Refunds of Previously Deducted Items

If you recover or receive back an amount that you had already deducted on a prior year's return, you generally must report the recovered amount as income in the year you receive it. This rule saves you the trouble of having to file an amended tax return for the prior year.

State or local income tax refunds are the most commonly encountered items of this type. Therefore, they have been assigned their own line (Line 10) on Form 1040. If you itemized your deductions in the year to which the refund applies, you must report the refund as income on Line 10. If you did not itemize, you don't have to report the refund since you didn't gain any tax benefit from it. Federal tax refunds are not reported because you cannot claim an itemized deduction for your federal taxes.

This rule - the rule that you must report the refund or recovery only if you got some tax benefit from it in a previous year - applies generally to all types of refunds and recoveries, except that recoveries other than state and local tax refunds, credits and offsets are reported on Line 21 of Form 1040.

You only have to report recoveries of items to the extent that they helped your itemized deductions to exceed the standard deduction for the year in question.

Example In 2006, your filing status was single, which would have qualified you for a standard deduction of $5,150. Instead, you claimed itemized deductions of $5,550. In 2007, you received a $1,000 refund of state income tax. Since your itemized deductions minus your standard deduction was only $400, you must report $400 of the recovery as income for 2007. The remaining $600 of the recovery is not taxable.

If your deduction for the item was less than the amount you recovered, you only have to report a taxable recovery for the amount that you had actually deducted.

Example In 2006, your employee business expenses were $1,000, but since your adjusted gross income was $40,000, you faced the 2 percent of adjusted gross income limitation on miscellaneous deductions (including employee business expenses). So, you had to subtract $40,000 x .02 = $800 from the expense amount, to arrive at an allowable deduction of $200. In early 2007, your employer reimbursed you for $300 of your business expenses. Your taxable recovery is limited to the amount you deducted, or $200.

Taxpayers who itemized their deductions for the year to which the recovery applies, but had their deductions limited because they were high-income taxpayers, must go through some special calculations to determine how much of the recovery they must report. Basically, this involves determining how much of a deduction they would have been able to claim for the item if it were reported accurately, as compared to the amount they actually were able to claim for the item, taking the limitation into account.

Example In 2006, $9,000 in state income taxes were withheld from your paycheck, but you could only deduct $3,600 of these taxes because your itemized deductions were reduced by 3% of the amount by which your income exceeded $150,500. In 2007, you received a state tax refund of $2,000. If you had correctly reported your state taxes for 2006 as $7,000, your itemized deduction for taxes would have been $1,800. Therefore, the difference between what you actually claimed, and what you should have claimed, is your reportable recovery amount ($3,600 - $1,800 = $1,800).