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George Saenz, the Bankrate.com Tax Talk columnist Taxability of state income tax refund

Dear Tax Talk,
Why does the state tax refund of the previous year become income for the following year that is taxed again at the end of the following year? Is it double taxing? The federal tax refund is not considered as income for the following year.
-- Ann

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Dear Ann,
The difference between federal and state taxes is that your state income taxes are deductible on your federal return and your federal taxes are not. If your itemized deductions in 2005 included state income taxes, then a refund or overpayment of your state income taxes on your 2005 state tax return is considered a recovery of a tax benefit in 2006. A tax benefit recovery is similar to income to the extent it reduced your federal income taxes in the prior year.

Even though you itemized your deductions in 2005, you may not have reduced your federal taxes by the full amount of your state income tax refund. For example, if you were subject to alternative minimum tax on your federal tax return in 2005, the state income tax deduction may not have benefited you fully and hence may not be income to you in 2006. If you did not itemize in 2005, the state refund is definitely not income in 2006.

The taxable portion of your state income tax refund can differ from the amount reported by the state on Form 1099-G. The taxable portion of your refund is reported on Line 10 of your 2006 Form 1040. The Form 1040 instructions, for line 10 which start on page 24, lists nine exceptions to reporting all or part of the refund as taxable. Most tax programs that are used year in and year out carry over the taxable portion of a state tax refund; otherwise the determination will require you to refigure your taxes in the prior year to determine the benefit you obtained.  My suggestion is that if you have a state income tax refund, use a computer tax program to help in figuring the taxable part of the recovery.

To ask a question on Tax Talk, go to the "Ask the Experts" page and select "taxes" as the topic.

Bankrate.com's corrections policy-- Posted: Feb. 15, 2007
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