The IRS has issued Revenue Ruling 2019-11 which outlines how state and local tax refunds will be treated when they arise from years subject to the $10,000 cap on deducting personal state and local income and property taxes imposed by IRC §164(b)(6) added by the Tax Cuts and Jobs Act (TCJA). The treatment agrees with the treatment outlined in our March 1, 2019 article on the matter (“Tax Benefit Rule of §111 Should Shield State Tax Refunds For Taxpayers Over the SALT Limit”, Current Federal Tax Developments website, March 1, 2019).

As was noted in the referenced article, the tax benefit rule of §111(a) requires determining the amount of such deduction that was later refunded could have been removed from the prior year’s return with no tax effect. That could be true to the extent:

The tax deduction for the prior year was capped at $10,000 by IRC §164(b)(6). In that case, any refund up to the amount of the disallowed tax deduction on the original return would not generate a tax benefit and, under IRC §111(a), would not be subject to inclusion in income in the received; or
Had the refunded amount not been deducted on the original return, the standard deduction would have exceeded the itemized deduction. In that case, no tax benefit is generated by the refund that is in excess of the amount of the total allowed itemized deductions on the original return in excess of the standard deduction.

The ruling provides three fact patterns and the tax results. The first one deals with a taxpayer whose deductions on the original return for state and local taxes were below the cap, but otherwise the total itemized deductions were well in excess of the standard deduction.

Facts for the first situation: Taxpayer A paid local real property taxes of $4,000 and state income taxes of $5,000 in 2018. A’s state and local tax deduction was not limited by section 164(b)(6) because it was below $10,000. Including other allowable itemized deductions, A claimed a total of $14,000 in itemized deductions on A’s 2018 federal income tax return. In 2019, A received a $1,500 state income tax refund due to A’s overpayment of state income taxes in 2018.

Results in the first situation: In 2019, A received a $1,500 refund of state income taxes paid in 2018. Had A paid only the proper amount of state income tax in 2018, A’s state and local tax deduction would have been reduced from $9,000 to $7,500 and as a result, A’s itemized deductions would have been reduced from $14,000 to $12,500, a difference of $1,500. A received a tax benefit from the overpayment of $1,500 in state income tax in 2018. Thus, A is required to include the entire $1,500 state income tax refund in A’s gross income in 2019.

In the second case the taxpayer’s deduction was capped, and he/she receives a refund that is less that the amount his state and local taxes exceeded $10,000 for the year in question.

Facts for the second situation: Taxpayer B paid local real property taxes of $5,000 and state income taxes of $7,000 in 2018. Section 164(b)(6) limited B’s state and local tax deduction on B’s 2018 federal income tax return to $10,000, so B could not deduct $2,000 of the $12,000 state and local taxes paid. Including other allowable itemized deductions, B claimed a total of $15,000 in itemized deductions on B’s 2018 federal income tax return. In 2019, B received a $750 state income tax refund due to B’s overpayment of state income taxes in 2018.

Results for second situation: In 2019, B received a $750 refund of state income taxes paid in 2018. Had B paid only the proper amount of state income tax in 2018, B’s state and local tax deduction would have remained the same ($10,000) and B’s itemized deductions would have remained the same ($15,000). B received no tax benefit from the overpayment of $750 in state income tax in 2018. Thus, B is not required to include the $750 state income tax refund in B’s gross income in 2019.

In the third situation, the taxpayer was subject to the cap, but the state income tax refund is more than the amount that total state and local taxes paid in the year were in excess of the $10,000 cap.

Facts in the third situation: Taxpayer C paid local real property taxes of $5,000 and state income taxes of $6,000 in 2018. Section 164(b)(6) limited C’s state and local tax deduction on C’s 2018 federal income tax return to $10,000, so C could not deduct $1,000 of the $11,000 state and local taxes paid. Including other allowable itemized deductions, C claimed a total of $15,000 in itemized deductions on C’s 2018 federal income tax return. In 2019, C received a $1,500 state income tax refund due to C’s overpayment of state income taxes in 2018.

Results in the third situation: In 2019, C received a $1,500 refund of state income taxes paid in 2018. Had C paid only the proper amount of state income tax in 2018, C’s state and local tax deduction would have been reduced from $10,000 to $9,500 and as a result, C’s itemized deductions would have been reduced from $15,000 to $14,500, a difference of $500. C received a tax benefit from $500 of the overpayment of state income tax in 2018. Thus, C is required to include $500 of C’s state income tax refund in C’s gross income in 2019.

In the final situation, we see a combination of the interaction of the cap and the standard deduction, which ends up with two different issues that deny a tax benefit to different portions of the refund.

Facts in the fourth situation: Taxpayer D paid local real property taxes of $4,250 and state income taxes of $6,000 in 2018. Section 164(b)(6) limited D’s state and local tax deduction on D’s 2018 federal income tax return to $10,000, so D could not deduct $250 of the $10,250 state and local taxes paid. Including other allowable itemized deductions, D claimed a total of $12,500 in itemized deductions on D’s 2018 federal income tax return. In 2019, D received a $1,000 state income tax refund due to D’s overpayment of state income taxes in 2018.

Results in fourth situation: In 2019, D received a $1,000 refund of state income taxes paid in 2018. Had D paid only the proper amount of state income tax in 2018, D’s state and local tax deduction would have been reduced from $10,000 to $9,250, and, as a result, D’s itemized deductions would have been reduced from $12,500 to $11,750, which is less than the standard deduction of $12,000 that D would have taken in 2018. The difference between D’s claimed itemized deductions ($12,500) and the standard deduction D could have taken ($12,000) is $500. D received a tax benefit from $500 of the overpayment of state income tax in 2018. Thus, D is required to include $500 of D’s state income tax refund in D’s gross income in 2019.