The taxability of refunds from 2018 tax returns will be based on the tax benefit rule, not the proportional amount of state income tax versus property and other deductible taxes entered. (Rev. Rul. 2019-11) This issue has been a concern for many practitioners because some software products have been generating worksheets showing that their clients’ refunds will be taxed based on the proportional amount.
The IRS guidance clarifies that taxpayers who are impacted by the SALT limitation will determine the taxability of their state or local tax refund by recalculating their 2018 itemized deductions, and reducing the income tax deduction by the amount of their refund. They will only be subject to tax if that reduction reduces their overall itemized deductions.
For example, assume that a taxpayer deducts $15,000 in property taxes and $20,000 in state income taxes, and then receives at $1,500 state tax refund. You would reduce the state income tax deduction on the 2018 Schedule A to $18,500 ($20,000 – $1,500). The refund would not be taxable because the property taxes alone exceed the $10,000 SALT limitation.
Even taxpayers with less than $10,000 in property taxes might not be subject to tax on their refunds. Assume a taxpayer deducts $5,000 in property taxes and $8,000 in state income taxes, and then receives a $500 refund. That taxpayer would now deduct only $7,500 in state income taxes, but their overall SALT deduction is still $10,000.
For the full text of the Revenue Ruling go to: