Some states relent on taxation of federal tax rebates
By Kay Bell • Bankrate.com®

No good tax break goes unpunished. That's the sentiment of some state taxpayers who may end up sending a portion of their federal tax rebate money to state tax collectors.

Nine states, according to Federation of Tax Administrators data, allow residents to deduct at least a portion of their federal tax payments to help reduce their state income tax liability. In eight of these states, if taxpayers claimed the federal tax deduction to reduce last year's state bills, they would have to report the rebate, based on taxes paid last year, as taxable income received this year.

Just where do the unlucky taxpayers live? Iowa, Louisiana, Missouri, Montana, North Dakota, Oklahoma, Oregon and Utah.

Facing upset taxpayers, five states -- Iowa, Missouri, Oklahoma, Oregon and Utah -- recently took steps to protect the federal money from state tax collectors. In Alabama, where taxpayers also can use federal taxes to reduce state tax bills, a spokesman for the governor's office notes that the state's tax method will keep the federal refunds free from state taxation.

Iowa's move to exempt the rebates was prompted by the numbers crunched to illustrate the dollar effect of the rebate -- and state collection -- on taxpayers there. Brent Siegrist, Iowa's Speaker of the House, says preliminary estimates are that $38.2 billion will be rebated nationwide.

Based on 1998 numbers, Iowa pays 1.06 percent of the national tax returns. Assuming Iowa receives that percentage in projected rebate dollars, its taxpayers would get back $404.9 million. If all of the rebates are taxed at a 5 percent marginal rate (roughly the average of Iowa's tax range of 0.36-to-8.98 percent), it will cost Iowans $20.2 million in added state taxes.

On a case-by-case basis, the actual dollar cost to many state taxpayers would be relatively small and perhaps not worth worrying or fighting about. That seems to be the attitude in Louisiana, Montana and North Dakota, where the rebates may marginally hike state tax bills.

But to others, the amount isn't as important as the principle. The prospect of taxpayers getting cash from Uncle Sam and then giving part of it back to local tax collectors moved lawmakers in the other affected states to exempt the federal rebate money from state collection.

-- Updated: July 23, 2001