In December 2017, as a part of the Tax Cuts and Jobs Act, P.L. 115-97 (TCJA), Congress enacted new Inside Income Code Part 164(b)(6) limiting people’ state and native tax (SALT) deductions to $10,000 per yr ($5,000 for married submitting individually). (Observe that this $10,000 limitation doesn’t apply to actual or private property taxes paid or accrued whereas carrying on a commerce or enterprise or an exercise for the manufacturing of revenue described in Inside Income Code Part 212.)
Since then, a lot of the main focus has been on the efforts of states and people to avoid this restrict. Much less consideration has been paid to the interaction between this restrict and the applying of the tax profit rule, however questions have been raised relating to if and when state tax refunds for quantities restricted by the $10,000 cap on SALT deductions can be taxable revenue. On March 29, 2019, the IRS launched Income Ruling 2019-11, (the ruling), offering 4 examples of the interaction between IRC Part 111 and Part 164(b) and confirming that a SALT refund will nonetheless solely be taxable revenue to the recipient to the extent it really reduces taxes paid.
Tax Profit Rule
The tax profit rule is easy, not less than on paper: If a taxpayer takes a deduction in a single yr, however recovers in a subsequent yr some or the entire quantity that gave rise to the deduction, then that restoration goes to be taxable revenue to the taxpayer. Part 111 limits the applying of the tax profit rule with respect to sure deductions and credit, together with deductions for prior taxes, by excluding from gross revenue any restoration of an quantity that didn’t really scale back the quantity of tax owed within the yr of the deduction. Earlier than the TCJA, if a taxpayer itemized deductions on her revenue tax returns in lieu of taking the usual deduction, claimed a deduction for the complete quantity of state and native taxes paid and obtained a refund of a few of these taxes after submitting her return, then the tax profit rule would apply to deal with some or all of that refund as taxable revenue. The limitation in Part 111 would maintain a portion of the SALT refund from being handled as taxable revenue if, for instance, the entire SALT refund was larger than the distinction between the taxpayer’s itemized deductions and the relevant commonplace deduction.
4 Examples
The TCJA didn’t amend Part 111, and taxpayers and practitioners have been left questioning learn how to apply Sections 111 and 164(b)(6) collectively. The ruling supplies readability by setting forth 4 examples, all involving a single taxpayer who chooses to itemize deductions on her 2018 federal revenue tax return in lieu of taking the usual deduction of $12,000. Within the first instance, for 2018, Anna claimed a SALT deduction of $9,000, had complete itemized deductions for 2018 of $14,000 and obtained a refund of $1,500. As a result of her SALT deduction wasn’t restricted by Part 164(b)(6), if Anna had paid the precise quantity of state revenue tax she owed in 2018, her complete itemized deductions would have been decreased by the entire quantity of the refund. Your complete refund is taxable revenue to Anna in 2019.
Within the second instance, Barbara paid $12,000 of state and native taxes in 2018, however after utility of Part 164(b)(6) she was solely in a position to deduct $10,000. Her complete itemized deductions for 2018 have been $15,000, and in 2019 she obtained a state revenue tax refund of $750 as a result of her overpayment of state revenue taxes in 2018. As a result of the refund is lower than the quantity by which Barbara’s SALT deduction was restricted underneath Part 164(b)(6), her complete itemized deductions wouldn’t have been affected if she had paid the correct quantity of taxes in 2018, and no portion of the state revenue tax refund is taxable in 2019.
Within the third instance, Charlie paid $11,000 of state and native taxes in 2018, however after utility of Part 164(b)(6) she was solely in a position to deduct $10,000. Her complete itemized deductions for 2018 have been $15,000 and in 2019 she obtained a state revenue tax refund of $1,500 as a result of her overpayment of state revenue taxes in 2018. As a result of Charlie’s SALT deduction was decreased by $1,000 underneath Part 164(b)(6), if she had paid the correct quantity of taxes in 2018, her complete itemized deductions would have been decreased by $500 if she had paid the correct quantity of taxes in 2018, and solely $500 of the state revenue tax refund is taxable in 2019.
Within the fourth instance, Diana paid $10,250 of state and native taxes in 2018, however after utility of Part 164(b)(6) she was solely in a position to deduct $10,000. Her complete itemized deductions for 2018 have been $12,500, and in 2019 she obtained a state revenue tax refund of $1,000 as a result of her overpayment of state revenue taxes in 2018. As a result of Diana’s SALT deduction was decreased by $1,000 underneath Part 164(b)(6), if she had paid the correct quantity of taxes in 2018, her complete itemized deductions would have been decreased by $750 to $11,750 if she had paid the correct quantity of taxes in 2018. As a result of that might carry Diana’s itemized deductions beneath the $12,000 commonplace deduction, she really solely benefited from $500 of the overpayment, and solely $500 of the state revenue tax refund is taxable in 2019.
Backside Line
As these examples present, and because the ruling notes, figuring out whether or not a SALT refund is includible in a taxpayer’s gross revenue comes down as to whether the taxes that have been refunded moved the needle when it comes to calculating the taxpayer’s taxable revenue in a previous yr. The SALT refund will probably be revenue to the extent the taxpayer’s deductions would have been decrease had she simply not overpaid her state revenue tax within the first place. If paying solely the correct quantity of taxes wouldn’t have modified something on the taxpayer’s federal return, then the SALT refund gained’t be taxable revenue within the yr obtained.
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