Can I reduce my state income tax deduction, to avoid taxes on the refund?

Question

Suppose I have paid $3000 in state income taxes in 2022, but I expect to receive a $1000 refund. I am itemizing deductions on my 2022 federal return, so normally I would deduct $3000, then include the $1000 refund in my 2023 taxable income.

Is there a way that I can choose to deduct only $2000 on my 2022 return, and then not include the $1000 refund in my 2023 taxable income?

This would be beneficial if I will be in a higher tax bracket in 2023 than in 2022.

In case it's relevant, suppose:

• I do not expect to itemize deductions for 2023.

• I am not hitting the $10000 cap on state tax deductions.

• My state general sales tax deduction would be much lower (let's say $500), so it doesn't enter the picture.

I looked through Pub. 525 to try to find an answer. The Recoveries section talks about excluding some or all of a refund if you weren't allowed to deduct the full amount of your state taxes due to the $10000 cap. But it's not clear to me whether the same principle would apply if you could have deducted the full amount but chose not to.

Answer 1

Is there a way that I can choose to deduct only $2000 on my 2022 return, and then not include the $1000 refund in my 2023 taxable income?

No, because you're a cash based taxpayer and 2022 has already ended. There's no provision of retroactive refunds, so you deduct taxes paid in the year paid, and include in the income refunds received in the year received.

Answer 2

If you don't want to make have the refund taxable, and the =$10,000 SALT limit doesn't protect the refund, then the most obvious way is to not-itemize. That could result in significantly greater taxes now , just to not have to pay slightly higher taxes later.

If you were asking about something that the IRS doesn't know about, such as charitable deductions, then you could decide to not claim all your your charitable deductions. Yes, I know there is no concept of a refund with a charitable deduction. But my point is that your state income tax amount is mentioned on your W-2.

Because the IRS can see the state income tax on their copy of the W-2, they are likely to notice it at some point. It could be after the initial review, which could see it as a typo, and send you a check after making an automatic adjustment. The IRS could also flag it during document matching and send you a notice about the mismatch.

When I was in college a neighbor of my parents did something similar. They only put down for their state taxes their net state taxes on Schedule A. Late in the calendar year, it was noticed by the IRS. It took several rounds of letters to get it resolved. They determined it was not worth the pain. The funny thing is that weren't doing it to save money, they were doing it because they thought it made more sense.