taxability of state income tax refund

[dyne]

Another message board has a message that states that their tax software is taxing only
the portion of the prior year state tax refund which exceeded the general sales tax that
could have been claimed. Is that correct?
I believe:
1. None of the state tax refund from the prior year is taxable if the standard deduction
was claimed in the prior year.
2. None of the state tax refund from the prior year is taxable if the general sales tax
was deducted in lieu of the state tax withholding in the prior year.
3. Only a PORTION of the state tax refund from the prior year is taxable if the taxpayer
itemized in the prior year and claimed state tax withholding. Only the excess between
the state tax withholding and the general sales which COULD have been claimed is
taxable. Example:
$1,000 state tax withholding claimed in the prior year.
400 general sales tax deduction allowable
600 differance-only this amount is taxable of any state tax refund.

The example in IRS Pub 525 seems to state that is the way it is calculated.

This means that in all cases the taxpayer will be taxed upon only a portion of
the state tax refund IF they deducted the state tax withholding in the prior year
EXCEPT for those who live in a state which has no general sales tax.

Am I correct on this or am I still confused? Comments, please.
Best wishes.
Fred

[Snaggletooth]

Yes

Dyne, my vote is with you.

When sales tax deduction was resurrected in 2004, there was much discussion about preparers electing sales tax instead of state income tax, simply to avoid the taxpayer having to claim income on the SIT refund.

If what you say is true, then the SIT can be chosen without regard to the debacle above, as the Fed law actually caves in to recognize the situation.

[Kram BergGold]

Example

State taxes deducted $6,000. Sales tax could have been $1,000. State refund was $500. In this case all is taxable because a tax benefit was gained by all of it.

State taxes deducted $1,000. Sales tax would have been $900. Refund was $200. Now only $100 is taxable because that is all taxpayer benefited by.

This is how I think it works

[DonPriebe]

Quite clear in Pub 525

The examples in Pub 525 make it quite clear that the taxability is limited to the excess of the state income tax deducted over the state sales tax not deducted. In retrospect it's consistent with the 'tax benefit' rule.

I also am using that software this year and was surprised when the line 10 number first came up. One caution however - the software bases the number on the income tax deducted less the sales tax that the software computes could have been deducted. Many times in a high income tax state [like NY] it is obvious that the income tax will be higher, so the preparer doesn't actually run the comparison. This means that the software computes only the state portion of the sales tax, and not the local portion [which may actually exceed the state portion here in NY]. This results in excess computed taxability of the state refund.

[dyne]

taxability of state tax refund

Thank you so much guys!.
I believe my tax software has not being
computing it correctly.
I had become very confused about this issue.
Best wishes.

Fred

[Brad Imsdahl]

Here is an interesting twist.

Lets say according to the Sales Tax Tables, your deduction for Sales tax was $1,000 in 2005. Your income tax withheld in 2005 was $2,000, so you obviously chose the state income tax instead of Sales tax. The maximum state income tax refund that is taxable in 2006 is $1,000 (excess of what you deducted over what you could have deducted).

OK, we all get that.

But what if they also bought a car with $700 of sales tax. You never bothered recording that last year because the $1,700 of Sales tax was still less than income tax. Now the taxable state income tax refund is limited to $300, not $1,000.

How is your software going to know that if you didn’t enter the sales tax on the car purchase into the program last year?

[dyne]

I saw on another message board where their tax software was requesting them to
enter sales tax paid on a car or something to that effect. We would have to enter
it for the software to know about it. This is becoming a can of worms.

[Dervis]

IRS calculator

The IRS website has a calculator for sales tax deductions for either 2005 or 2006. You need to know their approximate AGI and the zip code where they reside. You also have the option of adding in any sales tax for car purchases, etc. It also can handle two or more zip codes if they moved. If you type in 2005 state sales tax in the search box, the first entry it pulls up is for the calculator.