In May, we shared a brief update on how taxpayers can utilize the new State and Local Tax (SALT) deduction limits to save money. Ever since the Tax Cuts and Jobs Act lowered the deduction threshold to $10,000 per year ($5,000 for married filing separate), guidance on issues related to the SALT deduction limit has remained vague. Recently, the IRS published Revenue Ruling 2019-11, which explains the tax treatment of SALT refunds.
Up until 2018, taxpayers who itemized their returns and deducted state and local income taxes, property taxes, and/or sales taxes had to pay tax on any refund they received. Taxpayers who used the standard deduction were exempt from owing tax on any state or local tax refunds. But, the tax environment was much different before the Tax Cuts and Jobs Act was enacted at the end of 2017. Now that the standard deduction has been doubled and many available deductions have been reduced or eliminated, millions of taxpayers who used to itemize are now taking the standard deduction.
But taxpayers living in high-tax states may still find savings when itemizing their returns. The IRS’s latest guidance states that state or local tax refunds may not need to be included in gross income. Some calculations are needed to determine if there was a tax benefit to the refunds.
The key is to determine the actual amount of state and local taxes that would have been deducted, had they paid only the actual state and local tax due – in other words, the breakeven point where there is no refund and no additional tax owed. Next, compare that amount to the total of all itemized deductions, or the standard deduction that could have been taken. If this calculation reveals that there was no tax benefit to taking the SALT deduction, then income tax is not due on the refund.
The IRS included four scenarios in their ruling to help taxpayers understand how state and local tax refunds would be treated regarding the SALT deduction. The full ruling is available here, where the word-for-word scenarios can be read in detail. As a quick summary:
Taxpayer A paid $9,000 in property and income taxes, less than the $10,000 threshold. They claimed a total of $14,000 in itemized deductions and received a refund of $1,500 in state tax. The refund would be taxable, because if they only paid the actual amount of taxes, then the itemized deduction amount would have been reduced. They received a tax benefit, in other words.
Taxpayer B paid $12,000 in property and income taxes and claimed a total of $15,000 in itemized deductions. They received a refund of $750 in state tax that would not be taxable, because the deduction amount would have been the same whether they paid only the actual tax due versus claiming the deduction on Schedule A. They did not receive a tax benefit.
Taxpayer C paid $11,000 in property and income taxes and claimed a total of $15,000 in itemized deductions. They received a refund of $1,500 in state tax that would be partially taxable, because the amount they overpaid in state taxes – $500 in this example – resulted in a tax benefit, but only partially. The other $1,000 in the refund did not equal a tax benefit.
Taxpayer D paid $10,250 in property and income taxes and claimed a total of $12,250 in itemized deductions. They received a refund of $1,000 that would be partially taxable, because the amount they overpaid in state taxes – $500 – results in a difference between itemized deductions and the available standard deduction.
The key to each of these scenarios is to look at the difference between the available SALT deduction – $10,000 – the taxes actually paid, and any benefit from overpayment. In B, for example, the amount of the deduction and the actual amount of taxes paid would have been the same, and the itemized deductions would have been the same. Since there wouldn’t have been a change, the refund is not a tax benefit.
Compare this scenario to A, where the refund was fully taxable. If the taxpayer would have paid only the actual amount due in taxes, then the SALT deduction would have been reduced ($9,000 deduction less the $1,500 refund equals actual liability of $7,500). Thus, the $1,500 overpayment resulted in a tax benefit and would need to be included in gross income.
Consider these scenarios in the rest of tax planning for 2019. Losing the unlimited SALT deduction affected millions of taxpayers who may have received lower refunds than in years past. Congress is unlikely to alter the deduction limit and it doesn’t expire until 2025, so taxpayers who used to itemize their returns and take the SALT deduction need to do some extra math to figure out the best scenario. It is possible to save money and minimize the loss in tax savings as a result of the SALT deduction limit. Contact our office with any questions.