If you have a situation where you must include in income an amount you paid and deducted in a previous year and then recovered please review the following information for more details on how to handle the situation.
This situation often arises in connection with state or local income tax refunds and medical expense reimbursements. The answer depends on whether you received a 'tax benefit' when the amount was originally paid. If you didn’t, the recovery is tax-free. If you did, then all or part of the recovery will be taxed, depending on the tax benefit you received. This principle is known as the 'tax benefit rule.' The idea is: if you didn’t benefit through tax savings when the amount was paid, you shouldn’t incur a tax cost when it’s recovered.
No tax benefit when paid. The simplest case in which the recovery is tax-free arises where you didn’t itemize deductions in the year you originally paid the amount. Say you and your spouse paid state income taxes of $2,000 in 2011 but didn’t itemize deductions because your total itemized deductions didn’t exceed the standard deduction then available. If you receive a state income tax refund in 2012, say, of $800, you don’t include any of it in your 2012 income.
Full tax benefit when paid. At the opposite extreme, if every dollar recovered had been deducted when originally paid, the recovery is fully taxable. Suppose, for example, you and your spouse paid $5,000 in state taxes in 2011 and claimed itemized deductions totalling $15,000. If you receive a state tax refund of $1,000 in 2012, you must include it all in your 2012 income. Here, when you paid the 'extra' $1,000 to the state in 2011, it increased your deduction on your federal tax return by a full $1,000, from $14,000 to $15,000. Thus, the entire amount recovered had given you a tax benefit when originally paid.
Partial tax benefit when paid. In some cases, the amount you recover may be only partially included in income for the year of recovery. This occurs where only part of it resulted in a tax benefit when originally paid.
Example: Tom and Sue filed jointly in 2011. They claimed a total of $12,150 in itemized deductions, which included $3,000 in state income taxes paid. In 2012, they receive a state income tax refund of $1,000. If they had not paid this 'extra' $1,000 in 2011, their total itemized deductions would have been $11,150. In that event, they would have taken the standard deduction ($11,400) instead of itemizing. Accordingly, the extra $1,000 of state taxes paid in 2011 only increased their deductions by $250: from $11,150 to $11,400. Thus, when they received their $1,000 refund, only $250 of it is taxable.
When you recover an amount paid in an earlier year, don’t automatically assume it’s fully taxable. Many individuals mistakenly include their entire state tax refund in income without checking to see if it’s partly or entirely excludable. The same holds true for medical expense reimbursement or any recovered amount. Review your tax situation for the year in which the recovered amount was originally paid. To the extent paying the amount didn’t generate a tax benefit, its return shouldn’t result in a tax detriment.
If you would like me to assist you in determining the proper tax treatment of a recovered amount, or wish to discuss this area further, please call.
Very truly yours,
Dean Holland, CPA