State Tax Refund/AMT/Recovery

[Randall]

Client (OH resident) sold property in MD in 2013.  MD required a large withholding on gross proceeds ($60k).  2013 Sch A included the $60k as a state tax deduction.  But this caused a large AMT also.  For 2014 return, reading instructions and Pub 525 seems wordy and confusing.  To recompute 2013 tax without the Sch A state tax deduction, I went to 2013 ATX, duplicated the return and backed out the $60k deduction.  This showed regular tax $17k more and AMT $12k less.  Total tax shows $5k more.  Am I correct that the amount to show on 2014 1040 line 10 would be limited to the $5k, the actual tax savings of the 2013 Sch A deduction for the state tax?

 

 

[SaraEA]

Randall, you're leaving out something here.  How much was the state refund?  If you just enter that amount into the input screen from the 1099G, the program should calculate the taxable amount.  In UltraTax, it adds a notation something like "no tax benefit due to AMT."  So if your client derived no benefit from deducting the state tax payment because of AMT, any refund should not be taxable.  It will depend on his other deductions and whatever else AMT disallowed, but the program should figure that out for you.  Let us know what the program ends up with.

[Randall]

Sara, I'm using ATX.  Going to the worksheet for Line 10 (2014 program), there is a line to manually input the amount of the limit if tax benefit was limited due to prior year AMT.  Without entering an amount there, the program automatically shows the full refund taxable.  UltraTax is one of the high end programs but ATX is not calculating the taxable amount, just showing the full refund as taxable unless I manually enter a limit on the Line 10 worksheet.

1040 instructions have a similar worksheet as ATX but says if prior AMT limited tax benefit, go to Pub 525.  Pub 525 is a little wordy in the section discussing the prior year AMT limitation.  I went to my 2013 ATX program and duplicated the 2013 return so I could play around with the Sch A tax deduction to see the tax and AMT outcomes.  With my original post, I was thinking the taxable limit of the refund would be the $5k tax increase but I don't think that's correct.  I went back to my 2013 duplicated return and entered different amount for the Sch A tax deduction to see when the total tax (Reg plus AMT) would change.  It appears the first $28k of the Sch A deduction causes no change in the tax.  But above that amount, there is a tax benefit.  In my case, the refund is $61k and the total tax paid to MD was $68k.  So now I'm wondering if $28k of the refund should not be taxable and the limit entered into my Line 10 worksheet should be $33k (61 minus 28).  It appears that the additional $33k Sch A deduction has resulted in the tax benefit ($5k).  Pub 525 says to go back to 2013 and recompute the tax.  If no change in tax, do not include recovery (refund) in 2014 income.  If recomputed tax increases, include the recovery (refund) up to the amount of the deduction that reduced your tax in the earlier year.  That's why I'm thinking $33k of the refund should be included in 2014 income.SA

 

 

 

[Abby Normal]

ATX does not limit taxable refunds to the tax benefit in AMT cases, you have to calculate manually as you have, and override on line 8 of the Ln 10 worksheet. I agree with your 5,000 limit.

[Randall]

ATX does not limit taxable refunds to the tax benefit in AMT cases, you have to calculate manually as you have, and override on line 8 of the Ln 10 worksheet. I agree with your 5,000 limit.

jmdaviscpa, you do agree that the tax amount (2013 tax savings $5000) being the limit of refund included in 2014?  My 2nd thoughts in my 2nd post was that the amount of the 2013 (Sch A deduction-$33,000) causing tax savings ($5000) would be the limit of the refund included in 2014.

[Randall]

Looking at PPC 1040 Deskbook, they have an example that takes the tax dollar benefit and divides by the tax rate to determine the amount of the refund that should be included in taxable income.  Their example is simple with the low tax rate of 15%.  If I take my $5k tax benefit from 2013 and divide by 28% (top marginal rate of 2013 return), I come up with about $18k to include in taxable income.  It sounds reasonable and I tested it by taking $18k income out of my recomputed 2013 return resulting in a close total tax outcome that my original 2013 return had.  Unless anyone has a more definitive  method, I think I'm going with this.  I'm including preparer comments with the efiling to show total 1099-Gs and amount I'm reporting as taxable.

[jklcpa]

When you receive a state or local tax refund of taxes that were included in Sch A in the prior year and were also subject to AMT, you recompute that prior year's income tax liability with the deduction reduced on Sch A by the amount of the refund you received.  If the resulting recomputed tax is lower or is unchanged, there was no tax benefit.  If the resulting recomputed tax is higher, as it is in your client's case, then the difference between the amount of total tax on the return as filed and the recomputed tax liability is the amount of the tax benefit that was derived by the deduction on that prior year's return, and is the amount of the refund that is taxable.

Example with made up numbers: Client's 2013 Sch A included $68K in state taxes paid.  Client's total tax liability for 2013 including AMT is $180,000. In 2014 $61K of state tax is refunded.   Recompute tax with only $7K of the state tax on Sch A (the 68K tax paid minus the refunded portion) and now total tax liability as recomputed is $180,018.  Because the resulting tax would have been $18K higher, the client received a tax benefit of $18K on the 2013 return as a result of that state tax deduction that was refunded in 2014, and therefore in this example, $18K of the state refund is taxable in 2014.

 

 

[Randall]

jklcpa, do you have a reference for that?  My first thought was as you say in your example.  That is, the amount of the actual tax benefit would be the includable portion of the refund.  But the wording in Pub 525 says that you include up to the amount of the 'deduction' that 'reduced' your tax in the earlier year.  The example PPC gives follows this method by taking the dollar amount of the tax benefit and dividing by the tax rate to get the amount to be included in income.  In other words (my thinking) is that since the Sch A deduction reduced income by that amount and didn't reduce tax dollar for dollar, so you don't simply include the tax benefit dollar amount in the following year in income but the amount of the deduction that reduced taxable income in the prior year.  That deduction then allowed the tax benefit.  So taking the tax benefit divided by the tax rate would seem to be the correct amount to include in the following year income.  I would like to include only the smaller amount but I'm thinking that is incorrect.

 

[jklcpa]

Here's a page from TaxAlmanac online that states virtually the same thing: http://www.taxalmanac.org/index.php/State_Income_Tax_Refunds_-_Tax_Benefit_Rule.html

Here's a page with a discussion about the tax benefit rule written by an attorney that practices in the areas of tax, estate and business planning that also describes the calculations in more depth. It is possible that my simplified example didn't go far enough if your client was on the borderline of whether or not he would be subject to the AMT with or without the higher deduction, and that could be an additional wrench in the works and that you are headed in the proper direction of calculating how much of that original deduction created the tax benefit. This page does give a cite to Treas Reg 1.111-(1)(b)(1), if that is helpful for you to know.  http://www.jeffjacobslaw.com/taxability-of-recovery-items-such-as-state-tax-refunds/

 

 

[Randall]

Thanks for the references.  This is what I had come up with too.  It's just a matter of what amount to include.

[Abby Normal]

jklcpa is correct. Going back to last year's tax return and reducing Sch A taxes by amount of refund is the way to go. You can print the resulting 1040 & Sch A as proof of amount taxable. Just don't save last year's return when you exit.

jklcpa, in your example the taxable amount should be $18 not $18k.

[jklcpa]

jklcpa, in your example the taxable amount should be $18 not $18k.

Late night brain fail.   

[Abby Normal]

 

Late night brain fail.   

That's what you get for choosing big numbers and not making the math easy on yourself.

[Abby Normal]

That's also why we use computers!!!