State tax refunds for non-resident aliens and excess

Question

According to the instructions for Form 1040-NR-EZ, tax payers must refer to Publication 525 to decide if any of the state tax refunds need to be listed as additional income in Line 4. Here, for Non-Resident Aliens the Itemized Deduction Recoveries discussion in Publication 525 applies. It states with respect to state tax refunds that

you must include in your income the full amount of a refund of state or local income tax or general sales tax if the excess of the tax you deducted over the tax you didn't deduct is more than the refund of the tax deducted.

Consider a 2018 federal tax return 1040-NR, Line 37 Itemized Deductions x$ are listed based on min(state income tax, 10000). Then, is the following correct?

1) tax not deducted refers to state income tax ­- x 2) tax deducted refers to x 3) excess refers to the tax deducted - tax not deducted

And thus, if excess > refund, the refund must be listed as income, which should be generally true for most non-resident aliens?

Answer 1

The part of Publication 525 is confusing, but the section you are looking at is only considered if the 5 statements in the previous section are all true. So you need to first check that each of the 5 previous statements are true, including that your itemized deduction exceeded your standard deduction by at least the amount of the refund (nonresident aliens have no standard deduction, so it's just: your itemized deduction was at least the amount of the refund), you had positive taxable income, you were not subject to AMT, etc., before you check this section. If any of those statements weren't true, you would have to consult the "Total recovery not included in income" section and use the worksheet.

So what the statement is referring to are the two types of state taxes that can be deducted: income tax and sales tax. You can only choose to deduct one of them, and that is "the tax you deducted", and the other one that you didn't choose is "the tax you didn't deduct". So the "excess" refers to state income tax deducted - state sales tax you could have deducted (or vice versa). Since nonresident aliens cannot deduct state sales tax, for your case, the "the tax you didn't deduct" is the state sales tax, which is 0. So the statement boils down to: you must include in your income the full amount of a refund of state or local income tax if the excess of the state or local income tax you deducted is more than the refund of the tax deducted.

When in doubt, you can always follow the instructions in the "Total recovery not included in income" section and use the worksheet. If it is the case that your entire refund is taxable because the statements in the "Total recovery included in income" section are all true, then the worksheet will show that the taxable amount is the whole refund.