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In Apr 2018, for 2017 taxes, I filed for extension and made a payment for estimated tax for the State & local taxes of NY of 20K. I was completely wrong, and ended up getting a State refund of 30K when finally filing in Oct 2018. (EDIT: emphasize on: the 20K paid in 2018 were not counted towards the itemized deduction. I got not deduction for those 20K paid).

Now, for 2018, with Trump TCJA, State and Local Taxes deductions are capped at 10K, so I'm not itemizing.

My accountant claims those 30K are taxable refunds (form 1040 / sched 1 / 10 ). I believe the fair amount I should be taxed on is "the refund", 10K, not the refund + my over estimation. I never claimed any deduction on the 20K, so the income that did not get taxed on is 30K - 20K = 10K. And I would hope that is what I should count as income in 2018.

Without the tax overhaul (Trump's TCJA), the estimated payment of 20K / Apr 2018 would have been itemized which would offset some of the 30K refund, as in Question about federal taxation of state refund (US)

Is my accountant right? What can I do in such a situation? Is there a way to try to negotiate with the IRS? Many thanks for your help.

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    Did you itemize deductions on your 2017 federal tax return, and did you deduct your state tax payment of $20K? – void_ptr Apr 14 at 5:04
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    Also, I fail to see why the SALT cap would be the reason you are itemizing. Did you mean you aren't itemizing? – Ben Voigt Apr 14 at 5:59
  • Yes itemized for 2017 taxes. No did not deduct the 20K as I was paying in 2018. Correct, I meant I did not itemize sorry, edited my question. – ILoveCoding Apr 14 at 6:19
  • (edited to add dates to clarify the sequence) – ILoveCoding Apr 14 at 7:44
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You need to allocate the $30,000 recovery between payments made in 2017 and payments in 2018. For example, if you paid (and deducted as an itemized deduction) $30,000 in 2017, then the $30,000 recovery would be allocated as 60% for 2017 payments and 40% for 2018 payments. The 60% does need to be included as income on schedule 1. The 40% would affect your itemized deduction for 2018, but since you’re not itemizing, it has no effect.

You are supposed to include a statement with your return describing how the allocation was done. See “Recoveries” in publication 525.

  • Thanks for your answer. I'm trying to follow... wouldn't the recovery be 10K, ie the "real" recovery? (The 20K were never deducted anywhere). – ILoveCoding Apr 14 at 8:32
  • You never said how much state income tax deduction was for in 2017. We need that to compute the amount of the recovery attributable to 2017. (Actually we don’t need to know the amount of the 2017 deduction, we need to know how much was deducted for 2017 state taxes. Some of the 2017 deduction may have been for 2016 state taxes paid in 2017.) – prl Apr 14 at 9:11
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    Please carefully read the Recoveries section in pub 525. It has a more thorough explanation than I can give here, along with examples and worksheets that specifically address your situation. – prl Apr 14 at 9:13
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    Yes, specifically the heading "Recovery for 2 or more years" and Example 27 (HTML) or 28 (PDF) in Pub 525. – nanoman Apr 14 at 10:38
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Was the $20K state tax payment made in 2017, or made in 2018 for your 2017 taxes?

If the $20K payment was made in 2017, it could have been deducted on your 2017 federal return, along with any other state tax payments. The TCJA was not in effect for 2017 and the $10K cap did not apply.

It seems that you received the $30K refund in 2018. Regardless of the TCJA, such a refund is taxable only to the extent that the corresponding overpayment was deducted (and saved you money over the standard deduction) in a previous federal tax year.

If both the $20K payment and the $30K refund occurred in 2018, then the only part of the $30K that is taxable is the amount of whatever other payments of state tax for the same year (if any) were profitably deducted on your 2017 (or earlier) federal return. Then, you can federally deduct your state tax paid in 2018 up to $10K.

The principle is that you end up benefiting from federal deductions of state taxes as if you paid exactly the right amount every time (no overpayment). Refunds are taxed in a way that effectively adjusts the federal deduction previously taken to that which would have been taken on the exact state tax owed. And the "would have been" takes into account caps, fallback to the standard deduction, etc.

It was certainly undesirable to make a state tax payment in 2018 for year 2017, versus making the payment in 2017 when it was fully deductible.

EDIT: The potentially unclear aspect is how the 2017 state tax refund received in 2018 is treated when state tax payments for 2017 were made in both 2017 and 2018 (and deducted for 2017). I found a source commenting on this explicitly. See the section "Taxpayer makes payments of year 1 taxes in year 2", and the key statement:

The IRS’ position, however, is that the overpayment was generated by the total payments and cannot be allocated directly to any payment. Accordingly, the overpayment ... would be proportionately allocated to each year’s payment.

Thus, some but not all of the $30K refund is taxable. The part allocated to 2018 is not taxable but reduces your net state tax payments in 2018.

  • Thanks a lot for your answer. Added in the comment that I'm in the second case: paid in 2018 for 2017 taxes. Also fixed a mistake: I'm NOT itemizing. The principle you describe is indeed what I think / hope makes sense. I'm not entirely sure I understand your 3rd paragraph though. To me : 2017 state deduction didn't count the 20k; so my deduction was in fact 10K too big. So I should put 10K in Sched 1 / 10. IE everything as if I had just received 10K. Does this sound correct? Many thanks again. – ILoveCoding Apr 14 at 6:36
  • @ILoveCoding No, I don't think so. What amount of 2017 state taxes did you deduct on your 2017 federal return? Unfortunately, you chose to make the $20K payment in 2018 instead of making it in 2017 (or not making it at all), and that has a consequence. – nanoman Apr 14 at 6:47
  • Amount deducted for 2017: only the State and Local taxes withheld during 2017; not including the 20K estimated payment in Apr 2018, nor the 30K received back in Oct 2018. – ILoveCoding Apr 14 at 7:40
  • if I can pick your brain one last time: example 28 paid in Jan 2018, so his 400 refund is split accross 2017 2018. I got back 30K, so more than I paid for Apr estimate. So the recovery is 10K, and it's entirely for 2017. Correct? – ILoveCoding Apr 15 at 4:00
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    @ILoveCoding I don't think so. Just follow the same calculation as in the example. It sounds like you paid about $100K in 2017 (deducting it in full) and $20K in 2018. Thus about $25K of the refund is taxable (being associated with the 2017 payments you deducted), and $5K is treated as a recovery from the 2018 payment. Your state tax payments in 2018 are $15K plus whatever has been withheld for 2018 taxes, but of course the exact amount doesn't matter because it's already over the $10K cap and you're not itemizing anyway. – nanoman Apr 15 at 4:27
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Here's how it works. If you take a tax deduction for state income tax in a given year, and you get a refund on that tax, then you must declare the refund as income in the year you get the refund.

But if you didn't take all the deduction you're entitled to, you don't need to declare all the refund you get.

Example:

  • 2014 - I take a schedule A tax deduction for my FULL state income tax withheld/prepaid in - 2014.
  • 2015 - I do not take a tax deduction for my state taxes withheld in 2015
  • 2016 - I take a Schedule A tax deduction for $10,000 less than my state income tax withheld. (withholding was $27,410, I took a deduction for $17,410).

For whatever reasons, I get all the state tax refunds in calendar year 2017.

  • The 2014 refund of $14,100 is declared as income on my 2017 Federal taxes, because I deducted all the withholding in 2014.
  • The 2015 refund of $9,313 is not declared as income, because I didn't itemize on my Federal 2015.
  • On the 2016 refund of $12,411, I only declare $2,411 as income on my Federal 2017 taxes, because I didn't deduct the other $10,000.

You see the common thread? Whatever you did not benefit from a deduction on, you also do not need to declare as income. The 2015 refund was totally excluded, as was $10,000 of the 2016 refund.

So hypothetically let's say you had $55,000 of withholding and also made a $5000 prepayment for your 2017 state tax, and on your 2017 Federal Schedule A you took $55,000 in deductions because you forgot the $5000 payment. Then in calendar year 2018 you get your 2017 refund of $30,000. You declare as income that less the $5000 you forgot to deduct, or $25,000. And you do it on your 2018 taxes because that's when you received the money. (Weird but applicable).

In 2018, if your state tax was $22,000 withheld and $9,000 actual, and you did itemize and take the allowed $10,000 of deduction (disallowing $12,000), and you got a $13,000 refund in 2019, again you would only need to pay tax on the $1000 since you didn't take a deduction on the other $12,000.

How do I know this? I took the IRS to tax court on this exact issue, and IRS attorneys totally agreed with me and said the auditor was wrong. It was settled so easily it did not become published law, so I can't cite it.


A "cleaner" way to do the whole above thing of avoid having to declare state tax refunds as Federal income, is to not take the state tax deduction at the time you file your Federal. Then, after your state taxes settle, amend your Federal to deduct the actual amount of state tax. This is what the IRS actually wants (in the sense that IRS likes simple because simple is more easily audited), and it spares the runaround of deducting withholding and declaring refund.

This strategy is especially helpful if you have high state over-withholding triggering AMT (high state refunds are an AMT magnet because the state withholding appears out-of-proportion to taxable income). That is the situation my court case applied to, and the IRS attorneys said "that's the way to do it", otherwise the state tax refund would unwind the AMT in calculations worthy of Stephen Hawking.

  • In 2018 I amend my 2015 Federal taxes to claim the 2015 state tax I didn't take before. I have two valid choices (more than two, but whatevs):

    • Amend my 2015 to take the withholding, then amend my 2017 to declare the refund. This will result in taxes and penalties due on my 2017.
    • Amend my 2015 to take the actual, final amount of my state tax; and do not change my 2017 tax. (Literally I am claiming $9,313 less than I am entitled to, and in 2017 declaring $9,313 less of my refund, or $0.)
  • How does this affect my 2015 state taxes? Run the numbers but states usually disregard both your deduction of state tax withheld and your declartion of state tax refunds. (either by a parallel 1040-like form that doesn't have those line items, or they "Adjust" your 1040 numbers to remove them). So this becomes a "wash" as far as your state income. Check your state rules on if you need to amend 2015, but with my second actual-tax method, you definitely wouldn't need to amend state 2017.

  • Can you give a reference for your final paragraph? I’ve not seen anything that indicates that that’s allowed, much less that it’s recommended. – prl Apr 14 at 18:04
  • @prl What isn't allowed? Claiming less than your full state tax withholding? Or amending your taxes? Or amending your taxes to itemize deductions when you didn't at first pass? "They should also amend to claim deductions or credits not claimed" from this link. I may not be following your meaning, apologize. I will grant you that I'm using artistic license there, presuming IRS prefers simple tax forms to complicated ones. – Harper - Reinstate Monica Apr 14 at 19:02
  • What I think isn't allowed is omitting a recovery of state income tax from income in a subsequent tax year when state income tax was included in itemized deductions in the prior tax year. – prl Apr 14 at 19:06
  • ... to continue my earlier comment, in particular I'm referring to AMT, because ludicrous amounts of state tax withholding as compared to taxable income is a red-flag AMT trigger. (ludicrous when state tax is based on raw income and you take tons of deductions). The problem is, if the high state tax deduction triggers AMT in 2017, then taking the refund in 2018 unwinds the AMT via outlandishly complex calculations, which then itself is an audit magnet. The IRS lawyers told me "Please don't do that, your thing is the better." – Harper - Reinstate Monica Apr 14 at 19:07
  • I may have misunderstood your last paragraph. It starts with "another way", which led me to believe that it was an alternative not directly related to your previous paragraphs. – prl Apr 14 at 19:11

protected by JTP - Apologise to Monica Apr 14 at 15:00

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