One of the major changes brought about by the Tax Cuts and Jobs Act (TCJA), the massive tax reform laws that took effect in 2018, was a new limitation on the personal itemized deduction for state and local taxes, also called SALT. SALT includes property taxes, state income taxes, and state sales taxes; however, itemizers must choose between deducting income taxes or sales taxes.
For 2018 through 2025, the TCJA limits the SALT deduction to a maximum of $10,000 per year ($5,000 for married taxpayers who file separately instead of jointly). Thus, for example, if you pay $20,000 in SALT and itemize your personal deductions instead of taking the standard deduction, you may only deduct $10,000. The remaining $10,000 is lost forever.
One big question about the limit on the SALT deduction is the impact of a state tax refund on a taxpayer who itemized personal deductions and deducted state and local taxes. Does such a taxpayer have to include the entire state or local tax refund in income in the following year? The IRS has ruled that such a refund need not be included in income if it would not have affected the taxpayer’s deduction the prior year. (IRS Ruling 2019-11.)
Example. Amy paid $12,000 in SALT tax in 2018, including $7,000 in state income taxes and $5,000 in property tax. Amy itemized her deductions and deducted the $10,000 SALT limit. In 2019, she receives a $750 refund of the state income taxes she paid in 2018. This means the actual 2018 state income tax she had to pay was only $6,250 ($7,000 minus her $750 refund). However, the $750 refund does not change Amy's SALT deduction for 2018. It would still have been limited to $10,000, even if it was based on $6,250 in state income taxes plus $5,000 in property tax. Because Amy didn’t get a tax benefit on her 2018 federal income tax return from her overpayment of state income tax in 2018, she is not required to include her tax refund on her 2019 return.
On the other hand, you must include such a state tax refund in your taxable income if you took a larger SALT deduction that you would have been entitled to if you had not received the refund.
Example: Arthur, a single taxpayer, paid local real property taxes of $4,000 and state income taxes of $5,000 in 2018. Arthur’s state and local tax deduction was not limited by the SALT limit because it was below $10,000. Including other itemized deductions, Arthur claimed a total of $14,000 in itemized deductions on his 2018 federal tax return. In 2019, Arthur receives a $1,500 state income tax refund due to his overpayment of state income taxes in 2018. Had Arthur paid only the proper amount of state income tax in 2018, his SALT deduction would have been reduced from $9,000 to $7,500. As a result, Arthur’s itemized deductions would have been reduced from $14,000 to $12,500, a difference of $1,500. Arthur received a tax benefit from the overpayment of $1,500 in state income tax in 2018. Thus, Arthur is required to include the entire $1,500 state income tax refund in his gross income on his 2019 return.
The IRS’s ruling applies only to tax years 2019 and later. It has no impact on state or local tax refunds received in 2018.