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For the first time in several years, I'm preparing the income tax filing for my family. Since a professional did the preparations last year, we had no electronic records to directly load into the software we bought for the preparations. Thus, I've entered some values by hand. During the software's "interview", it asked about our previous year's (2016) itemized deductions. I dug up the number from our 2016 1040 and entered it. Much to my surprise, our tax liability went up by a few hundred dollars. Zeroing out that entry reduces our tax liability.

The biggest itemizations (for both 2016 and 2017) were our mortgage interest, property tax, and state income taxes, with some charitable contributions also. There was no sort of carry over of deductions. The refund we received in 2017 for our 2016 state taxes is entered elsewhere as income.

With no sort of carry over, it makes no sense to me that our 2016 itemized deductions would have any effect on our 2017 taxes. Thus my question is why would this be? Or is there a bug in the software?

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Last year you deducted all of the state tax that was withheld from your paycheck in 2016 off of your income.

But then you did your 2016 state income tax return, and the state sent you some of that money back.

Because you deducted it last year and then got a refund, your state income tax refund is taxable by the federal government and must be added in to your 2017 income. This goes on Line 10 of your Form 1040.

If you had taken the standard deduction last year, the state tax refund would not be taxable, and you would not need to add it to your income.

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    @jamesqf You are mistaken. The state tax refund is only taxable by the feds if you took the state income tax deduction the previous year on your itemized deductions. – Ben Miller Apr 12 '18 at 18:27
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    @GreenMatt I understand that the software has you enter the refund elsewhere, but if you had told the software that you did not itemize last year, then it would have ignored it. The software doesn’t really need to know the details of your deductions last year. If you itemized last year, then your refund is taxable this year. – Ben Miller Apr 12 '18 at 18:33
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    @GreenMatt To test whether my answer is right or wrong, try doing your taxes both ways and see what it puts on Line 10 of Form 1040 in each case. – Ben Miller Apr 12 '18 at 18:35
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    @GreenMatt The purpose of my suggested test is not to debug the software; the purpose is to convince you that my answer is correct. :) – Ben Miller Apr 12 '18 at 19:50
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    For those wondering what sense this makes, it's because you don't pay taxes on the income you used to pay your state tax in 2016, so when you get it back now you have to pay the taxes. – Mehrdad Apr 13 '18 at 17:50
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With no sort of carry over, it makes no sense to me that our 2016 itemized deductions would have any effect on our 2017 taxes. Thus my question is why would this be?

Two scenarios:

  1. 2016 itemize $14,600; get state tax refund in April 2017 of $500; tell tax software in April 2018 that you itemized the previous year; enter total amount itemized and amount of state tax refunded.

  2. 2016 itemize $12,700; get state tax refund in April 2017 of $500; tell tax software in April 2018 that you itemized the previous year; enter total amount itemized and amount of state tax refunded.

In scenario 1 when you enter the amount itemized the previous year the tax software makes a quick calculation.

Previous years standard deduction = $12,600   
Previous years amount itemized   = $14,600  
amount refunded from state =  $500

$14,600 - $500 > $12,600 therefore the entire refund is taxable.

In scenario 2 when you enter the amount itemized the previous year the tax software makes a quick calculation.

Previous years standard deduction = $12,600   
Previous years amount itemized   = $12,700  
amount refunded from state =  $500  

$12,700 - $500 < $12,600 therefore the refund is partially taxable. 

Only $100 is taxable, because that is the amount above the standard deduction.

The tax software can only make the calculation when it knows how much you itemized.

Next year this will be automatic because the software will already have these numbers.

  • +1 Good details on what happens when your itemized deductions are close to the standard deduction. – Ben Miller Apr 12 '18 at 20:09
  • Interesting. However, in our case our itemized deductions were well above the standard deduction, and the state refund wasn't large enough to pull us below it. – GreenMatt Apr 12 '18 at 20:33
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    thus it is all taxable. – mhoran_psprep Apr 12 '18 at 20:37
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Did the software just ask for one number, your total deductions for 2016? Or did it ask for a breakout? Because yeah, last year's total deductions per se should have no effect on this year. But tax law is complex: I'd be reluctant to say that there is NOTHING in there that might not result in an increase.

If there are many lines of entries, I'd try entering them one by one and see which one changes the amount of tax due.

If there's only one number, or if trying to enter numbers one at a time doesn't help for some other reason, I'd say: 1. Enter this number as zero. Print out your tax forms. 2. Enter the actual value in this field. Print out the tax forms again. 3. Compare the two sets of tax forms and see where they're different.

As there's no place on a 1040 to put "last year's deductions", presumably the difference has to show up somewhere else. Once you see where the two forms are different, you might say, "aha, that's why, I get it now". If it's still mysterious, or especially if the tax due changes but nothing above that on the form is different, then that sounds like a problem with the software and I'd be calling the manufacturer.

Update

See comment from @BenMiller. I checked the forms and he's correct: There is a rule there that I was unaware of. I you hack through that worksheet, it turns out that the point is that if subtracting your state refund from LAST YEAR's itemized deductions would have put you below the standard deduction, they only tax you for the difference rather than the full amount. I was unaware of that rule until now.

Maybe Ben should post his own answer as this could clear it up, but to take credit for Ben's observation:

If your tax software used $0 for your 2016 itemized deductions, then your state income tax refund is not taxable. Once you give a number, then more of it becomes taxable.

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    Actually the program asked for a number from the 2016 deductions worksheet; not having that, I saw that it was for the TOTAL deductions. So I pulled that off the 2016 1040. – GreenMatt Apr 12 '18 at 19:29
  • First thought: But still, just one number, right? Second thought: Are you sure that the number was for TOTAL deductions and not something else? There's no place on a 1040 to enter what your previous year's total deductions were, it doesn't figure into anything, so I don't see why it would be relevant. The only thing I can even think of is that some deductions are limited but allow a carryover, but that would make your taxes go down, not up. – Jay Apr 12 '18 at 19:36
  • Pretty sure it was for total 2016 deductions - that's what I entered anyway. The query was not for this year's 1040, but "Last Year's Data" (or some such). – GreenMatt Apr 12 '18 at 19:41
  • There is a place to enter the total deductions from the previous year. Not on Form 1040 itself, but on the “State and Local Income Tax Refund Worksheet,” which is found in the Form 1040 Line 10 instructions. The result of that worksheet determines how much gets entered on Line 10. – Ben Miller Apr 12 '18 at 20:20
  • Um, I did post my own answer. See above. – Ben Miller Apr 12 '18 at 22:27

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