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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?

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  • This seems to be correct according to the Worksheet 2 in Publication 525
    – leezu
    May 17, 2020 at 20:21

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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.

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  • Thank you for clarifying the definition of excess and the 5 statements. So in summary, as "Your itemized deductions exceeded the standard deduction by at least the amount of the recovery." is true for all NRAs (otherwise there wouldn't be a refund in the first place) and thus " If you recover any itemized deduction that you claimed in an earlier year, you must generally include the full amount of the recovery in your income in the year you receive it" applies.
    – leezu
    May 18, 2020 at 17:57
  • @leezu: Well, it's still possible to have negative taxable income, if your itemized deductions was higher than your AGI, but that's highly unlikely currently as you basically would have to pay more state income tax than your income, which shouldn't happen unless you actively paid estimated taxes. Before 2018, it was more plausible for a nonresident alien to have negative taxable income, because there were personal exemptions before 2018, which would cause the taxable income to be negative if the AGI was less than the personal exemptions.
    – user102008
    May 18, 2020 at 21:34

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