How much of my state income tax refund is considered taxable income?

Question

Under the previous tax law, if you itemized and deducted your state income taxes but then got a state income tax refund, the refund was considered taxable income in the subsequent year's federal income tax. Under the new tax laws with 10k cap on state income tax + property tax, will any refund still be 100% taxable?

As an example, in 2018, assuming married, joint filing:

• Property tax: 8k
• State income tax: 8k
• Other deductible expenses(e.g. mortgage interest, charitable contributions, etc.): 15k
• Total deductions: 25k (total tax deduction is 16k but capped at 10k)

During state income filing, we find out we've withheld too much and get a refund of $2k. How much (if any) is the refund considered taxable income? All of it because we itemized? None of it because we were able to fill up the 10k limit with property tax and state income tax? Prorated?

Related question: Are tax federal or state tax refunds taxable in the next tax year?

Answer 1

Under the old law (as well as the new law AFAIK), state tax refunds are taxable only to the extent that you benefited from taking itemized deductions. For example, if you got a big state tax refund, but your itemized deductions last year were only a little bit higher than your standard deductions, then not all of your state tax refund is taxable -- the part that is taxable is no more than the difference between your itemized deductions and standard deduction last year. This is calculated in the State and Local Income Tax Refund Worksheet in Form 1040 instructions for line 10 (or, in complicated cases, Publication 525 Worksheet 2).

Since your standard deduction for Married Filing Jointly in 2018 is $24k, the benefit you got from using itemized deductions is $25k - $24k = $1k, so no more than $1k of your state tax refund would be taxable.

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Update: I though about this some more, and I think actually that none of your state tax refund would be taxable in 2019. This is because you did not get any benefit from the last $2k of state income tax deductions. If you had paid the correct amount, i.e. $6k, in state income tax in 2018, and not overpaid, your federal itemized deductions would still have been the same (both $14k and $16k get capped to $10k). Since you did not get any extra federal deduction by overpaying state taxes, there is no need to put that amount back into federal income.

Answer 2

This is how I am interpreting the discussions regarding the new tax bill:

2017

• Property tax: 8k
• State income tax: 8k

• Other deductible expenses(e.g. mortgage interest, charitable contributions, etc.): 15k

• Total SALT Deduction: 16K

• Total deductions: 31K
• State income tax refund received in April 2018: 1K

2018

• Property tax: 8k
• State income tax: 8k
• Other deductible expenses(e.g. mortgage interest, charitable contributions, etc.): 15k
• Total SALT Deduction: 10K (the new Tax law limited this to 10K)
• Total deductions: 25K
• The 1K refund received in April 2018 is taxable because you deducted it from your 2017 taxes. The SALT deduction would have dropped to 15K.
• State income tax refund received in April 2019: 1k

2019

• Property tax: 8k
• State income tax: 8k
• Other deductible expenses(e.g. mortgage interest, charitable contributions, etc.): 15k
• Total SALT Deduction: 10K (the new Tax law limited this to 10K)
• Total deductions: 25K
• The 1K refund received in April 2019 is NOT taxable.
• State income tax refund received in April 2020: 1K

The reason that is isn't taxable is that 16K from 2018 minus 1K from the refund in 2019 is still greater than 10K. The 1K refund from the state tax would not have changed the SALT deduction.

I wonder if the 10K limit is indexed to inflation?