Robbe, a cash basis single taxpayer, reported $50,000 of adjusted gross income last year and claimed itemized deductions of $5,500, consisting solely of $5,500 of state income taxes paid last year.

Robbe's itemized deduction amount, which exceeded the standard deduction available to single taxpayers for last year by $1,150, was fully deductible and it was not subject to any limitations or phase-outs.

In the current year, Robbe received a $1,500 state tax refund relating to the prior year. What is the proper treatment of the state tax refund?

a. Include none of the refund in income in the current year.

b. Include $1,150 in income in the current year.

c. Include $1,500 in income in the current year.

d. Amend the prior-year's return and reduce the claimed itemized deductions for that year.

Solution:

Rule: IRC Section 111 provides that gross income does not include income attributable to the recovery during the taxable year of any amount deducted in any prior taxable year to the extent such amount did not reduce the amount of tax previously imposed (the tax benefit rule).

Choice "b" is correct. Under the tax benefit rule, an itemized deduction recovered in a subsequent year is included in income in the year recovered. In this question, only $1,150 of the state income taxes was actually deducted as an itemized deduction last year. The recovery is thus limited in the amount actually deducted (and not to the entire amount of the state tax refund).

Choice "a" is incorrect. The amount deducted, not $0, is included in income in the current year.

Choice "c" is incorrect. The amount originally deducted, not necessarily the entire amount of the refund, is included in income in the current year.

Choice "d" is incorrect. The amount deducted is included in income in the current year. There is no necessity to amend the prior year's return.

  (Source: Questions and answers published by AICPA)