Federal income tax on state income tax refund

TP paid too much state estimated tax for 2008, all during 2008.
So on the 2008 federal return, there's a large deduction in Schedule A. But for 2009 there'll be a state income tax refund.
The refund would typically be taxed as income for 2009, which seems fair since to balance tax benefit on 2008 Schedule A.
But TP is subject to AMT for 2008. There, state taxes are added back into income. So there wasn't a real tax benefit in 2008. (This was checked using TurboTax; if the 2008 state estimated tax was reduced to produce no refund, the federal tax remained the same and schedule A line 5 didn't switch to sales tax.)
On the 2009 return next year, will there be a calculation that sorts all this out, so the refund isn't really taxed? Is there some pitfall to be avoided about taxes on the refund?
Thanks.
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"pomegranate-man" wrote:

Yes. See Publication 525.
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into
using
refund,
to
all this out,

Not necessary. AMT means no deduction, so its refund in 2009 is not recognized.
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in article gpespq$1vn$ snipped-for-privacy@aux.snarked.org, D. Stussy at snipped-for-privacy@bde-arc.ampr.org wrote on 3/13/09 9:27 PM:

Disagree. This is not always true, although it is most of the time. If you actually do the calculations, sometimes you find that the refund is still taxable. I am consistently surprised, when I actually go back and adjust the prior year AMT calculation.
Uncompensated advice guaranteed correct or double your money back
Frank S. Duke, Jr. CPA Cincinnati, OH USA
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you
Please provide an example.
Comapring a return with AMT and a deduction for any schedule A tax to the equivalent return without that schedule A tax yields no difference in the total tax (although the amount allocated between regular tax and AMT will change - but the TMT line will not), so where's the tax benefit that says that the refund is taxable?
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in article gpgskl$m9n$ snipped-for-privacy@aux.snarked.org, D. Stussy at snipped-for-privacy@bde-arc.ampr.org wrote on 3/14/09 4:39 PM:

Taxpayer is filing MFS in 2007 and 2008. AGI in 2007 is $225,805 with itemized deductions of $24,128. Tax is $56,005 and AMT $2615 for a total of $58,620. Recalculating the return by reducing the deductions by the $1391 state refund yields deductions of $22,737, regular tax of $56,492 and AMT of $2,146 for a total of $58,638, $18 more so there was a slight savings from the state tax deduction. ProSeries makes the whole refund taxable.

Uncompensated advice guaranteed correct or double your money back
Frank S. Duke, Jr. CPA Cincinnati, OH USA
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The change in tax after removing 1391 of state deductions is 487 more, which is precisely 35% of 1391, subject to rounding error, which makes sense as the client is in the 35% tax bracket. However, the increase in AMT is less than $487, which is something I can't repro on my program.
Here's what I did:
MFS W2 income of 225,805 Mortgage interest of 10,000 which is allowed under AMT State tax of 14,128. Tax is 56,068 and 2,671 for a total of 58,739.
Now with state tax reduced by 1,391, so it is 12737. Tax is 56,555 and 2,184 for a total of 58,739 (same as before). Regular tax increased by $487, AMT increased by that same amount.
So something else special must be going on in your return.
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wrote:

total of

$1391
AMT of

from
Increase? TMT and AMTI should remain the same, so the only "change" to AMT should be exactly balanced by a change to regular tax.

No. AMT DECREASED by the same amount.
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in article gpk8nc$kf8$ snipped-for-privacy@aux.snarked.org, D. Stussy at snipped-for-privacy@bde-arc.ampr.org wrote on 3/15/09 10:39 PM:

I appreciate all the simulating that people have done but to make it correct you have to have all the data. The ProSeries worksheets associated with the State Refund calculation go on for 3 pages and ask for more than 20 items of date from the prior year return, automatically carried forward in all my returns. I'm sorry but at this time of the year, I just don't have the time to give you all the details. What I can tell you is that most of the time, prior year AMT protects the current year refund but it is not always the case so I always do the prior year recalculation and judiciously check the numbers if it does not. I have seen the same effect in TurboTax and in TaxWise.
Uncompensated advice guaranteed correct or double your money back
Frank S. Duke, Jr. CPA Cincinnati, OH USA
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Oops, I made a typo. Yeah, the AMT is decreased by the same amount so that the total tax is the same, when we remove a state tax deduction. But in the OP's situation, the change in AMT is not balanced by a change to the regular tax. What might the reasons for this be (that was the point of my post)?
I'm trying to figure out the worksheet in http://www.irs.gov/publications/p525/ar02.html#en_US_publink100098400 . But if when we remove a state tax deduction, the regular tax increases by 487 and the AMT tax decreases by 469, then it seems logical that the benefit from the deduction was (487-469)/487 which is 3.6961%, so only 3.6961% of the recovery should be taxable.
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wrote in message

I suggest that you've made a math error. The sum of the digits of the difference is divisible by 9, so that means that possibly you've transposed two digits in one of the numbers involved in the computation. What you say is not possible, as the TMT remains the same. As AMT = TMT - Regular Tax (where TMT > Regular), any change in the regular tax MUST have a change of equal magnitude in AMT.
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"pomegranate-man" wrote:

in article gpespq$ snipped-for-privacy@aux.snarked.org, D. Stussy at s...@bde- arc.ampr.org wrote on 3/13/09 9:27 PM:

D. Stussy wrote:

in article gpgskl$ snipped-for-privacy@aux.snarked.org, D. Stussy at s...@bde- arc.ampr.org wrote on 3/14/09 4:39 PM:

"pomegranate-man" wrote:

>Subject to alternative minimum tax. If you > were subject to the alternative minimum tax in > the year of the deduction, you will have to > recompute your tax for the earlier year to deter- > mine if the recovery must be included in your >income. This will require a recomputation of > your regular tax, as shown in the preceding >example, and a recomputation of your alterna- > tive minimum tax. If inclusion of the recovery > does not change your total tax, you do not > include the recovery in your income. However, > if your total tax increases by any amount, you > received a tax benefit from the deduction and > you must include the recovery in your income > up to the amount of the deduction that reduced > your tax in the earlier year.
To all:
There are two circumstances where a state income tax overpayment in a year the AMT is paid can produce a tax benefit:
1. The state income tax overpayment causes more of the capital gains to be taxed at the lower tax rate and fewer of the capital gains to be taxed at the higher rate. See page 2 of Form 6251. For tax years 1997 through 2007 the tax benefit would equal 10% of the overpayment. In 2008, the tax benefit would be 15% of the overpayment.
2. The state income tax overpayment causes a transition from paying the only the regular tax to paying the AMT. In this situation a portion of the refund would be taxable when the AMT is paid.
Cheers,
WDK
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On Mar 22, 8:50 pm, snipped-for-privacy@aol.com wrote:

What does "up to the amount of the deduction that reduced your tax in the earlier year" mean?

Sorry, I'm not following.
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On Mar 23, 12:16�am, " snipped-for-privacy@yahoo.com" <removeps-

Look at page 2 of Form 6251 for 2007. There you will find that capital gains may be taxed at either 5 or 15 percent.
For a taxpayer whose regular taxble income is taxed at a rate below 25 percent, the portion of long-term capital gains that constitute the difference between the threshold for the 25 percent tax rate and the taxpayer's regular taxable income, excluding capital gains, are taxed at 5 percent and the remainder are taxed at 15 percent.
Because state income taxes reduce regular taxable income, excluding capital gains, and thereby increase the portion of capital gains taxed at 5 percent and reduce the portion taxed at 15 percent, there is a tax benefit equal to 10 percent a state income tax overpayment that reduced the portion of capital gains taxed at 15 percent.
The tax benefit will be revealed by the instructions in Publication 525 that were cited above.
Cheers,
WDK
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wrote:

Zero, since the tax isn't deductible under AMT. The tax benefit rule applies in full.

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> > �year the AMT is paid can produce a tax benefit:
> > �1. �The state income tax overpayment causes more of the capital gains > > �to be taxed at the lower tax rate and fewer of the capital gains to > > be �taxed at the higher rate. See page 2 of Form 6251. For taxyears 1997 > > through 2007 thetax�benefit would equal 10% of the overpayment. In 2008, thetaxbenefit > > �would be 15% of the overpayment.

> Sorry, I'm not following.

Stussy:
You are right, the tax benefit rule does apply, but zero is not the answer under the scenario that I described. Here is why.
State income taxes are deductible in determining regular taxable income.
Regular taxable income is used to determine the long-term capital gains portion of the AMT.
When the regular taxable income (excluding long term capital gains) was below the threshold for the 25 percent tax rate, about $63,700 for MFJ for 2007, the long-term capital gains rate was 5 percent. When regular income plus capital gains exceeded the threshold for the 25 percent tax rate, the excess capital gains were taxed at 15 percent.
Thus, a state income tax overpayment in a year the AMT is paid can produce a tax benefit because it can cause more of the long-term capital gains to be taxed at the lower rate and fewer of the capital gains to be taxed at the higher rate since itemized deductions impact regular taxable income and regular taxable income determines the portions of capital gains taxed at the higher and lower rates.
Hence, there is a tax benefit equal to 10 percent of the portion of long-term capital gains that was shifted from being taxed at the 15 percent rate to being taxed at the 5 percent rate by a state income tax overpayment.
In 2008, the benefit will be 15 percent of the portion of long-term capital gains that was shifted from being taxed at the 15 percent rate to being taxed at the 0 percent rate.
It may be helpful if you construct a dummy return that has regular taxable income excluding capital gains well below the threshold for the 25 percent regular tax and with several hundred thousands of dollars of capital gains so that payment of the AMT is required and then play around with the amount of state income taxes deducted. I learned about this a few years ago, after the fact, and the return was not a dummy return.
When you understand that a state income tax overpayment can produce a tax benefit when the AMT is paid, I will tell you about my experience at the "Closing the Tax Gap" symposium at Stanford Law School on November 8, 2008, when I raised the issue of IRS's treatment of state income tax refunds when the AMT is paid.
Cheers,
WDK
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On Mar 24, 7:42 pm, snipped-for-privacy@aol.com wrote:

Name = AMT State Filing Status = Single, 1 exemption State of residence = CA W2 = 50,000 Long term capital gain = 300,000 Federal tax withheld = 0 State tax withheld on W2 = 2,000 State tax estimated payments = 30,000
Itemized deduction after phaseout = 30,099 Exemption after phaseout = 2,333 Taxable income = 317,568 Tax = 44,988 AMT tax = 10,765 Net tax = 55,753
Now reduce the state tax by 1000 (make the estimated payment 29,000).
Itemized deduction after phaseout = 29,099 (less by 1000) Exemption after phaseout = 2,333 (same as before) Taxable income = 318,568 (more by 1000) Tax = 45,288 (more by 300) AMT tax = 10,615 (less by 150) Net tax = 55,903 (more by 150)
So the extra deduction $1000 for state tax did make a difference. Amazing!
So if you get a refund of $1000, how much of the refund is taxable?
It seems reasonable to me that because the $1000 took $300 off the regular tax but added $150 back through AMT, the benefit from AMT was 50%, so only 50% of the refund should be taxable. Say someone deducted $10000 of state tax and got a mere $1 benefit, then if they get a refund of $5000, does it seem right that the full $5000 is taxable? Maybe I'm stretching it, but "to the extent" below seems to support my ratio idea :). The OP said that his tax program claimed the entire refund was 100% taxable.
<Quote source="http://www.law.cornell.edu/uscode/uscode26 / usc_sec_26_00000111----000-.html">
(a) Deductions Gross income does not include income attributable to the recovery during the taxable year of any amount deducted in any prior taxable year to the extent such amount did not reduce the amount of tax imposed by this chapter.
</Quote>
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On Mar 31, 12:39�am, " snipped-for-privacy@yahoo.com" <removeps-

Good work!

It depends! See answer below.

Sorry, that is now how it works. See explaination below.

If the taxpayer were similarly situated in the refund year, i.e. required to pay AMT and have regular taxable income, excluding LT capital gains below the 25% tax rate threshold, the $1000 refund entered on line of Form 1040 would increase the total tax by $150. What happens is that the $1000 refund entered on Line 10 of Form 1040 causes an increase in regular taxable income, excluding LT capital gains, of $1000. This reduces the amount of LT capital gains taxed at 0% and increases the amount taxed 15%, thus there is a $150 increase in taxes, which is just the opposite of what happened in the year of the overpayment.
The refund entered on Line 10 of Form 1040 is carried over in the amount entered on Line 1 on Form 6251. On Line 8 of Form 6251 (2008) the $1000 entered on Line 10 of Form 1040 is subtracted in determining AMTI. Thus, AMTI does not change regardless of whether the $1000 is added on Line 10 or not. The $150 increase in tax attributable to the refund is all related to the Increase in the capital gains portion of the AMT as shown on Page 2 of From 6251.
If the taxpayer is required to pay the AMT again in the refund year and the $1000 refund does not reduce the capital gains taxed at 0% and increase the capital gains taxed at 15% because the taxpayer's regular taxable income, excluding capital gains, is above the threshold for the 25% tax rate, the taxpayer's tax would not increase with or without the $1000 refund included on Line 10 of Form 1040. Thus, the taxpayer receives an overall benefit of $150 when fully accounted. This result is consistent with the IRC. It is the AMT equivalent of overpaying a state income tax in a year the marginal tax rate is 25 percent and reporting the refund in a year the mariginal tax rate is 15%. It is a "rate thing" and that is not taken into account by section 111(a) of the IRC which you have cited above.
However, if the taxpayer pays only the regular tax in the refund year, he will be taxed at the regular tax rate on the refund based on IRS instructions. Thus, the taxpayer would have to pay the regular tax on the refund after paying the AMT on the income used for the overpayment in the prior year. The problem with this is that IRS instruction violates Section 111(a) of the Internal Revenue Code.
Based on the language in section 111(a) of the IRC, the only increase in tax allowed in a year the regular tax is paid as a result of a refund of a tax overpayment that produced a tax benefit a year the AMT was paid (not considering a state income tax overpayment that would cause a transition from paying the regular tax to paying the AMT) is that which would result from an increase in the capital gains portion of the regular tax. Of course this would require that the refund cause more of the capital gains to be taxed at the higher capital gains rate, i.e. 15% and less at the )% rate for 2008.
Now consider what happens BASED ON IRS INSTRUCTIONS when the taxpayer gets the full benefit of a state income tax overpayment when paying ONLY the regular tax in the overpayment year and then pays the AMT in the refund year. The taxpayer gets the tax benefit from the overpayment and then is instructed to exclude the tax refund from AMTI in a year the AMT is paid. The income used for the overpayment is offset by the deduction of the overpayment and then the refund is added on From 1040 and subtracted on Form 6251 in the other. Thus the income/refund related to the state income tax overpayment is never taxed directly. Compare IRS the instruction that excludes ALL refunds of state income taxes that were allowed as itemized deductions in a year the regular tax was paid under section 164(a)(1-3) of the IRC with the language in section 56(b)(1)(D). Take particular note of the reference in section 56(b)(1)(D) to "No recovery of any tax to which subparagraph (A)(ii) applied" and the fact that IRS instructions makes no distinction between taxes to which subparagraph (A)(ii) applied and taxes to which section 164(a)(1-3) applied.
Here are sections 164(a)(1-3) and 56(b)(1)(A-D) of the IRC.
<quote>
Sec. 164. Taxes (a) General rule Except as otherwise provided in this section, the following taxes shall be allowed as a deduction for the taxable year within which paid or accrued: (1) State and local, and foreign, real property taxes. (2) State and local personal property taxes. (3) State and local, and foreign, income, war profits, and excess profits taxes.
<close quote>
<quote>
Sec. 56. Adjustments in computing alternative minimum taxable income b) Adjustments applicable to individuals In determining the amount of the alternative minimum taxable income of any taxpayer (other than a corporation), the following treatment shall apply (in lieu of the treatment applicable for purposes of computing the regular tax): (1) Limitation on deductions (A) In general No deduction shall be allowed - (i) for any miscellaneous itemized deduction (as defined in section 67(b)), or (ii) for any taxes described in paragraph (1), (2), or (3) of section 164(a). Clause (ii) shall not apply to any amount allowable in computing adjusted gross income. (B) Medical expenses In determining the amount allowable as a deduction under section 213, subsection (a) of section 213 shall be applied by substituting "10 percent" for "7.5 percent". (C) Interest In determining the amount allowable as a deduction for interest, subsections (d) and (h) of section 163 shall apply, except that - (i) in lieu of the exception under section 163(h)(2)(D), the term "personal interest" shall not include any qualified housing interest (as defined in subsection (e)), (ii) sections 163(d)(6) and 163(h)(5) (relating to phase-ins) shall not apply, (iii) interest on any specified private activity bond (and any amount treated as interest on a specified private activity bond under section 57(a)(5)(B)), and any deduction referred to in section 57(a)(5) (A), shall be treated as includible in gross income (or as deductible) for purposes of applying section 163(d), (iv) in lieu of the exception under section 163(d)(3)(B)(i), the term "investment interest" shall not include any qualified housing interest (as defined in subsection (e)), and (v) the adjustments of this section and sections 57 and 58 shall apply in determining net investment income under section 163(d). (D) Treatment of certain recoveries No recovery of any tax to which subparagraph (A)(ii) applied shall be included in gross income for purposes of determining alternative minimum taxable income.
<close quote>
Now check this out! If IRS instructions are followed, both the income used for the state income tax overpayment and the refund of the overpayment are be used to reduced medical expense deductions regardless of whether the regular tax or AMT is paid. Obviously what we have here are sections of the IRC that are FUBAR in the translation by IRS into Forms and Instructions.
Cheers,
WDK
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pomegranate-man wrote:

Was it an unreasonable amount based on income during the year? There's probably some leeway, but an extreme overpayment could attract unwanted attention.
Since estimated payments are required quarterly but refunds are only issued annually, there is some opportunity for gaming the system, but I don't think the rate of return is all that impressive.

If subject to AMT again in 2009, the refund will be excluded from the AMT calculation. If not, you could probably perform such a calculation.
-Mark Bole
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in article Xns9BCDA48E179E5PJJGFZPLIpomegranate@85.214.105.209, pomegranate-man at snipped-for-privacy@emailNot.invalid wrote on 3/13/09 7:37 PM:

Actually most tax software, including Turbotax has a state tax refund worksheet and a carryover worksheet to bring over data from the prior year. In 2009, this worksheet will know that the taxpayer was subject to AMT from the carryover worksheet. The state tax refund worksheet will ask you if you want to "recalculate AMT" but does not really say how to do it. I go back to the prior year return, find a W-2 where most of the state tax was withheld and put a negative entry in the amount of the state refund on the W-2, right under the original state tax withholding. The software will scream about the negative entry but it works. I print page 2 of the form 1040 before and after. The adjusted tax and AMT are the 2 numbers you need for the 2009 state tax worksheet. Be sure you don't save the adjusted prior year return.
Of course, if you did not prepare the prior year, finding all the information you need to fill in the state tax worksheet is probably not worth the trouble. Uncompensated advice guaranteed correct or double your money back
Frank S. Duke, Jr. CPA Cincinnati, OH USA
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