Overpay state tax on purpose to get a higher federal refund

He has misinterpreted the intent & purpose of the instructions. He will get a bill some time before 4/15/2011 interest & penalty on top of the income taxes due on the under reported SITR (State Income Tax Refund)

How does that worksheet lead him, or you, to conclude that the refund is not taxable? The refund would be taxable. He is probably doing something wrong on the worksheet. In 2008, when he files for 2007, the worksheet will refer to his 2006 tax return, not his 2007 tax return, just as it now refers to 2005 when you are filing for 2006. The worksheet is based on the year you took the deduction, not the year you got the refund. Is that the misunderstanding? Bob Sandler

I'm not a tax pro, but I think the wheels come off the wagon at this step. Your friend should check his math.

-- Vic Roberts Replace xxx with vdr in e-mail address.

not taxable, at least according to the "State and Local

He's making a mistake on the worksheet.

-- D.F. Manno | snipped-for-privacy@mail.com Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning. ­ Winston Churchill

I think he needs to re-read the instructions.

The instructions are applying the tax benefit rule, and since he received the benefit from itemizing his 2006 deductions, the refund of his 2006 state tax will be taxable. __ Art Kamlet ArtKamlet @ AOL.com Columbus OH K2PZH

He'll lose the audit when they challenge the overpayment.

Seth

This where his "plan" falls apart. The refund, to the extent that he got a tax benefit from it the previous year IS taxable in the year of the refund. Tell him to read the instructions again.

Oh, it's taxable alright. The 1040 instructions are not being understood correctly. Since he itemized in 2006 (the year he paid the state tax) and got a tax benefit, the refund will be taxable in 2007 (whether or not he itemizes in 2007 is irrelevant). There are some detailed rules regarding the difference between what he could have deducted and what he actually did deduct, but in the end, rest assured this loophole has been thoroughly closed. There can be some net benefit if he knows that his marginal tax rate will drop next year, since the deduction this year could offset, say, 25% tax-rate income while the refund might be taxable the following year at only 15%. But I've also heard that CA tax authority sniffs this out and might question the unjustified overpayment. Ironically, until recent changes, when selling non-residential real estate, the CA taxing authority forced this situation themselves, by requiring withholding on the sale that typically would far exceed the actual tax due.

-Mark Bole

He's completing the worksheet incorrectly. To the extent the excess $5000 payment reduces his 2006 taxes, the refund becomes taxable in 2007. State income tax refunds are not taxable when you did NOT itemize the previous year. Ira Smilovitz

No, this won't work. He will get a 2007 1099G from California documenting his refund, which will have to be added back to his income on his Federal tax return because he itemized in 2006. So he will pay federal tax for it on his 2007 return. But CA doesn't tax refunds, so it will be subtracted from his CA return. But CA also doesn't allow state tax paid as an itemized deduction, so when he filed his 2006 return, he had to subtract the $5,000 from his itemized deductions in the first place. So all he has done is delay paying tax on the $5,000 from the 2006 return to the 2007 return. Dennis

Look at the TIP in the instructions:

"None of your refund is taxable if, in the year you paid the tax, you either (a) did not itemize deductions, or (b) elected to deduct state and local general sales taxes instead of state and local income taxes." He DID itemize deductions in the year he paid the tax, so it is taxable. I guess that it's possible, if you know that your income the next year will be much lower, to overpay your state tax to increase the deduction, then pay tax on the refund the next year at a lower rate. I'd be surprised if the IRS doesn't have some sort of limitation on this sort of income shifting.

Well, I think you can poke some holes in it if you put some numbers into the state & local income tax refund worksheet. The refund will be taxable income in 2007 to the extent his total 2006 itemized deductions (including the extra $5,000 in state income tax), as limited by his 2006 AGI, exceed the

2006 standard deduction. (So plug in $5,150, etc. in place of $5,000, etc. on Line 3 of the worksheet.) In other words, the refund will be taxable income in 2007 to the extent he gets a tax benefit from the deduction in 2006. It's still a deferral, of course.

The deduction may be disallowed by the IRS to the extent that it does not reflect a reasonable estimate of the state tax due on his 2006 return. See, e.g., PLR 8222009,

2/26/1982. Katie in San Diego

Your friend has it figured incorrectly. To use the examples of the 2005 tax year Form 1040, to the extent that his itemized deductions exceeded $5,000 (assuming he's single, and not head of household), the portion of his state income tax refund that is taxable in 2006 for federal income tax purposes is the lesser of (a) his actual tax refund, or (b) the excess of his itemized deductions over $5,000. Since he'd have made state income tax payments in excess of $5,000, and since he itemized, his allowable itemized deductions from line 28 of Schedule A (2005 Form 1040) would have been at least $5,000. Thus, he would have had to answer "YES" to the question on line 6 of the worksheet. For example, assume that he paid california taxes of $6,000, plus the additional $5,000 at year-end. Also assume that he had other allowable itemized deductions of $2,050, for total allowable miscellaneous deductions of $13,050 for 2005. In

2006 he would receive a check from California for $5,000 along with a Form 1099-G (a copy of which goes to the IRS). Going through the worksheet, and assuming that he is single, not blind or over 65, he would have the following entries: Line 1: $5,000 Line 2: $13,050 Line 3: $5,000 Line 4: "NO," -0- Line 5: $5,000 + $0 = $5,000 Line 6: "YES," $8,050 ($5,000 is less than $13,050 and line 2 minus line 5 = $13,050 - $5,000 = $8,050) Line 7: $5,000 (smaller of line 1 or line 6 - $5,000 is smaller than $8,050)

Thus, the TAXABLE PART of your friend's refund would be $5,000. In other words, the entire amount of the excess that he paid over to California in December.

Hard to believe the $5,000 isn't taxable for 1040 purposes. If he itemized for 2006, that's what's used on the worksheet, not 2007. Your co worker could spend his time selling the idea if it would work. Jeff Berk Jenkintown, PA

I wouldn't be so sure about that. It looks an awful lot like a §1092 straddle to me.

Stu