I'm doing my 2017 taxes and I've been extremely confused by how federal taxes treat state refunds. Here are the details:
- In 2017 I paid $750 as part of my filing for an extension for my NY 2016 state taxes.
- I then received a $1050 refund for my NY 2016 taxes, in 2017.
- TurboTax says that $980 of my refund is taxable (I think this is the proportion of the refund that was based on tax payments made during 2016)
- The remaining $70 is apparently not taxable because it was based on payments made during 2017, but TurboTax is going to reduce my 2017 state and local deduction by $70 as a result.
I think I understand why state tax refunds are taxable in general (because the refund represents an amount that the federal government didn't get to tax last year, so it makes up for it by taxing it this year). However, I have two other questions:
Why divide the refund into two different categories, the refund that was attributable to 2016 payments and the refund that was attributable to 2017 payments? Why not just treat the entire thing as taxable income?
Why is the 2017-attributable portion reducing my 2017 state/local deduction? I don't understand why that would happen.
On that, it also seems like I could have lost unlimited sums of money (in the form of a reduced state/local tax deduction) by arbitrarily increasing my extension payment. If I increased my extension payment by an extra $500 I would have expected to receive an increased refund of $500, but then TurboTax would have gone ahead and reduced my state/local deduction by some additional amount. I must be missing something, what is it?