What is the Tax Benefit Rule?
Editor's Note: This article is part of our 2014 Tax Tips series. Robert Flach is an expert with more than 40 years of experience as a tax professional and also blogs as The Wandering Tax Pro.
NEW YORK (MainStreet) When you claim a tax deduction on Schedule A, for example state and local income taxes withheld, you receive a "tax benefit," because the deduction has reduced your taxable income and therefore your tax liability. The tax benefit is the lessor of the actual deduction claimed or the amount the deduction causes your total itemized deductions to exceed your applicable Standard Deduction amount.
If you receive a refund of all or part of a deduction you claimed, for example a state tax refund, you must report as income the amount of tax benefit you had received from the amount of the refund.
For example - you deducted $1,000 in state income taxes on your 2012 Schedule A. This represents the total amount of state income tax withheld from your wages in 2012 from your Form W-2. When you filed your 2012 state income tax return you were entitled to a refund of $300, which you received. All or part of the refund must be reported as income on Line 10 of your 2013 Form 1040.
If you filed your return as Single your Standard Deduction for 2012 was $5,950. If the total amount of your itemized deductions for 2012 was $7,000 you must report as income the full $300 state tax refund on your 2013 return.
If the total amount of itemized deduction for 2012 was $6,175, you only have to claim $225 of the refund as income in 2013. The $1,000 deduction for state and local income taxes you claimed on the 2012 Schedule A caused your total deductions to exceed the Standard Deduction by $225. So the tax benefit you received from the $300 refund was only $225.
Of course, if you were not able to itemize for 2012 none of your state tax refund is taxable for 2013.
If you were a victim of the Alternative Minimum Tax (AMT) for 2012 your state tax refund is probably not taxable because taxes claimed on Schedule A are not allowed as a deduction when calculating the AMT.
State tax refunds are reported to you on Form 1099-G. However many states no longer mail Form 1099-G to recipients of tax refunds. You must go to the website of your state's department or division of taxation or revenue to download the form.
This concept also applies to other refunds of previously deducted items, such as a state property tax rebate check.
Written by Robert D. Flach for MainStreet