IRS applies tax benefit rule to state and local tax refunds

In Rev. Rul. 2019-11, issued on March 29, the IRS addressed how the long-standing tax benefit rule interacts with the new $10,000 limit on deductions of state and local taxes to determine the portion of any state or local tax refund that must be included in income on the taxpayer’s federal income tax return.

Sec. 164 generally provides an itemized deduction for certain taxes paid or accrued during the tax year. However, Sec. 164(b)(6), as added by the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, limits an individual’s deduction for the aggregate amount of state and local taxes paid during the calendar year to $10,000 ($5,000 in the case of a married individual filing a separate return). Sec. 111(a), which partially codifies the tax benefit rule, excludes from gross income amounts attributable to the recovery during the tax year of any amount deducted in any prior year to the extent the amount did not reduce the amount of tax imposed by Chapter 1 of the Code.

Taxpayers who itemize deductions and who paid state and local taxes in excess of the state and local tax deduction limit may not be required to include the entire state or local tax refund in income in the following year. According to the IRS, a key part of that determination is calculating the amount the taxpayer would have deducted had the taxpayer only paid the actual state and local tax liability, with no refund and no balance due.

The IRS therefore ruled that if a taxpayer received a tax benefit from deducting state or local taxes in a prior tax year and the taxpayer recovers all or a portion of those taxes in the current tax year, the taxpayer must include in gross income the lesser of:

1. The difference between the taxpayer’s total itemized deductions taken in the prior year and the amount of itemized deductions the taxpayer would have taken in the prior year had the taxpayer paid the proper amount of state and local tax; or
2. The difference between the taxpayer’s itemized deductions taken in the prior year and the standard deduction amount for the prior year, if the taxpayer was not precluded from taking the standard deduction in the prior year.

This holding applies to the recovery of any state or local tax, including state or local income tax and state or local real or personal property tax.

The IRS provided four examples in the revenue ruling to illustrate the interaction of the limit and the tax benefit rule. The IRS noted that the ruling has no impact on state or local tax refunds received in 2018 and reportable on 2018 returns that taxpayers are filing this season.

The AICPA requested guidance on this issue from the IRS in its June 2018 recommendations for 2018-2019 guidance, available at www.aicpa.org.