Every year when
clients send their "tax stuff" I invariably get a sticky note on the 1099-G from
the state. The note usually says "what's this?" First, I should tell you that
the 1099-G is used by states to report your state tax refund from the prior year.
Therefore, if your 2006 tax return indicated that you overpaid your state taxes
by $100, you will receive a 1099-G this January indicating that the state tax
refund may need to be reported on your current year's tax return.
In
taxes, this is called the Tax Benefit Rule. If you receive a deduction for something,
and later "recover it", then you must put it back into income. Therefore, if you
itemize deductions and take all of the state payments you made during the year
as a deduction, if you overpaid your state tax, you have technically taken too
many deductions.
Example:
In April of 2007 you
had to pay your state $505 of tax on your 2006 tax return. During 2007 you had
$3,546 of state tax withheld from your pay. On your 2006 tax return you would
be entitled to a deduction for state taxes paid during 2007 of $4,051.
The
$3,546 would go on your state tax return as taxes withheld. Let's assume your
tax for 2007 is $3,361. Your 2007 tax return that you are preparing in 2008 would
show that you are entitled to a refund of $185. If all goes well with your state
filing, you will receive a check for $185 some time during 2008.
That
$185 was part of the $3,546 you had withheld during 2007 — and took as a
deduction. But your "real" deduction should have only been for $3,176 —
because in the end you overpaid by that amount. But tax return preparation is
too hard now — so imagine if you had to keep going back and forth to Schedule
A (Itemized Deductions) and change it every time you played with your state return.
That would be nightmare.
Therefore,
if you itemized deductions last year, and received a deduction for your state
income taxes paid during that year, and received a refund — the refund amount
goes on Line 10 of your Form 1040 as income. If you did not itemize deductions,
you did not receive a tax benefit from your state tax payments and the refund
is not income and is not included on your Form 1040 this year.
Other
Recoveries
The state tax
refund is the most common form of the Tax Benefit Rule for individuals, but there
are other situations where this rule may affect you.
For
instance, you may have had damages to your rental property. You repaired the damages
and took the deduction for the repairs on your current year's tax return. You
then filed a lawsuit against your former tenant and later collected all or part
of the repair bill. The amount collected would be included in income in the year
you receive it. If you had collected the money in the same year as the repairs,
you would have reduced the repair costs by the amount paid by the tenant —
and had less of a deduction. If you collect in a later year, after having taken
the full deduction, the recovery can only be income to you.
Another
example would be payments received in a later year from your health insurance
company for medical expenses for which you received a deduction. Be careful on
how much you report as income. Medical expenses are subject to a 7.5% of AGI reduction,
and the reimbursement is only income to the extent of the deduction you actually
received.
I know you will
still send those "huh?" stickies with your tax return information — but
maybe now you can move it to the 1099-OID. If you would like further information regarding this topic or any other tax related issue, please contact The Henssler Financial Group Tax & Accounting Division at 770-428-4025.
