With the tax season mostly done now, I noticed a problem that needed an IRS fix.

You all know by now that SALT (state, local, and property taxes) have been limited under the Tax Cut and Jobs Act to a maximum deductibility of $ 10K.  The GOP wanted to penalize those states under Democratic Party management, where SALT is usually higher, because better services are provided their citizenry.

Add that bit of political chicanery to the combination of the previous personal exemptions and standard deduction into one number (different for single folks, heads of household, and married couples) meant that itemizing is now a much less frequent choice for taxpayers. (It’s expected that about ½ the folks who itemized in 2017 will be able to do so in 2018, for a total of about 17 million tax returns.)

But…

Let’s assume you did itemize.  You had $ 15K of mortgage interest, $ 5K of charitable donations, and $ 19K of state, local, and property taxes.  Which means you could only deduct $ 10K of the salt, with a total itemized deduction of $ 30K ($15K, $ 5K, and $19  10K).

And, now, let’s consider the following.  You are now getting a refund from your state (in this case, the Commonwealth of Virginia) of $ 2.5K.

What happens next year?

Up until this year, that refund was developed from taxes that you listed as expenses on the tax return.  So, it was only fair that the government got to get back taxes on the amount you paid that was returned to you.  (You listed that $ 19K of SALT last year- which is from where the $ 2.5 K refund came.)

[You can skip over this paragraph- unless you want to understand the legal background behind these facts.  The new tax law (Tax Cuts & Jobs Act) forced the creation of Section 164(b)(6) that limited the SALT deduction to $ 10K.  (Section 164 discusses how certain taxes provide an itemized deduction.) Section 111(a) excludes the requirement to include income from any recovery of taxes to the extent that the tax did not reduce the amount of taxes paid under the laws.]

But, now????

You were deprived of $ 9K of SALT deductions.  Why should any state refund be taxable?  Or, if it is taxable, should it be limited by the percentage to which you could deduct it?  (In this case, that would mean $ 10K deduction/$19K SALT paid or just 52% of the 2.5K refund.)

Or, according to some tax scholars, none of the refund should be taxable, since the total state taxes paid minus the refund exceeds the $ 10K threshold.  This is using something called the Tax Benefit Rule; it stipulates that if one deducts an item that doesn’t yield a tax advantage, it cannot be taxable.

The same scholars indicate that if the were $ 10K of charitable donations, mortgage interest of $ 15K, and  SALT of $ 11K, that $2.5K tax return would be only partially taxable next year ($2.5K- $1K of non-deductible salt, for 2019 income of $ 1.5K.)

(Just because someone is a tax scholar, it does not mean that the IRS will accept that position. ) We needed the IRS to make a ruling on this problem.   And, just like that- after I wrote this post, but after the issue was brought to their attention, on the 30th of March 2019, the IRS has proposed an answer…

The IRS has ruled that the gross income for 2019 and subsequent years (since you obtain the state refund the year AFTER you claimed the taxes) will not include the entire refund any state provides.  Instead, the lesser amount of the (a) difference between the total itemized deductions taken in a given year or (b) what the itemized deductions would have been had there been no state tax refund(s) or the difference between the itemized deductions taken and the standard deduction.

So, what does that really mean?

Using the example above,  what is the result?  To recap, we had $ 15K of mortgage interest, $ 5K of charitable deductions, and $ 19 K of SALT, with a $2.5K Virginia refund in 2019.  In 2017 and prior years, we would have itemized $ 39K of deductions- but since it’s 2018, we can only deduct $ 30K.  (That accursed $ 10K SALT limitation.)

Given the refund was 2.5K, it meant we only had  $ 16.5K of SALT, ($19K paid, minus the $ 2.5K tax refund)  of which $ 10K was deducted.  Which also means our itemized deduction would still be $ 30K   So, the Virginia refund is NOT going to be taxable.

Whew!