Every year when clients send their “tax stuff,” I invariably get a sticky note on the 1099-G from the state. The note usually says, “What’s this?” First, I should tell you that the 1099-G is used by states to report your state tax refund from the prior year. Therefore, if your prior year tax return indicated that you overpaid your state taxes by $100, you will receive a 1099-G this January indicating that the state tax refund may need to be reported on your current year’s tax return.
This is called the Tax Benefit Rule. If you receive a deduction for something and later recover it, then you must put it back into income. Therefore, if you itemize deductions and take all of the state payments you made during the year as a deduction and you overpaid your state tax, you have technically taken too many deductions.
Example:
In April 2012, you had to pay the state $505 tax on your 2011 tax return. During 2012, you had state tax of $3,546 withheld from your pay. On your 2012 tax return, you would be entitled to a deduction for state taxes paid during 2012 of $4,051.
The $3,546 is shown on your state tax return as taxes withheld. Let’s assume your tax for 2012 is $3,361. Your 2012 tax return that you are preparing in 2013 would show that you are entitled to a refund of $185. If all goes well with your state filing, you should receive a check for $185 some time during 2013.
That $185 was part of the $3,546 you had withheld during 2012 and took as a deduction. However, your “real” deduction should have only been $3,361 because you overpaid by $185. Tax return preparation is too hard now. Imagine if you had to keep going back and forth to Schedule A (Itemized Deductions) and change it every time you played with your state return. That would be a nightmare.
Therefore, if you itemized deductions last year, received a deduction for your state income taxes paid during that year and received a refund, the refund amount goes on Line 10 of your Form 1040 as income. If you did not itemize deductions, you did not receive a tax benefit from your state tax payments. Hence, the refund is not income and is not included on your Form 1040 this year.
Other Recoveries
The state tax refund is the most common form of the Tax Benefit Rule for individuals, but there are other situations where this rule may affect you.
For instance, you may have had damages to your rental property. You repaired the damages and took the deduction for the repairs on your current year’s tax return. You then filed a lawsuit against your former tenant and later collected all or part of the repair bill. The amount collected would be included in income in the year you receive it. If you had collected the money in the same year as the repairs, you would have reduced the repair costs by the amount paid by the tenant and had less of a deduction. If you collect in a later year after having taken the full deduction, the recovery can only be income to you.
Another example would be payments received in a later year from your health insurance company for medical expenses for which you received a deduction. Be careful on how much you report as income. Medical expenses are subject to a 7.5% of AGI reduction, and the reimbursement is only income to the extent of the deduction you actually received.
I know you will still send those “huh?” stickies with your tax return information, but maybe now you can move it to the 1099-OID. If you would like additional information regarding this topic or any other tax related issue, contact contact Henssler Financial at 770-429-9166 or at experts@henssler.com.
Disclosures
This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
