for that year over the tax you did not choose to deduct for that year.”

“Example 1. For 2005 you can choose an $11,000 state income tax deduction or a $10,000 state general sales tax deduction. You choose to deduct the state income tax. In 2006 you receive a $2,500 state income tax refund. The maximum refund that you may have to include in income is $1,000, since you could have deducted $10,000 in state general sales tax.”

“Example 2. For 2005 you can choose an $11,500 state general sales tax deduction based on actual expenses or an $11,200 state income tax deduction. You choose to deduct the general sales tax deduction. In 2006 you return an item you had purchased and receive a $500 sales tax refund. In 2006 you also receive a $1,500 state income tax refund. The maximum refund that you may have to include in income is $500, since it is less than the excess of the tax deducted ($11,500) over the tax you did not choose to deduct ($11,200 - $1,500 = $9,700). Since you did not choose to deduct the state income tax, you do not include the state income tax refund in income.”

[dyne]

state tax refund

Thank you Brad. I found in Pub 17, page 82 and more details in IRS Pub 525 page 20 and 21
which clearly states that if a person itemizes and claims a general sales tax deduction
in lieu of the state tax withheld, a PORTION of the state income tax refund IS
taxable IF there was any state tax withheld. I had thought that none of it was taxable.
Drake Tax Software has this right.