Federal income tax on state income tax refund

pomegranate-man · 2009-03-13T23:37:26+00:00

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.

On Mar 31, 12:39?am, " snipped-for-privacy@yahoo.com" wrote:

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.

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.

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.

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