Federal income tax on state income tax refund

Yes. See Publication 525.

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

Not necessary. AMT means no deduction, so its refund in 2009 is not recognized.

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

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

snipped-for-privacy@bde-arc.ampr.org

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?

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

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.

Thanks to all who replied.

I found the relevant part of Publication 525:

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.

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.

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

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

if when we remove a state tax deduction, the regular tax increasesby 487 and the AMT tax decreases by 469, then it seems logical thatthe benefit from the deduction was (487-469)/487 which is 3.6961%, soonly 3.6961% of the recovery should be taxable.

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.

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:

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:

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.

1. 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

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

Sorry, I'm not following.

thetaxbenefit

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

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

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

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.

(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.