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TurboTax and TaxCut disagree over whether state income tax refund is taxable. Who's right?

Hi all:

I took the standard deduction in my 2007 Federal income tax return. In 2008 I will itemize.

In January, 2008 I paid my 4th quarter estimated state income taxes, but I got a refund of state income taxes after filing in April.

Grinding this information into TurboTax along with all the other income/adjustment/deduction items results in TurboTax reducing by a small amount the state income tax deduction I would otherwise expect. That is, there's no entry on line 10 of my 2008 Form 1040 but there's a reduction of the amount of state income taxes I paid in 2008 on line

5 of Schedule A.

Doing the same exercise in TaxCut results in TaxCut declaring that no portion of the refund is taxable. No entry appears on line 10 of Form

1040 and there's no reduction of state income taxes I paid in 2008 on line 5 of Schedule A.

Naturally, I like TaxCut's answer more that TurboTax's, but I have a feeling that TurboTax's answer might be the right one. There's a certain logic to reducing a deduction in the year you both pay deductible state income taxes and receive a state income tax refund for the same tax year, but I know "logic" and "taxes" are words you don't use in the same sentence very often.

I went looking through the Form 1040 instructions, Publication 17 and Publication 525 and I still can't quite get a firm answer. The nearest comprehensive answer I found was this one in Pub 525:

"Tax benefit rule. You must include a recovery in your income in the year you receive it up to the amount by which the deduction or credit you took for the recovered amount reduced your tax."

All the examples and verbiage in Pub 525 speak to recoveries in the current tax year vs. deductions in the prior tax year but the rule as stated above doesn't really require this "2 different years" situation. That is, I get a benefit in 2008 for paying 2007 state taxes so the recovery in 2008 of 2007 state taxes has to be recognized, to a certain extent.

Is my thinking about this correct? Does TurboTax have the right answer in my situation, or am I mis-understanding the tax benefit rule and TaxCut has got it right?

TIA.

Tom Young

Reply to
TomYoung
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TurboTax is right.

The refund you received in 2008 is partly a refund of what you paid in 2007 and partly of what you paid in 2008. The part of the refund attributable to what you paid in 2007 is not taxable income because you didn't take an itemized deduction for state taxes in 2007. That's why there is nothing on Form 1040 line 10. But the part of the refund attributable to your January 2008 estimated tax payment reduces your deduction for 2008. You can't deduct the entire estimated tax payment because you got part of it back in the same year.

You need to read a little further in Pub. 525. The following is on the next page after the paragraph that you quoted.

"Recovery for 2 or more years. If you receive a refund or other recovery that is for amounts you paid in 2 or more separate years, you must allocate, on a pro rata basis, the recovered amount between the years in which you paid it. This allocation is necessary to determine the amount of recovery from any earlier years and to determine the amount, if any, of your allowable deduction for this item for the current year."

This is followed by a lengthy example in which the amount allocated to the current year, in which the January estimated tax payment was made, reduces the deduction for state taxes paid in the current year.

Bob Sandler

Reply to
Bob Sandler

Bob:

Thank you. I must say I was getting exhausted reading poorly-worded IRS instructions and publications (Form 1040 Instructions >

Publication 17 > Publication 525) and gave up a bit too soon.

Tom Young

Reply to
TomYoung

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  1. I don't know anything about TaxCut but am surprised if it cannot handle this situation correctly. It is far too common and basic to be overlooked. I suspect you may not have given it all the information it needs in the correct places.
  2. I wouldn't blame the IRS or their poorly worded instructions. I think actually they do a pretty good job. But it is very hard to document a mess, which is what the tax system is. The people to blame are the arrogant and ignorant people who write the laws.

Regards, Bob Taylor .

Reply to
Bob Taylor

I was surprised as you were and thought that I'd entered something wrong. But after looking at the input very carefully I'm convinced TaxCut has the right information. It knows I didn't itemize last year, it knows I'm itemizing this year, it knows I paid my last state estimated tax for tax year 2007 in 2008 and it knows I got a refund in

2008 on my 2007 state tax return. I just don't think it's missing anything to come to the right conclusion about my situation.

I tried 3 times via "chat" to discuss this with TaxCut but the customer reps (3 different) all insist that TaxCut is right and I don't have to recognize any portion of the tax refund. The reps are clearly program-oriented and not "tax" oriented. I was told "tax" folks would be available after January 5 and I may try again at that time.

Tom Young

Reply to
TomYoung

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