This is the first year the new limit on state and local tax (SALT) deductions applies on federal income tax returns. Now, the IRS has issued new guidance on state and local tax refunds in years in which the SALT limit is in effect (Rev. Rul. 2019-11, 3/29/129).
Previously, a taxpayer could deduct the full amount of state and local property taxes paid during the year plus either state and local income tax payments or state and local sales tax payments. However, the Tax Cuts and Jobs Act (TCJA) limits the annual SALT deduction to $10,000. This provision, like many others for individual taxpayers in the TCJA, is effective for 2018 through 2025.
In addition, the TCJA increases the standard deduction while curtailing or eliminating other itemized deductions. Thus, more taxpayers are likely to claim the standard deduction on their 2018 returns and in succeeding years.
As before, state and local tax refunds aren’t taxable if a taxpayer chose the standard deduction for the year in which the tax was paid. But when an individual itemized deductions, the refund is subject to tax, to the extent they received a tax benefit from the deduction.
The new SALT limit further complicates matters. Significantly, a taxpayer may not be required to include the entire state or local tax refund in income in the following year. A key part of that calculation is determining the amount they would have deducted had they only paid the actual state and local tax liability (i.e. no refund and no balance due).
In the new ruling, the IRS describes four situations involving state and local tax refunds where the SALT limit comes into play.
For example, in one such situation explained in the IRS press release on the ruling, a single taxpayer is an itemizer who claims a total of $15,000 in deductions on a 2018 federal income tax return. They list a total of $12,000 in SALT payments taxes on the return, including state and local income taxes of $7,000. Because of the new limit, however, the taxpayer’s SALT deduction is only $10,000.
The IRS goes on to state that taxpayer receives a $750 refund of state income taxes in 2019 for taxes paid in 2018. In other words, the taxpayer’s actual 2018 state income tax liability was $6,250 ($7,000 - $750 refund). Accordingly, the taxpayer’s 2018 SALT deduction still would have been $10,000, even if it had been based on the actual $6,250 state and local income tax liability for 2018.
Based on these facts, the individual didn’t receive a tax benefit on a 2018 federal income tax return from an overpayment of state income tax in 2018. Bottom line: The taxpayer is not required to report any tax on the 2019 state income tax refund on a 2019 return.
Note that the new ruling has no impact on state or local tax income tax refunds received in 2018 and reportable on the 2018 returns that taxpayers are filing this season.
As you can see from the example described above, the new rules can easily create confusion among your clients. Be prepared to field inquiries on this issue.