When Is a State or Local Tax Refund Taxable?

A state or local tax refund is a payment received when the amount of tax paid to a state or municipality exceeds the actual amount owed. This overpayment often occurs when an employer withholds too much from an employee’s paychecks, from making estimated tax payments that are higher than necessary, or from qualifying for state-level tax credits that reduce the final tax liability after payments have been made.

Determining if Your Refund is Taxable

The taxability of a state or local tax refund on your federal return hinges on the “tax benefit rule.” If you received a federal tax advantage in a prior year for paying state and local taxes, your subsequent refund of those taxes may be considered taxable income. The determining factor is whether you chose to itemize your deductions or take the standard deduction on your federal tax return for the year the taxes were originally paid.

If you claimed the standard deduction on your federal return, your state tax refund is not taxable. The standard deduction is a fixed dollar amount that is not affected by the specific amount of state and local taxes you paid. Since you did not receive a federal tax deduction for those payments, the refund is a non-taxable return of your money.

Conversely, if you itemized your deductions on the prior year’s federal return, your state tax refund might be taxable. By itemizing, you deducted the amount of state and local taxes you paid, which lowered your federal taxable income for that year. Because you received this tax benefit, the IRS requires you to report the refund as income in the year you receive it.

This rule applies to refunds of state and local income taxes. If you chose to deduct state and local general sales taxes instead of income taxes when you itemized, your state income tax refund is not taxable. Since you did not receive a federal tax benefit for deducting income taxes, the refund of those taxes does not need to be reported as income.

Calculating the Taxable Amount

If a state tax refund is potentially taxable because you itemized, you must calculate the exact amount to include as income. The taxable portion of your refund is the lesser of the actual refund amount you received or the tax benefit you gained from the deduction in the prior year.

To begin the calculation, you must compare the total itemized deductions you claimed in the prior year with the standard deduction amount you were eligible for in that same year. The tax benefit is the amount by which your itemized deductions exceeded the standard deduction.

A factor in this calculation is the State and Local Tax (SALT) deduction limit. Federal law caps the amount you can deduct for state and local taxes at $10,000 per household per year. For example, if you paid $12,000 in state income taxes but could only deduct $10,000 due to the SALT cap, the first $2,000 of any state refund you receive is not taxable because you never received a federal tax benefit for paying it.

For example, assume a single filer’s total itemized deductions were $16,500, including the maximum $10,000 SALT deduction, while the standard deduction was $15,000. The tax benefit from itemizing was $1,500. If this person receives a state tax refund of $2,000, the taxable portion is limited to $1,500, the amount of the tax benefit. The IRS provides a worksheet in Publication 525, “Taxable and Nontaxable Income,” to guide this calculation.

Reporting the Refund on Your Federal Return

After determining that your state tax refund is taxable, you must report it correctly on your federal income tax return. State governments issue Form 1099-G, Certain Government Payments, to any individual who received a tax refund. The form reports the total amount of the refund, usually in Box 2.

The amount shown on Form 1099-G is the total refund, not necessarily the taxable amount. You should not automatically report the full figure from Box 2 as income. Instead, use the calculation based on your prior-year return to determine the taxable portion to report.

The taxable amount of the state refund is reported on Schedule 1 of Form 1040, as “Taxable refunds, credits, or offsets of state and local income taxes.” This amount is then included in your total income on the main Form 1040.

If you believe the refund amount on your Form 1099-G is incorrect, contact the state agency that issued it to request a corrected form. If you received a taxable refund but did not get a Form 1099-G by mid-February, you are still responsible for reporting the taxable income. You should contact the state taxing authority to obtain the necessary information.