How to Determine whether Your State or Local Income Tax Refund is Taxable

If you received a state or local income tax refund, you may or may not have to include it as taxable income on your tax return. Here are two steps to help you determine whether your state or local income tax refund is taxable.

Step 1: Check whether you took state and local income tax deduction in the year you paid taxes.

Your state and local income tax refund is taxable only if you took state and local income tax deduction on line 5 of Schedule A, Form 1040 in the year you paid taxes. If you took standard deduction, or sales tax deduction on Schedule A, your refund is not taxable.

For example, if you received a state income tax refund for year 2014, you should check your 2014 federal income tax return to see if you took any state and local income tax deduction on line 5a of Schedule A. If nothing is reported on Line 5a, or you took standard deduction (no Schedule A was filed), your refund is not taxable.

Go to Step 2 to determine taxable amount of your state and local income tax refund if you took state and local income tax deduction on line 5 of Schedule A in the year you paid taxes.

Step 2: Determine taxable amount of your state and local income tax refund.

Generally, if you received a state or local income tax refund in 2015 for tax you deducted on your 2014 return, you can use Worksheet 1 to calculate the taxable amount of your refund. However, if you meet any of the exceptions listed below, you must either use Worksheet 2  to calculate your taxable refund or recompute your prior year tax liability or deduction to figure how much your refund is taxable.

Note 1: Follow the steps below to figure your taxable refund if you owed alternative minimum tax.

1. Reduce the state and local income tax you deducted by the amount of refund and refigure your total tax liability ( both regular and AMT tax) for the earlier year.

2. If your total tax liability does not change, your state refund is not taxable.

3. If your total tax liability increases, your taxable refund is the increased tax amount divided by your earlier year's tax rate.

Note 2: Follow the steps below to figure your taxable refund if you had unused tax credits.

1. Reduce the state and local income tax you deducted by the amount of refund and refigure your total tax liability (after applying credits) for the earlier year.

2. If your total tax liability does not change, your state refund is not taxable.

3. If your total tax liability increases, your taxable refund is the increased tax amount divided by your earlier year's tax rate.

Note 3: Follow the steps below to figure your taxable refund if your itemized deductions was limited.

1. Reduce the state and local income tax you deducted by the amount of refund and refigure your total itemized deduction for the earlier year.

2. Compare the standard deduction with the total itemized deductions from step 1 and choose the greater one as your deduction for the year.

3. Subtract the amount you choose from step 2 from the total itemized deductions you actually deducted from earlier year. The difference is your taxable refund.

4. If your taxable income for the earlier year was a negative amount, reduce your taxable refund by the negative amount.

For more information, please see Instructions for Form 1040, U.S. Individual Income Tax Return and IRS Publication 525, Taxable and Nontaxable Income.



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