Question

Exercise 5-26 (Algorithmic) (LO. 3)

Apply the tax benefit rule to determine the amount of the state income tax refund included in gross income in 2020.

If an amount is zero, enter "0".

a.  Myrna and Geoffrey filed a joint tax return in 2019. Their AGI was $79,825, and itemized deductions were $31,800, which included $25,440 in state income tax and no other state or local taxes. In 2020, they received a $15,264 refund of the state income taxes that they paid in 2019. The standard deduction for married filing jointly in 2019 was $24,400.
$

b.  Veronica filed as a single taxpayer in 2019. Her AGI was $238,000, and itemized deductions were $45,300. Her local property taxes were $14,700 and her state income taxes were $19,100. In 2020, Veronica received a $3,800 refund of the state income taxes she paid in 2019. The standard deduction for single filers in 2019 was $12,200.
$

Answer 1

The Tax Benefit Rule states that if an amount of expense incurred in a previous year is recovered in the current year, then the amount recovered must be included in the income in the year of recovery. The refund of state income tax refunds is the most common example of the applicability of the Tax Benefit Rule. The rule applicable in case of state income tax refunds is that if If a taxpayer has claimed state and local income taxes in a previous year as an itemized deduction, she will need to pay taxes on her state income tax refund in the current year. The amount of her state tax refund from the previous year will then be included in her gross income in the current year. But if the taxpayer chose to claim only standard deduction in a previous year and did not claim state and local income taxes as itemized deductions, she will not need to pay taxes on her state and local tax refund in the current year.

a. Myrna and Geoffrey filed a joint tax return in 2019 in which they claimed itemized deductions of $31,800, including $25,440 in state income tax paid. Hence, whole of their tax refund $15,264 will have to be included in their gross income in 2020 since it was expensed in the previous year 2019.

b. In case of return filed by Veronica, the question is silent about whether itemized deductions of $45,300 included state income tax and local property taxes paid. But considering the amount of her itemized deductions, it is reasonable to presume that the itemized deductions she claimed included state income tax and local property taxes paid. Hence, her tax refund $3800 will have to be included in her gross income in 2020.

A note for the student: As the question is silent about whether itemized deductions including state income tax and local property taxes, please note that if Veronica had claimed only standard deduction in 2019 and did not claim state income tax and local taxes paid, then her tax refund $3800 will not be includable in her gross income in 2020.