Are Colorado TABOR refunds taxable as federal income, if a state sales tax deduction was taken previously?

Question

Colorado has a law called TABOR that, in years when the state government has more revenue than predicted, allows every taxpayer to claim a refund. This is done with a line item on the state income tax return, and paid out together with the taxpayer's income tax refund (or credited to their income tax liability). However, the TABOR refund is actually characterized as a refund of state sales tax. See for instance line 33 of Colorado 2022 Form DR 0104:

Now, for federal income tax, taxpayers who itemize federal deductions are allowed to choose to take a "general state sales tax deduction" on Form 1040 Schedule A line 5, in place of the more common state income tax deduction. Generally, if you deduct a tax on a federal return in one year, and receive a refund of some or all of that tax in a future year, the refund is federally taxable income in the year it is received.

So if a Colorado taxpayer takes the state sales tax deduction on their 2022 federal return, does this mean that their TABOR refund (let's say $208) must be included as federally taxable income for 2023?

Will the state send a 1099-G for this amount?

Conversely, suppose one deducts state income tax for 2022, and receives a regular state income tax refund. They get a check for, let's say, $1000, which includes the $208 TABOR refund. Does that mean that they should include only $792 of that amount as income for 2023? Would the 1099-G take that into account?

This question could be relevant in deciding whether it is more advantageous to take the state income tax or state sales tax deduction on one's 2022 federal return.

(This is similar to Are Colorado Cash Back payments taxable as federal income? but not the same. The IRS document given as the answer there does not address regular TABOR refunds, only the special 2022 Colorado Cash Back payment, which was not explicitly described as a sales tax refund.)

Answer 1

The IRS guidance refers specifically for payments from the state, not refunds of taxes paid. In that regard, the 2022 Colorado cash back based on SB 22-223 is covered, but annual tax refunds are not. Here's the reason (from CO State Assembly):

Concerning an additional mechanism to refund excess state revenues for state fiscal year 2021-22 only that provides a refund in an identical amount to each qualified resident individual, and, in connection therewith, making an appropriation.

Basically, Colorado gives the same amount to everyone eligible and that is covered by "the General Welfare Doctrine".

Regular TABOR tax refunds are tiered based on income and correlate to taxes paid and as such are treated as tax refunds. So if you deducted the taxes from your income - the refund should be included back in. If you didn't deduct the taxes from your income, then the refund is not taxable.

Use the tax refund worksheet for Schedule 1 to calculate the taxable portion. Read more in the IRS Pub. 525.

The State probably should issue 1099G, but the mere issuance or non-issuance of the form 1099 (of any kind) by the payer means nothing with regards to the tax liability of the recipient (the taxpayer).