I was paid $1,000 by company X as part of a contract in 2020. I am deciding to cancel the contract and have to pay back $1,000. What happens if I pay back this amount in 2021? The company will issue me a W-2 form for 2020 and I will have to pay taxes on $1,000 in year 2020. But how can I now claim back the taxes in my 2021 return since I refunded the money back to the company? Is it possible to make this adjustment in my 2020 tax return itself? Say I pay back in Jan 2021?
Talk to your employer. If you can return the money this year, it makes the whole thing easier.
If you pay it back next year...
Sometimes they will reissue a W-2C form with the corrected amount. If they go this route then you can use the adjusted numbers when you file your taxes. If you already have filed the taxes when they issue the W-2C, then the 1040-X is the way to go.
If they don't issue a corrected W-2C then you have to look at the Repayment section of IRS Pub 525.
Type of deduction.
The type of deduction you're allowed in the year of repayment depends on the type of income you included in the earlier year. In most cases, you deduct the repayment on the same form or schedule on which you previously reported it as income. For example, if you reported it as self-employment income, deduct it as a business expense on Schedule C (Form 1040 or 1040-SR) or Schedule F (Form 1040 or 1040-SR). If you reported it as a capital gain, deduct it as a capital loss as explained in the Instructions for Schedule D (Form 1040 or 1040-SR). If you reported it as wages, unemployment compensation, or other nonbusiness income, you may be able to deduct it as an other itemized deduction if the amount repaid is over $3,000.
For tax years beginning after 2017, you can no longer claim any miscellaneous itemized deductions, so if the amount repaid was $3,000 or less, you aren’t able to deduct it from your income in the year you repaid it.
Repaid social security benefits.
If you repaid social security or equivalent railroad retirement benefits, see Pub. 915.
Repayment over $3,000.
If the amount you repaid was more than $3,000, you can deduct the repayment as an other itemized deduction on Schedule A (Form 1040 or 1040-SR), line 16, if you included the income under a claim of right. This means that at the time you included the income, it appeared that you had an unrestricted right to it. However, you can choose to take a credit for the year of repayment. Figure your tax under both methods and compare the results. Use the method (deduction or credit) that results in less tax.
That section in bold appears to mean that since you will be repaying $1,000 you can't go the miscellaneous deduction route.
The rest of the section discusses what to do if the amount is over $3,000.
If I'm not mistaken the only way to do that is, in fact, to file a correction to your 20 return.
It's pretty easy, people do this all the time. (In TaxAct etc., you just click the "amend" button, select the year.)
BTW it looks like there could be a three-year limit to do this.